How to avoid misclassifying workers who are independent contractors.

Improperly Classifying Employees as Independent Contractors: What are the Penalties?

Posted March 28, 2016 by Robert W. Ditmer in Keeping Compliant
Misclassifying employees as independent contractors is a serious issue that could cost your company money. Learn the penalties you need to avoid.

In response to our article regarding whether part-time or temporary workers are employees or independent contractors, one reader wrote the following:

I sit in a pod with 3 other full time employees doing the exact same work I'm doing. Company supplies a computer, a phone extension, an email address. I have to work 9 to 5:30 Monday through Friday, occasionally (sometimes often) staying late (at least I'm paid hourly). ... They had me sign a contract that said “I am not a full-time worker, company is not liable”, etc.

Was this individual really an independent contractor?

Well, an American Payroll Association instructor once told a class, “You can call a shark a guppy, but that won't stop him from biting you.”

Having a worker sign an agreement that states he is not an employee does not necessarily make it so. We've outlined what makes an independent contractor more thoroughly here. 

Update: We've built a comprehensive guide outlining all seven employee types. You can download it for free here.

Independent Contractors

What is an independent contractor?

This IRS publication clearly shows that the degree of control exercised by the employer determines whether or not a worker is an employee or independent contractor.

Let's examine these factors in light of the above scenario.

Behavioral Control

Does the employer have the right to control how the above worker does the work for which they were hired?

In this case, the employer specified when and where the worker worked, and what equipment they used. In addition, they were performing the same work as other workers who were treated as employees. So, the worker should have been paid as an employee.

Financial Control

An independent contractor is likely to have unreimbursed business expenses, have a significant investment in the facilities or tools they use, can make their services available to the relevant market, and is usually paid a flat fee.

The worker in the above scenario doesn't have business expenses, has no investment in the tools they are using, cannot make their services available to others because they are working full-time, and is paid hourly. Therefore, they are an employee.

Learn how to correctly classify all seven employee types.

Get the Guide

Type of Relationship

Under this factor the key point is that the services the worker was performing “are a key aspect of the regular business of the company.” Thus, this individual was an employee.

Why Do Employers Misclassify Employees?

The simple answer is money. By classifying a worker as an independent contractor instead of employee, an employer avoids the following expenses:

  • Employer's share of Social Security and Medicare taxes
  • Overtime pay
  • Employee benefits, including vacation, holiday, and sick pay
  • Unemployment compensation tax
  • Workers' compensation insurance

What Are the Penalties If an Employer Is Caught Misclassifying Employees?

First of all, how do employers get caught? A worker that believes they have been misclassified as an independent contractor may file a complaint with either their state Department of Labor or with the U.S. Department of Labor (DOL).

Some states may handle individual complaints, but the DOL usually only handles cases where there is a possibility other workers have been misclassified, and there has been a loss to a number of employees. A DOL investigation will include all employees and independent contractors for a three-year period.

An estimated 3.4 million employees are classified as independent contractors when they should be reported as employees.

The ramifications for an employer can vary depending on whether or not the DOL and the IRS determine the misclassification was unintentional or intentional, or even fraudulent.

If the misclassification was unintentional, the employer faces at least the following penalties based on the fact that all payments to misclassified independent contractors have been reclassed as wages:

  • $50 for each Form W-2 that the employer failed to file because of classifying workers as an independent contractor.
  • Since the employer failed to withhold income taxes, it faces penalties of 1.5% of the wages, plus 40% of the FICA taxes (social security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
  • 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.

If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties. For instance, the employer could be subjected to penalties that include 20% of all of the wages paid, plus 100% of the FICA taxes, both the employee's and employer's share. Criminal penalties of up to $1,000 per misclassified worker and 1 year in prison can be imposed as well. In addition, the person responsible for withholding taxes could also be held personally liable for any uncollected tax.

In 2009, misclassification cost the US an estimated $54 billion in underpayment of employment taxes.

The U.S. Government Takes This Issue Seriously

For example, the July 2011 newsletter of the American Bar Association stated: “By some estimates, contingent or temporary workers could reach 30-50 percent of the U.S. workforce. A federal study contends that an estimated 3.4 million employees are classified as independent contractors when they should be reported as employees. A 2009 study by the treasury inspector general estimated that misclassification costs the United States $54 billion in underpayment of employment taxes and $15 billion in unpaid FICA and unemployment taxes.”

In Fiscal Year 2013, DOL Wage and Hour Division investigations resulted in more than $83,051,159 in back wages for more than 108,050 misclassified workers in low-wage industries.

There have been some dramatic cases involving unpaid overtime and FICA taxes that were the result of employee misclassification.

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In December 2013, Norwood Commercial Contractors Inc. of Bensenville, Illinois, agreed to pay 96 workers $395,465 in back wages and liquidated damages. In March 2014, Empire Janitorial Sales and Services Inc. of Metairie, Louisiana, paid more than $277,500 in back wages to current and former workers employed by subcontractor Acadian Payroll Services LLC because of misclassifying 233 janitorial workers. And in May 2014, Paul Johnson Drywall Inc. of Phoenix, Arizona, paid $600,000 in back wages and penalties because it misclassified 445 current and former employees.

How Employers Can Protect Themselves

Endeavor to properly classify workers. If you are a Justworks customer, you have access to Justworks Concierge, with HR professionals at the ready to help you determine the best way forward with these complicated issues.

In addition, if when hiring a worker the worker and employer disagree on the individual's classification, the employer can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. While waiting for a determination from the IRS, the employer should treat the worker as an employee, withholding all necessary taxes.

Misclassification of employees as independent contractors is a serious issue. With Justworks' help you can avoid the consequences.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.