Employee Misclassification: A Costly Mistake You Can’t Afford to Make

Independent Contractor Employee

Relying on independent contractors to meet the needs of your business is perfectly acceptable. You may require freelancers, consultants, contractors, 1099ers, project workers, temps or specialists to supplement your staff and get the work done.

What’s not acceptable, however, is wrongly classifying employees as independent contractors to cut costs. And it’s happening more and more in companies across the nation. According to the National Employment Law Project (NELP), approximately 3.4 million workers are misclassified as independent contractors.

Whether you’ve done it intentionally or it’s an honest oversight, misclassification carries a heavy financial risk. In fact, the costs you save initially – from Social Security and Medicare taxes to unemployment insurance premiums – could add up to a hefty amount of back taxes and penalties down the road.

Federal and state crackdown

More vigorous enforcement by the Department of Labor (DOL) means every employer needs to be on high alert with the classification rules. Since 2008, the DOL has hired thousands of additional investigators to “detect and deter” companies from misclassifying employees as independent contractors.

At the same time, many state agencies are entering into a memorandum of understanding (MOU) with the DOL under the “Misclassification Initiative” to share information and coordinate their enforcement efforts.

Under these arrangements, if a state agency finds out an employer is misclassifying workers to skirt unemployment taxes, for example, the DOL will be contacted. As a next step, the DOL can then investigate the employer to determine if it’s also evaded federal taxes. Currently, the DOL has MOU’s or Partnership Agreements with several states that establish a collaborative relationship to promote compliance.

These combined efforts are clearly making an impact. In 2017, DOL investigations led to more than $86 million in back wages for 97,000 classified workers in low-wage industries, such as janitorial, food, construction, day care and hospitality.

The costs add up

If you’ve wrongly classified a worker, the risk of getting caught is always present. All it takes is a worker to file a complaint with either the state labor agency or federal DOL. Some states may take on individual complaints, while the DOL will most likely step in if more than one worker is involved and/or there’s a more sizable loss.

The consequences vary, depending on whether the DOL and IRS deem the misclassification intentional or unintentional.  In the case of unintentional classification, you could incur the following penalties:

  • $50 for the Form W-2 that wasn’t filed because of the improper classification
  • 1.5% of the wages (since income tax wasn’t withheld), plus 20% of the Social Security and Medicare (FICA) taxes the employee should have paid and 100% of the matching taxes the employer should have paid
  • A “failure to pay taxes” penalty of 0.5% of the unpaid tax liability for each month, up to 25 percent of the total tax liability
  • These are only a few of the penalties listed as more may apply

If the IRS suspects fraud or intentional misconduct, you could be looking at additional fines and penalties – including as much as 20 percent of the worker’s wages and 100 percent of the FICA taxes (both the employee and employer’s portion). If the IRS suspects fraud or intentional misconduct, you could be looking at additional fines and penalties – including up to $500,000 in fines and possible criminal penalties resulting in jail time.

Get familiar with the guidelines

Obviously, it’s never been more important to get worker classification right. For a refresher on the classification rules, please see Independent Contactor vs. Employee at efile4biz.com. The IRS uses Common Law Rules to determine worker status. As a general rule, the more control you have over the worker – and the worker’s contributions to the business – the more likely the worker is an employee and NOT an independent contractor.

For detailed guidance, consult your tax professional.

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