A key compensation issue is whether someone is an employee or a contractor, since the reporting of income to the IRS varies considerably for each one, as do the tax withholding requirements of the employer. The defining criteria that establishes a person as an employee is when the company controls not only the types of work done by the person, but also how the work is done. An employer also controls the type of work done by a contractor, but not how the work is done. Other supporting evidence that defines an individual as a contractor is the presence of a contract between the parties; whether the contractor provides similar services to other clients; and whether the contractor is paid based on the completion of specific tasks, rather than on the passage of time.

An employer may be tempted to categorize employees as contractors even when it knows this is not the case, since the employer can avoid matching some payroll taxes by doing so. However, taking this approach leaves an employer liable for all the federal income, Social Security, and Medicare taxes that should have been withheld. Consequently, strict adherence to the rules governing the definition of an employee and contractor should be followed at all times.