What are the penalties for misclassification of workers?

By improperly classifying a worker, you may:

  • Put yourself at risk of paying the worker incorrectly or not paying necessary workers’ comp premiums
  • Not record work time accurately
  • Fail to file the appropriate federal and state tax forms
  • Fail to file the required contributions to retirements plans
  • Not provide the applicable OSHA or NLRA protections. 

Furthermore, you may not have given the worker the right benefits notices and statements, and you may be in noncompliance with the ADA. 

This is only a partial list of the possible mistakes, and the penalties for making them can add up quickly. Misclassifying employees as independent contractors and failing to provide W-2 forms, for example, can cause your business to end up owing as much as 41.5% of the independent contractor’s wages in the form of back taxes going back as far as three years. 

The penalties can be much more severe if the IRS determines that you misclassified workers intentionally, but generally this is not a problem for business owners who try to do the right thing.  

The US Department of Labor also charges back taxes and fines for improper record-keeping and will audit your business for other violations, which can lead to even more penalties. State insurance agencies will also seek back payment on unemployment and workers’ comp premiums and charge you more fines. Finally, a misclassification may raise your company’s health insurance premiums. 

As you can see, this is not a matter to take lightly. Correctly classifying employees and independent contractors can make or break your entire business, and that’s why it’s vital that you understand…

How can you tell the difference between an employee and an independent contractor?

Broadly speaking, the rule of thumb to keep in mind is that if you, as the person paying the worker, have the right to control or direct only the result of the work, but not how it gets done, then the worker may be an independent contractor. 

On the other hand, if you have the right to control or direct details of how the service is performed, you will likely have hired an employee.

However, this rule of thumb is just that, and it is not always applicable to every situation. In determining whether a person providing service is an employee or independent contractor, small businesses should consider all information that offers evidence of the degree of control and independence in the relationship between the employer and worker. 

You should consider three areas: Behavioral control, financial control, and your relationship with the worker. 

Behavioral control categories are:

  • Type of instructions given. When and where to work, what tools to use, or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate that a worker is an employee.
  • Degree of instruction. More detailed instructions may indicate that the worker is an employee. Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
  • Evaluation systems to measure how the work is done point to an employee. Evaluation systems measuring just the result point to either an independent contractor or an employee.
  • Training a worker on how to do the job — or periodic or ongoing training about procedures and methods — is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

When it comes to financial control, you should consider: 

  • Significant investment in the equipment the worker uses in working for someone else.
  • Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
  • Opportunity for profit or loss is often an indicator of an independent contractor.
  • Services available to the market. Independent contractors are generally free to seek out business opportunities.
  • Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time, even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

Lastly, the type of relationship depends on how the worker and business perceive their interaction. This includes:

  • Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
  • Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay, have employees. Businesses generally do not grant these benefits to independent contractors.
  • The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
  • Services provided are a key activity of the business. The extent to which the worker performs services is seen as a key aspect of the company’s regular business.

Is it better to hire an employee and independent contractor?

The answer to this question depends entirely on your circumstances. Your business priorities, cash flow, and the type of relationship you wish to maintain with the worker are all factors you should consider in making this decision. 

Independent contractors typically fill specific task roles or do specialized projects. If the work you require is inconsistent, seasonal, or short-term, you will most likely want to hire an independent contractor. Work you will need regularly but will remain limited in scope and time may also call for hiring this type of worker. 

On the other hand, hiring an employee may be the right choice if you want continuity, consistency, and control over how the work gets done. 

What are the advantages and disadvantages of each type of hire?

Employees and independent contractors can both offer benefits and challenges. 

For example, hiring employees can be the costlier choice, with plenty of considerations beyond just wages. You will be paying your employee’s Social Security and Medicare taxes upfront and may need to provide benefits, insurance, or paid time off. You will also have to provide resources, training, and tools for your employee, and terminating an employee is more complex than a contractor. 

There are benefits to this type of hire, which can drive down costs in the long term. Employees are often more loyal and can add increasing value as they gain experience over time, whereas constantly hiring, training, and managing new independent contractors can be a time-consuming distraction. 

On the other hand, because an independent contractor is self-employed or employed by others, you are not responsible for withholding payroll taxes nor providing benefits or overtime. Additionally, independent contractors are usually already well-trained and experienced in the type of work you hire them to complete, so you don’t need to provide training or resources. 

However, although hiring an independent contractor offers you more flexibility, it gives you less control. They will conduct the work autonomously, and although you can set deadlines for deliverables, you cannot oversee the day-to-day execution of the work nor set hours or dictate how the work gets done. There are some legal considerations, too: if an independent contractor suffers an injury on the job, you could be liable. Finally, when an independent contractor completes the job and leaves, their expertise goes, too. 

As you can see, the type of worker you choose to hire depends on the kind of work you need to be done and the relationship you wish to have with the worker. Whether you decide to hire an employee or an independent contractor, however, it is vital that you understand which you are hiring and why. The consequences for misclassifying an employee are dramatic. 

Would you like some help?

If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.

If you aren’t a client, why not? We can take care of your accounting, bookkeeping, tax, and CFO needs so that you don’t have to worry about any of them. Interested? Contact us here to set up a no-obligation consultation.

Stay informed

Interested in receiving updates in your mailbox? Check out our newsletter, full of information you can use. It comes out once every two weeks, and you can register for it below.