Businesses that erroneously (and sometimes intentionally) classify workers as independent contractors run the risk of incurring significant penalties if they are audited or reported by disgruntled “contractor-would-be-employees.” In addition to underpaying their share of employment taxes, these employers effectively deny benefits to deserving employees, including overtime pay, family medical leave, unemployment insurance and workers compensation. Improperly classified employees end up paying their own health insurance and the full FICA tax. This also imposes a financial and competitive disadvantage on law-abiding employers who correctly classify their employees and appropriately pay their employer taxes, insurance and other expenses.
The Internal Revenue Service (IRS) has been engaged with the Department of Labor’s (DOL’s) Wage and Hour Division (WHD) in a “Worker Misclassification Initiative” to detect and discourage wrongful misclassification of employees as contractors. Business owners should be aware of the conditions put forth in this initiative, such as requiring employers to:
- Develop a worker classification analysis for each employee designated as exempt from minimum wage and overtime provisions under the federal Fair Labor Standards Act,
- Provide employees a written summary of the classification analysis, and
- Retain copies of the written summaries for additional recordkeeping requirement purposes.
Conditions promulgated by the DOL (the “Economic Realities” test) and the IRS (3 factor test) can help employers correctly differentiate between employees vs. independent contractors. Factors to be considered include:
- The business relationship that should be clearly based on the “the degree of control and independence” between an employer and the worker,
- Employer withholding of income taxes, withholding and payment of Social Security and Medicare taxes, and payment of unemployment taxes on wages paid to an employee, and
- Employer-provided employment benefits (e.g. vacation, sick leave, or training / tuition reimbursement) to employees.
As an employer, you can take proactive steps to audit the classification of employees before the Department of Labor or the IRS does it for you. Steps you should take include:
- Review all the employment relationships with those currently identified as independent contractors.
- Determine whether an independent contractor should be deemed an employee.
- Correct and remedy as needed any worker misclassified as an independent contractor.
- Document the findings to demonstrate your good faith efforts of maintaining your workplace compliance obligations.
The key is to respond proactively as an employer. Do not assume you won’t be challenged by workers or targeted by authorities from the DOL or IRS. All it takes is an unhappy worker who files a complaint with the federal or state DOL. Maybe a worker files a claim for unemployment or workers compensation, which draws attention of the authorities. Then you will wish you had dealt with the classification issue appropriately.
For more information and guidance about the appropriate classification of employees and contractors, check out HR Support Center.