Understanding The Rules of Employee and Independent Contractor Classification

(Azarvand Tax Law) Businesses in the CNMI and Guam face critical decisions every day that can have significant consequences. Deciding whether to bring someone on as an employee or an independent contractor ranks among the most important choices business owners make. While classifying workers as independent contractors may seem more manageable—less paperwork, fewer taxes, more flexibility—failure to classify correctly can lead to serious legal trouble.

The applicable federal laws apply entirely in both CNMI and Guam. As U.S. territories, businesses operating in these jurisdictions must comply with federal tax laws administered by the Internal Revenue Service and federal labor laws enforced by the Department of Labor. The IRS may implement penalties, interest, or even jail time in some circumstances for misclassification. This guide is designed to help CNMI and Guam business owners avoid that mess and determine who should receive a Form 1099-NEC (“1099”)  and who truly needs a Form W-2.

Independent contractors have greater autonomy and control over their work than employees, functioning like their own bosses. They are typically hired to perform specific tasks or services, but how they complete the work is primarily up to them. They set their own hours, meaning they usually decide when and how long they work, without needing to clock in or out. They also often use their own tools or equipment, such as laptops, trucks, or specialized gear. Importantly, independent contractors can work with multiple clients simultaneously since they usually aren't bound exclusively to a single business. For most independent contractors, there's no benefits package: no health insurance, paid time off, or retirement contributions. They typically submit invoices for payment and receive a 1099-NEC form at tax time. This requires them to manage all their own taxes, including self-employment tax, since no taxes are withheld from their payments.

Employees are under the control of the entity they work for. The employer sets the schedule, determines how the work should be completed, and provides the necessary tools or workspace. Typically, employees work primarily for one entity. Employees may receive benefits that are not offered to independent contractors, including employer-sponsored health insurance, paid time off, retirement savings plan contributions such as 401(k) matching, and other workplace benefits. 

Importantly, employers are responsible for withholding federal income taxes and Social Security and Medicare (“FICA”) contributions directly from employee paychecks, unlike independent contractors. Employers must also pay 50% of the employees' FICA liability, unlike independent contractors, who instead must pay an equal amount to FICA in Self Employment Tax (also funding Social Security and Medicare). Additionally, independent contractors, unlike employees with no self-employment income, are generally required to file Form 1040-SS with the IRS if their self-employment income exceeds just $400. 

How Do You Decide Which Classification to Use?

The IRS makes it crystal clear: no single factor is determinative. The determination requires a comprehensive evaluation of all relevant factors and circumstances. Whether your business operates in Saipan, Tinian, Rota, or anywhere in Guam, the IRS examines the entire working relationship through three key categories: behavioral control, financial control, and the type of relationship.

1. Behavioral Control examines whether the business controls what the worker does and how the work is done. Does the business dictate work hours, tools used, or procedures followed? If you, as a business owner in CNMI or Guam, can direct and control when, where, and how a worker performs their job, including the specific techniques they must use and the procedures they must follow, the worker may be an employee. Independent contractors typically have more freedom to determine how they complete their work.

2. Financial Control looks at who controls the financial aspects of the job. How is the worker paid? Are expenses reimbursed? Is there a risk of financial loss for the worker? Employees are generally paid a regular wage or salary, and the employer may provide the necessary tools and products. In contrast, independent contractors usually invest in their own tools, cover their own expenses, and are often paid a flat fee per job or project. They have the opportunity to realize a profit or incur a loss based on their own business decisions.

3. Type of Relationship considers what the contract says, whether the work is ongoing or for a set term, and whether benefits like health insurance or retirement are included. Key factors include whether there is a written contract, the permanency of the relationship, and whether the work performed is a key aspect of the business's operations. A long-term relationship in which the worker provides essential services and is integral to operations may indicate an employee relationship. If the worker is hired for a specific project with a precise end date and there is no expectation of ongoing work, they may be considered an independent contractor.

The greater the degree of control a business exercises over the methods, timing, and scope of work performed, and the more closely the working relationship mirrors conventional employment arrangements, the stronger the indication that the worker should be classified as a W-2 employee rather than an independent contractor. This principle applies uniformly across all U.S. states and territories.

The IRS makes the final determination regarding the tax treatment of workers. A worker can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, for any tax year within the statute to do so. If the balancing factors indicate that an independent contractor should be classified as an employee, despite their employer issuing a 1099, the worker may still be entitled to the legal rights and tax treatment of a W-2 employee, and the employer can be liable for significant penalties and interest under federal law, as well as repayment of the FICA that should have been paid. In cases of intentional worker misclassification, jail time is possible. 

Is It the Same with the Department of Labor?

Not exactly. While the IRS focuses on how taxes are handled, the Department of Labor examines whether a worker is entitled to protections under laws such as the Fair Labor Standards Act, which covers aspects like minimum wage, overtime, and rest breaks. The FLSA applies to CNMI and Guam employers, meaning workers in these territories are entitled to the same federal protections as workers in the 50 states. The DOL uses its own test for determining classification, often applying a stricter "economic realities" standard.

The economic realities test asks a fundamental question: Is the worker economically dependent on the employer, or are they truly in business for themselves? This test examines factors such as whether the work is integral to the employer's business, the worker's opportunity for profit or loss based on their own initiative and investment, the permanence of the working relationship, and the nature and degree of control the employer exercises. Under this framework, even workers with significant day-to-day autonomy may still be classified as employees if they are economically dependent on a single business for their livelihood.

A worker in CNMI or Guam might be treated as an independent contractor for tax purposes but still qualify as an employee under federal labor law. Even if you aren’t assessed with IRS penalties, the DOL has its own penalties that it enforces throughout all U.S. territories and states alike.

What Are the Consequences of Misclassifying?

The IRS and DOL take worker classification seriously throughout all U.S. territories, and the consequences can be steep, even for honest mistakes. When workers in CNMI or Guam are misclassified, the consequences can be severe and long-lasting, potentially including penalties, accrued interest, increased FICA taxes, and even prison time if the misclassification is believed to have been done intentionally. It is also important to note that in instances of willfulness, the person responsible for withholding taxes could be held personally liable for any uncollected tax.

Even without any bad intent, penalties can add up quickly. In accordance with the Internal Revenue Code, even if an employer filed proper Forms 1099 for the workers, the reduced penalties include 1.5% of wages for failure to withhold income taxes and 20% of the employee's share of FICA taxes that were not withheld. However, if the employer failed to file required Forms 1099 or W-2, the penalties increase significantly: 3% of wages for failure to withhold income taxes and 40% of the employee's share of FICA taxes. In either scenario, the employer also owes 100% of the employer's matching share of FICA taxes, plus a failure-to-pay penalty of 0.5% of the unpaid tax liability for each month, up to 25%. Interest also accrues on these penalties from the original due date. Additionally, the IRS imposes penalties for each missing Form W-2.›

If the IRS believes the misclassification was willful or fraudulent, the reduced rates mentioned above do not apply at all, and the employer faces full liability for all taxes that should have been withheld and paid. Criminal penalties may include up to one year in prison and fines. The penalties for failing to file required Forms W-2 also increase. Additional fines and penalties from the Department of Labor of $10,000 - $25,000 per employee, are also possible in cases of intentional misclassification. 

Taking Action

To avoid the pitfalls of worker misclassification, business owners in CNMI and Guam should review the classification of their workers regularly, assess the degree of control they have over each worker, examine the financial arrangements, and evaluate the nature of the relationship. Remember that federal law governs these determinations, and compliance with IRS and DOL requirements is not optional—it is mandatory for all businesses operating in U.S. states and territories alike. Correctly classifying workers as employees or independent contractors is essential for maintaining legal compliance, avoiding financial penalties, and ensuring the smooth operation of your business. 

For personalized advice based on your specific circumstances, contact Azarvand Tax Law at Info@AzarvandTaxLaw.com or book a free 30-minute consultation at AzarvandTaxLaw.com.