Knowing the difference between your employees and contractors can mean the difference between compliance and penalties. Misclassifying employees is a serious mistake that has costly consequences for employers. Failure to classify workers correctly can subject an employer to civil penalties, class action lawsuits, back taxes, fines, and more. Additionally, if the misclassified employee should have been entitled to benefits, employers may find themselves answering to the IRS for ACA non-compliance as well.
Why not just classify all workers as an employee to be on the safe side? Classifying workers as independent contractors relieves an employer from responsibility for payroll taxes, social security, Medicare, workers’ compensation, ACA compliance requirements, and other withholdings that employees are entitled to. Utilizing independent contractors can also reduce OSHA obligations for some employers, as well as reduce the likeliness of discrimination cases, as only workers classified as employees are protected by Title VII. According to a 2013 report from the Treasury Inspector General for Tax Administration, employers save an average of $3,710 per employee earning an annual income of $43,007 when they misclassify the employee as an independent contractor.
For employers, utilizing independent contractors is a great benefit, but also a huge risk. Consider these factors when deciding how to classify a new-hire, or when reviewing current employee classifications:
- Does your company control or have the right to control what the worker does and how the worker does his or her job?
- Are there employee-type benefits available for the worker such as a pension plan, insurance, vacation pay, etc.?
- Are all of the business aspects of the worker’s job controlled by the company? Facets such as how and when the worker is paid, expense reimbursement, and supplies provided?
- Is the work performed a key aspect of the business, and will the relationship continue past a designated amount of time or projects?
If the answer to any of these questions is yes, it’s likely that the worker is an employee rather than an independent contractor, however different government agencies and courts use different tests to determine if a worker is an employee or an independent contractor. In California, the state agencies that are most involved with the determination of independent contractor status are the Employment Development Department (EDD), which is concerned with employment-related taxes, and the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour and workers’ compensation insurance laws apply. Adding to the complexity, other agencies, such as the IRS, the Department of Labor, the Franchise Tax Board, and the Contractors State Licensing Board also have regulations concerning independent contractors.
According to the United States Government Accountability Office, up to 30% of audited firms had misclassified at least some employees. When a worker is misclassified and a lawsuit is decided in their favor, the employer will be ordered to pay back wages, back payroll taxes, fines, fees, and more. In addition, there’s a strong likelihood that the company will have auditors checking in more frequently. The exact ramifications for the employer will vary, depending on whether or not the agencies involved in the case determine if the misclassification was unintentional, intentional, or fraudulent.
Regardless of the intention of the misclassification, the employer faces – at minimum – the following penalties and fines:
- $50 for each Form W-2 that the employer failed to file due to misclassification.
- 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 there is evidence of fraud or intentional misclassification, the governing agencies involved can impose additional fines and penalties, including criminal penalties of up to $1,000 per misclassified worker, the full amount of taxes not withheld, or even time in prison.
For many employers – especially small business owners – the best way to minimize their chance of misclassification is to use a Professional Employer Organization (PEO). A PEO can provide payroll, benefits, HR services, and assist with compliance issues under state and federal law. This allows business owners to improve productivity and profitability, focus on their core mission, and grow their company, while the PEO maintains the regulatory compliance.
Emplicity understands that HR
Outsourcing should be simple and meaningful. As a Professional Employer Organization (PEO), we strive to be a great partner in supporting your business. If you would like to request more information on how we can assist your needs, please reach out to us at 877-476-2339. We are located in California – Orange County, Los Angeles, and the greater Sacramento and San Francisco area.
NOTICE: Emplicity provides HR advice and recommendations. Information provided by Emplicity is not intended as a substitute for employment law counsel. At no time will Emplicity have the authority or right to make decisions on behalf of their clients.