The Cost of Misclassifying Employees and Contractors
The rise of remote work has made it easier than ever to bring in a contractor to help with overflow work or expand your capabilities on a short-term basis. However, while this flexible model works well for businesses of all sizes, it also opens the door to a costly mistake:
Misclassifying employees as independent contractors (or vice versa).
Classifying workers incorrectly can result in significant financial and even legal consequences, from IRS penalties and back taxes to liability for unpaid benefits and even potential lawsuits. So properly classifying employees and contractors isn’t just a compliance issue — it can seriously affect your bottom line.
If you’re unsure whether your workers are classified correctly, or you want to make sure you have the proper information when it’s time to bring on new help, here’s what you need to know about worker classification, and how to avoid costly errors.
Why Worker Classification Matters
The primary distinction you need to make among your workers is whether they’re employees or independent contractors. This distinction affects a number of things, from how a worker is paid and taxed to whether they’re entitled to certain benefits and protections:
- Employees are on your payroll. You withhold income taxes, pay Social Security and Medicare taxes, and often provide benefits such as health insurance, retirement plans and paid time off.
- Independent contractors are self-employed. They typically invoice you for their services, handle their own taxes and are not entitled to employee benefits.
What’s the Legal Standard?
There is no single, clear-cut definition across all federal and state agencies. But generally speaking, the IRS and DOL focus on common-law rules determining the degree of control and independence in the working relationship.
The IRS Three-Factor Test
The IRS, per IRS.gov, relies on common-law rules that break the nature of a work relationship into three categories:
- Behavioral control: Do you control (or have the right to control) what the worker does and how they do their job?
- Financial control: Do you control how the worker is paid, whether expenses are reimbursed, and who provides tools or supplies?
- Type of relationship: Are there written contracts? Does the worker receive benefits? Will the relationship continue indefinitely?
If the answer to these questions leans heavily toward employer control, the worker is likely an employee — not an independent contractor.
The DOL’s Economic Realities Test
The Department of Labor (DoL) uses a slightly different “economic realities” test, looking at whether a worker is economically dependent on the employer or truly in business for themselves. The factors, according to the DoL, are:
- Opportunity for profit or loss depending on managerial skill
- Investments by the worker and the employer
- Permanence of the work relationship
- Nature and degree of control
- Whether the work performed is integral to the employer’s business
- Skill and initiative
Misclassification, even if accidental, can lead to violations of the Fair Labor Standards Act (FLSA), which guarantees minimum wage and overtime pay to employees.
What Misclassification Can Cost You
The financial fallout of misclassifying a worker can be significant, and includes:
1. Back Taxes and Penalties
If the IRS determines you misclassified a worker, you may be liable for back payment of federal income tax withholdings, the employer and employee share of Social Security and Medicare taxes, unemployment taxes, interest and failure-to-pay penalties.
2. Wage and Hour Claims
Misclassified workers may claim they were denied overtime or minimum wage. Employers may be required to compensate the worker for unpaid wages, plus interest and possible damages.
3. Benefits Liability
If a misclassified worker should have been offered benefits like health insurance, retirement contributions or paid time off, you could be on the hook for those costs, retroactively.
4. State-Level Consequences
States have their own labor laws and tax obligations. A single misclassification can result in penalties from multiple state agencies, including departments of revenue, labor and unemployment insurance.
5. Legal Fees and Reputational Damage
If a misclassified contractor sues, you could face court costs and legal fees. Even if you prevail, a drawn-out legal battle can harm your company’s reputation.
Common Misclassification Mistakes
Even well-meaning businesses can get classification wrong. Here are some common missteps:
For instance, some companies assume that a title alone defines a worker’s status. But simply calling someone a freelancer or consultant, for instance, doesn’t make them a contractor in the eyes of the IRS or Department of Labor.
Similarly, issuing a Form 1099 instead of a W-2 doesn’t in and of itself override legal classification standards.
Sometimes the issue occurs over time. For instance, a contractor relationship can eventually evolve into an employee relationship, especially if the contractor takes on core responsibilities or reports to a manager regularly.
Best Practices to Stay Compliant
The good news: You can avoid most classification pitfalls by taking a few proactive steps.
- Use written contracts (but don’t rely on them alone): A written agreement can clarify the terms of the relationship, but it won’t protect you if reality doesn’t match contract language. Make sure the actual working conditions support the classification.
- Conduct regular classification audits: Review your workforce annually. If you’ve added new contractors or changed the scope of work for existing ones, reassess whether their classification is still accurate.
- Keep detailed records: Maintain documentation on how you determined a worker’s status, including job descriptions, contracts and correspondence.
- Consult with professionals: Employment law and tax classification are nuanced areas. Work with an accountant, HR consultant or employment attorney to ensure your practices are in line with federal and state regulations.
And if you discover an error, don’t panic … just don’t ignore it. The IRS’s Voluntary Classification Settlement Program (VCSP) allows businesses to reclassify workers as employees in exchange for reduced penalties. It’s a useful option for businesses that want to come into compliance voluntarily.
Need Help Navigating Worker Classification?
Misclassifying workers can be a costly mistake, but it’s one that’s entirely avoidable — with the right guidance and oversight. Whether you’re building out a team of contractors or onboarding full-time staff, making the correct classification decisions upfront can save you significant time, money and stress down the road.
McManamon & Co. is an accounting, tax, fraud, forensic and consulting firm that serves small and midsize businesses. Our experienced consulting team can help you assess your current workforce structure, identify potential classification risks, and ensure compliance with IRS and labor regulations.
Call us at 440.892.8900 or contact us online to learn how we can help you stay on the right side of labor and tax law.
Tags: McManamon, small business, small business employees | Posted in McManamon & Co., small business