Consequences of Misclassification
The big question: What happens if a worker is labeled incorrectly? Any worker who is treated as an independent contractor but by law should be an employee is considered “misclassified.” Worker misclassification subjects the business and individuals doing the hiring to a lot of legal and financial risk.
How Do You Get Caught?
There are many potential routes to a government agency determining that a business misclassified its workers. Here are a few we’ve seen.
IDES Audit
An audit could be triggered if a business’s independent contractor gets laid off or terminated from a different job. That person may then file for unemployment benefits with the IDES. The IDES paperwork asks the person applying to list all “employers.” The worker, not considering the legal definition of “employer,” lists all the businesses he or she works with, including those where the worker is technically an independent contractor, not an employee. If the listed business hasn’t made unemployment contributions (because the business classified the worker as an independent contractor), the IDES will be very interested in exacting the outstanding contributions and start investigating the listed business’s worker classifications.
The IDES first sends the business a questionnaire and/or performs an on-site audit to ask questions about the worker(s) and the business. Sometimes, if the IDES finds that one worker is misclassified, they will perform a follow-up audit into whether the business has other misclassified workers.
Finally, if the IDES finds that the business has misclassified any of its workers, they calculate what the business owes for unpaid unemployment contributions, interest, fines, and penalties. The fines are higher (and the individual responsible for the worker misclassification can be personally liable [and be on the hook to pay the fines even if the business dissolves or goes bankrupt]) if the error was intentional.
IRS Audit
IRS audits are similar but, because they are often done by random selection, occur less often than state audits. However, these audits can also be triggered by a worker filing a report with the IRS stating that they believe their income was misclassified. Regardless of how such an audit is triggered, the government takes this issue very seriously, and these agencies have vast resources focused solely on classification audits.
The Worker Sues or Talks to a Lawyer
Workers can discover independently that they are improperly classified, especially if they’re upset by a termination and motivated to find a reason that the company owes them money. These workers might learn of their misclassification from a friend, by looking into employment laws, from a lawyer, Googling, etc. When they find out, they can sue the company and/or report the company to a government agency, such as the IRS as noted above.
What are the Penalties for Worker Misclassification?
Penalties for worker misclassification can include, but are not limited to, fines, back taxes, unpaid unemployment insurance contributions, interest payments, violations of employment laws, lawsuits, or even criminal penalties.
Fines
Both states and federal government agencies can and will issue fines to employers who misclassified their workers. These fines usually stem from failure to report payroll taxes, failure to maintain the appropriate documentation for employees (such as Form I-9: Employment Eligibility Verification), failure to maintain worker’s compensation insurance, and failure to pay the employer’s share of Social Security and Medicare.
Back-Taxes and Unpaid Unemployment Contributions
If a government agency finds out that a business treated someone as an independent contractor who should have been an employee, that agency will require payment of all employment taxes and/or unemployment insurance contributions that you have neglected (sometimes for all misclassified workers, not just the one that spurred the investigation), plus interest and penalties. Sometimes the business owner or person with authority over payroll can even have personal liability.
In our experience, this sum varies a lot depending on the number of employees, whether they are full-time or part-time, and how many years they were misclassified. Examples of back-taxes/contributions owed in previous cases:
- With the IDES
- $670.46 ($107.84 of which was interest (Emergency Treatment v. Department of Employment Security)
- $25,014.70 (EZ Movers, Inc. v. Rowell)
- $95,159.16 ($36,894.75 of which was interest) (SMRJ, INC. v. Russell)
- With the IRS
- $50,026.61 ($22,110.12 of which was interest) (US Department of Justice, Tax Div. v. Hudson)
- $62,852 (it would have been well over $1 million if the company was liable for its predecessor’s misclassification) (TFT Galveston Portfolio, Ltd. v. Commissioner)
Violations of Employment Laws
The government provides a lot of protections for employees. Many of these protections could be found to apply to misclassified independent contractors as well. For example, requirements to pay overtime or a minimum wage, prohibitions against discrimination or harassment, or regulations against improperly withholding money from a worker’s paycheck could be found to apply to misclassified independent contractors.
Criminal Penalties
It’s important to note that, while it doesn’t come up often, if the government can show that an individual in the company purposefully and intentionally misclassified workers as independent contractors, the individual can face criminal penalties.