Employee misclassification poses a serious risk for companies.
The practice of hiring individuals as independent contractors while they perform the duties of a full-time employee is illegal, and what many companies misunderstand is that it’s up to the company to define who’s an employee and who’s a freelancer.
In 2020, 59 million Americans considered themselves freelancers; that’s 36% of the U.S. workforce. That number is expected to surpass 90 million by 2025.
Business owners are generally talented people with drive and ambition. They may seem to have superpowers, but they can’t do it all. They need good people to do the things they can’t do on their own. During the hiring process, business owners must avoid the misclassification of employees or face expensive consequences later.
Accurate classification of employees is important for two reasons.
Firstly, it offers employees certain protections, such as minimum wage, sick pay, and unemployment benefits to the employee. These protections are expenses that the employer wouldn’t have to incur when hiring independent contractors.
The benefit of hiring employees is that the employer has more control over the work they’re hiring for. Therefore, some business owners may feel tempted to misclassify their workers.
Secondly, if a worker thinks they are an employee, they’re likely not paying their self-employment taxes. This causes the government to miss out on the revenue it’s due.
On the other hand, misclassification is sometimes an honest mistake. “Just because independent contractors call themselves an independent contractor doesn’t mean they are one in the eyes of the law,” says Forbes.
Rules for worker determination continually change. Each occupation’s rules vary according to its nature. The IRS may treat honest mistakes as intentional fraud depending on the circumstances.
Penalties for intentional misclassification of employees are expensive and often include jail time. If the IRS has contacted you about employment misclassification, contact a tax professional to negotiate with the IRS on your behalf.
When a business owner hires help, they must categorize the help for tax law purposes. We’ll discuss two of the most common choices. These are employees and independent contractors.
Employees (Common-Law Employee)
If you hire an employee, you have more control over the job. You determine what you need the employee to do and how you want them to do it. “What matters is that you have the right to control the details of how the services are performed,” says IRS.
Hiring employees requires you to withhold several taxes from employees’ pay. Tax law requires you to hold the monies in a separate bank account until the tax deadline.
Some of these withholdings require the business owner to contribute a matching amount to the account, as well. The business owner must then send them to the IRS by the tax deadline.
On the other hand, hiring independent contractors doesn’t require you, as the employer to withhold any taxes. As we mentioned above, independent contractors are responsible for paying self-employment tax.
Additionally, the employer isn’t responsible for such protections as sick pay and unemployment insurance. But you don’t have control over what the independent contractor does to achieve the result you pay for.
“The general rule,” says IRS, “is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
For example, hair stylists, mobile pet groomers, and lawyers are generally independent contractors.
Misclassification of Employees Penalties
It’s tempting for some business owners to classify their workers as independent contractors. But there are consequences for doing so without good reason. The IRS may hold you responsible for the employment taxes for the misclassified worker, in addition to other penalties and fines.
In the best-case scenarios, these penalties are steep and add up fast. Let’s take an unintentional misclassification of employees for example. Hint: Business owners with unintentional misclassification on their returns immediately reclassified payments as wages.
Minimum Penalty for Unintentional Misclassification
Tax Violation Penalties
- $50 per employee misclassified as an independent contractor
- 3% of wages that should have been withheld
- 40% of the Social Security and Medicare taxes not withheld
- 100% of the business owner’s contribution to FICA taxes
- 5% of the total tax unpaid plus ½ of 1% for every month the payment of tax was late up to 40 months. Not to exceed 25% of the total unpaid tax
Penalties for Intentional Misclassification (Fraud)
Federal Law Violation Penalties
- Up to $1,000 per misclassified employee
- Up to one year in jail
- Benefits insurance repayment
- Additional wage claim audits
- Individual lawsuits
- Class-action lawsuits
Furthermore, interest accrues on these misclassifications of employees’ penalties each day after the tax deadline.
Misclassification of Employees Can Lead to an Audit
A misclassification of employees can trigger an audit on your tax return, as well. ClearPath Workforce Management points out a few events that are red flags to the IRS.
- Your independent contractor filed an unemployment claim.
Once the unemployment department receives a claim, a process begins. First, the agent looks at the wages of the employee making the claim. If the business owner didn’t report any wages for the employee, then there’s a problem.
That’s because it’s likely the business owner didn’t pay employment taxes for that worker. In other words, the employer didn’t contribute to the unemployment fund for that worker.
- Worker receives forms W-2 and 1099 from you in one tax year.
Technology is a blessing and a curse. In this case, technology is a blessing for the IRS. “Thanks to automation,” says ClearPath, “it is easy to find when an individual receives a W-2 form and a 1099 form in the same tax year.”
It’s very rare for the same person to legitimately work for the same company under both capacities in the same year.
- The ratio of 1099 forms filed versus W-2 forms is disproportionate.
The IRS audited a small business. On the notice, the IRS explains the reasoning for the audit. The IRS chose this particular business to audit because it had too many independent contractors in comparison to employees.
“Taxing agencies have been able to study the data collected during misclassification audits,” says ClearPath, “to determine these types of rations and then apply them to business to find companies that are more apt to engage employees as independent contractors.”
Need More Information?
You’ve come to the right place. Misclassification of employees can be a pricey error, especially if the IRS thinks it’s intentional. Give us a call at 877.959.0975 for a free consultation. We have decades of experience negotiating with the IRS.
We’ll be happy to discuss your case in detail and determine your options. Our friendly staff is ready to answer your questions. We’re ready to start immediately if you decide to hire us.
Contact us today and sleep better tonight.
- 8, Author on December, and Professionally reviewed by Robin T Young. “Misclassification of Employees.” Tax Relief Professional, 8 Dec. 2022, https://taxreliefprofessional.com/misclassification-of-employees.
- Board, Franchise Tax. “Ftb Pub. 1024 Penalty Reference Chart Revised: 10/2012.” FTB 1024: Penalty Reference Chart | Forms and Publications | FTB.ca.gov, https://www.ftb.ca.gov/forms/misc/1024.html#:~:text=Failure%20to%20Pay%20Tax%20%2F%20Late%20Payment%20Penalty&text=5%25%20of%20the%20total%20tax,cause%20and%20not%20willful%20neglect.
- “Employee (Common-Law Employee).” Internal Revenue Service, https://www.irs.gov/businesses/small-businesses-self-employed/employee-common-law-employee.
- “Independent Contractor (Self-Employed) or Employee?” Internal Revenue Service, https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee.
- “Independent Contractor Defined.” Internal Revenue Service, https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-defined.
- Zaino, Gene. “Council Post: Why You Should Care about Compliance.” Forbes, Forbes Magazine, 28 Aug. 2017, https://www.forbes.com/sites/forbeshumanresourcescouncil/2017/07/27/why-you-should-care-about-compliance/?sh=4111ce2e8535.
- Zaric, Stefana. “Employee Misclassification Penalties, Examples, and Protection.” Payroll & Compliance for International Teams, Deel, 4 Nov. 2022, https://www.deel.com/blog/employee-misclassification-penalties.