Many businesses struggle with the proper classification of employees vs. contractors. The IRS, unfortunately, has very specific ideas about which workers are independent contractors, and which are actual employees. Failing to fall in alignment with their thoughts on the matter, could land your small business in some seriously hot water. It can also result in an employee misclassification lawsuit.
What’s the Big Deal about Misclassifying Employees?
Under the Fair Labor Standards Act (FLSA), employers are required to provide certain benefits to employees they are not required to offer to independent contractors. Chief among these are overtime benefits for work that goes beyond certain hours. The FLSA addresses many issues in addition to overtime pay including minimum wage, record keeping requirements, and youth employment standards.
Some companies make honest mistakes in determining employee status, while others deliberately look for loopholes and technicalities. The rule of law, though, is clear about which workers meet the qualifications of employees.
The determination rests largely on the degree of control businesses exercise over the people who work for them and the ability of those workers to work for other businesses. According to the IRS, the following simple questions can clear up any confusion.
- Does the business in question exercise control of (or maintain the right to exercise that control) what workers do and how workers perform their jobs?
- Does the business determine the business aspects of the job such as how workers are paid, expense reimbursements, and the provision of tools and supplies?
- Is there a written contract?
- Does the business offer benefits that resemble employee benefits?
- Is the work performed by individual workers key to the business?
Unfortunately, for many small businesses, these clarifications are about as clear as mud. Even the IRS admits that extenuating circumstances may also play a determining role.
That being said, those who knowingly treat employees as independent contractors could face stiff penalties not only in fines and penalties from the IRS, but also in civil litigation. A federal judge in the state of Colorado recently awarded two million dollars to workers in the oil and gas industry who were denied overtime pay due to misclassification.
In the case mentioned above, workers were required to work upwards of 70 hours per week without overtime pay (which effectively prevented them from seeking work elsewhere), due to their classifications as independent contractors. Additionally, the business controlled when and how employees did their work, issued pay, disciplined workers, supervised workers, and required them to perform duties as they would require employees while identifying them as independent contractors.
Fines for Misclassification of Employees
Since not all instances of misclassification are intentional, there are different penalties assessed for unintentional misclassifications and intentional misclassifications.
The big fee is in the form of back taxes for which the employer may be responsible for paying up to 41.5 percent of the contractor’s wages for up to three years.
Employers who unintentionally misclassify employees could face up to $50 per employee for failing to provide appropriate W-2 or 1099 form and 1.5 percent of all wages plus daily interest plus 40 percent of the FICA contribution employees should have made plus 100 percent of the FICA contributions employer should have made. Additionally, even unintentional violations are required to pay penalties for failure to pay taxes (this is in increments of 0.5 percent of unpaid tax debt per month up to 25 percent of the total) and $50 for each failure of employer to obtain social security numbers of employees.
The bottom line for business is that it pays to get the classifications right the first time. When mistakes do occur, though, you need to make sure your business is covered by the protection employment practices liability insurance (EPLI) provides.