What Are the Consequences of Misclassifying Your Employees?

by | Published on May 22, 2019 | Workers Compensation

Workers’ compensation insurance and unemployment insurance are valuable programs that help employees who are out of work for temporary periods due to injuries or lay-offs. Workers’ compensation is paid only after the injury or illness is proved and involves formalities such as medical record retrieval and medical record review. Given the value of this insurance program for workers, it is unfortunate that some employers misclassify workers as independent contractors rather than employees with a view to avoiding workers’ compensation and unemployment insurance coverage for those workers, and also to avoid paying unemployment and other taxes on workers. An independent contractor needn’t be paid overtime, or even the minimum wage. Moreover, an independent contractor cannot join a labor union. This highlights the importance of understanding the difference between an employee and an independent contractor.

Apart from having negative consequences for the workers themselves, such misclassification doesn’t bode well for state and federal governments. This is because they will lose billions of dollars in tax revenue. The IRS (Internal Revenue Service) estimates that payroll fraud including misclassification is costing the federal government $16 billion each year in lost taxes from employers. Misclassification is also responsible for thousands of wage-theft violations resolved by the Department of Labor each year.

What is the difference between a regular employee and an independent contractor?

  • In the simplest terms, if the employer has the right to control the work, the worker is an employee and not an independent contractor. In addition, the employer can exercise behavioral and financial control over an employee but cannot do so over an independent contractor.
  • Freelancers are independent contractors. An independent contractor is a small business owner and the company they work for is one of their clients, and not employer. By legal standards, an independent contractor can do business with as many companies as he/she would like and can have their own business card. They can advertise, have a business location, and have their own schedule. Independent contractors usually get paid a flat fee for the work they do but don’t get a regular paycheck. They don’t have a supervisor either.

Employers misclassifying their employees are at considerable risk, if they get caught. Typically, this happens when a worker who thinks he/she has been misclassified as an independent contractor files a complaint with the U.S. Department of Labor (DOL) or with their state Department of Labor. Or it may happen when a worker who has been misclassified files for unemployment benefits, or a worker injured on the job files a workers’ compensation claim. Besides these, state/federal agencies may perform audits to identify such misclassifications. Once caught, the consequences for an employer may vary depending on whether the misclassification is judged as unintentional, intentional, or even fraudulent.

If the IRS and the DOL finds that the misclassification was unintentional, the following penalties may be imposed.

  • Penalty for each Form W-2 that the employer failed to file because of the misclassification.
  • Tax related penalties since the employer failed to withhold income taxes. This could be 1.5% of the wages, plus 40% of the FICA (Medicare and Social Security) taxes that were not withheld from the worker, and 100% of the matching FICA taxes the employer ought to have paid. In addition, there will be interest accrued on these penalties daily starting from the date on which they should have been deposited.
  • There may also be a Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

Additional fines and penalties could be imposed if the IRS believes that there is intentional misconduct or fraud involved. The penalties could include 20% of all of the wages paid along with 100% of the FICA taxes (both the employee’s and employer’s share). More seriously, criminal penalties up to $1,000 for each misclassified worker along with one year in prison could be imposed. The person found responsible for withholding taxes due to the government may even be held personally liable for uncollected tax.

Misclassification of employees as independent contractors shouldn’t be taken lightly. It is a serious issue with grave consequences. It could lead to lawsuits and related expenses in the form of legal costs, punitive damages, and huge compensation amounts. Whether you own a law firm, an insurance company, a medical review company, a media organization or any other, you need to ensure that all employees are classified correctly. Apart from the heavy fines and penalties, employers found guilty of misclassifying employees also face the risk of losing their valuable reputation. It is difficult to play down the reputational damage caused, and therefore employers have to be very cautious.

Disclaimer:  The above content has been prepared for informational purpose only and does not constitute legal or tax advice. If you have any legal or tax related questions, please consult a professional legal or tax advisor.

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