At the start of the year, the Internal Revenue Service (IRS) and the U.S. Department of Treasury (the Treasury) issued guidance in several areas to assist employers and employees in revenue procedures, employer deductions for medical leave and retirement plan enrollment.
This highlights the importance of fully understanding the differences between employees and contractors according to IRS definitions and to review the recent guidance so that procedures are followed correctly.
IRS Rules for an Employee vs. an Independent Contractor
The classification of an employee or contractor depends on the relationship of the person hired to perform a task and business or entity that did the hiring:
IRS Definition of an Employee
According to the IRS definition, an employee — sometimes referred to as a common-law employee — is any person that carries out a service for an employer as long as that employer has control over what tasks will be completed and how, even if the employee has freedom of action. Meaning if you hire someone to complete a service and you have the right to control how that service is performed, you would be considered the employer and the person hired, the employee.
Employee status is not determined by the label of the position you hired for and is instead determined by the level of control you have as an employer. For instance, hiring for either a full-time or part-time position would not prevent the person hired from being classified as an employee under common law.
IRS Definition of an Independent Contractor
IRS rules state that a person qualifies as an independent contractor if the client paying for the service provided only has the authority to oversee the completion of the work and the overall outcome. This is different from an employee where the employer can control the method of completion or processes used to finish the assigned task.
It is also important to note that independent contractors are considered to be “self-employed,” making their earnings applicable for the self-employment tax.
What Is the Difference Between an Independent Contractor vs. an Employee?
One key difference is that an employee has their wages reported on a W-2 form annually with employment taxes paid under a prescribed schedule and reported quarterly on Form 941, while an independent contractor receives a Form 1099-NEC from the entity to whom services are rendered with no tax withholding.
There are also a few other ways an employee differs from a contracted worker:
|
Employee |
Contractor |
|
Employer has control over what work is completed and how |
Client oversees the completion of the service but only has control over the outcome of the work |
|
Hired by another person, business or entity |
Self-employed |
|
Paid a salary or wage |
Paid based on the service completed |
|
Income is reported using a W-2 form |
Receives a Form 1099-NEC from clients |
Highlights of Guidance Effective Now or in 2026
Learn more about recently released guidance and how these rulings could affect you and your employees or contractors.
Revenue Procedure 2025-10
Employers must classify workers as employees or independent contractors to determine proper income and employment tax reporting and withholding. As mentioned above, an employee is subject to income and employment tax withholding, while an independent contractor is not.
Section 530 of the Revenue Act of 1978 exempts an individual who has been treated as an independent contractor but is, in fact, an employee from reclassification if certain requirements are met. Revenue Procedure 2025-10 modifies and supersedes a 1985 revenue procedure by providing updated guidance regarding these rules.
Taxpayers treating individuals who are employees as independent contractors should review these rules to see if reclassification would not be required and if the service recipient is protected from penalties for the erroneous classification. In many cases, the rules will not be able to be met, and employers should consider filing a request for reclassification through the Voluntary Classification Settlement Program (VCSP).
This program allows the employer to reclassify workers as employees prospectively and provides audit protection from reclassification for prior years by paying a normal sanction amount. Generally, the program is available to any person or entity not currently under an employment tax audit, making it essential to review these issues before the IRS examines the taxpayer.
Revenue Ruling 2025-6
Many states have enacted state-administered family and medical leave programs to provide wage replacement to certain workers for periods in which they need to take time off from work due to:
- Recovering from non-occupational injuries, illnesses or medical conditions
- Caring for a family member with a serious health condition
- Other prescribed circumstances
These benefits are funded with employee and employer contributions made to a fund operated by the state. In some cases, the employer can pay the employee’s share of the contributions.
The ruling deals with the employer’s deductions for these required contributions, the employee’s income recognition for contributions and benefits received through the program and required income and employment tax withholding. Given the variety of programs, it is best to review the specific state program and employer arrangement to determine deductions, income inclusion and withholding and reporting requirements.
The ruling provides that 2025 is a transition year so employers can determine the rules' application to their programs and properly configure payroll reporting and withholding systems to reflect them. Employers should review these programs now to ensure that proper withholding and reporting occur in 2026.
Proposed Regulations for Auto-Enrollment in Newly Established 401(k) and 403(b) Plans
For plans established after December 29, 2022, a plan must automatically enroll the employee in its 401(k) plan at an initial contribution rate of at least 3% of the employee’s pay, unless the employee opts out. The plan must also automatically increase the initial contribution rate by one percentage point each year. This automatic increase continues until the contribution rate reaches at least 10% of pay.
These rules do not apply to church plans, governmental plans or plans established by certain small businesses. While the regulations will not apply until more than six months after final regulations are issued, employers and plan administrators should apply a reasonable, good faith interpretation of the statute before that time.
If an employer has adopted a plan after December 29, 2022, and is not otherwise exempted from the rules, it is important to review plan operations to ensure automatic enrollment is occurring.
Proposed Regulations for Certain 401(k) Catch-Up Contributions
Under recent tax law changes, catch-up contributions made by certain higher-income participants must be designated as after-tax Roth contributions. Additionally, there is an increased catch-up contribution limit for employees between the ages of 60 and 63 and those in newly established Savings Incentive Match Plan for Employees (SIMPLE) plans.
Any individual whose Form W-2 from the employer sponsoring the plan for the prior year included social security wages that exceeded $145,000 will need to make catch-up contributions as Roth contributions.
The IRS previously deferred the requirement for these catch-up contributions to be Roth contributions until 2026. Partners and others without social security wages are not subject to this requirement. In addition, if an employer 401(k) plan does not permit Roth contributions, then plan participants subject to this requirement will not be able to contribute.
The increased catch-up contribution for those ages 60 – 63 is available for taxable years beginning after December 31, 2024. For 2025, that amount is $11,250 for a 401(k) plan and $5,250 for a SIMPLE plan.
Employers that do not currently have plans permitting Roth contributions will need to consider amending their plans to allow for these contributions. Alternatively, they may choose to restrict employees who earned more than $145,000 in Social Security wages in the prior year. These employees cannot make catch-up contributions if the plan is not amended.
Your Guide Forward
Reach out to your trusted Cherry Bekaert tax advisor if you have questions or need assistance navigating how these changes impact your business.
Related Insights
