Companies increasingly opt for independent contractors instead of employees due to the financial advantages they offer, but many businesses often fail to categorize their staff correctly; for instance, according to the Economic Policy Institute (EPI), 10% to 20% of employers misclassify one or more employees either deliberately or by accident. Despite the difficulties in recognizing whether an individual is an employee or independent contractor, it is vital to classify workers correctly as misclassifying workers can result in hefty penalties, such as unpaid benefits, back taxes, and fines, irrespective of whether the misclassification is intentional. Read about the consequences of misclassifying employees as independent contractors, and discover how an Arizona business law attorney can help companies ensure they remain compliant in this area by contacting Harrison Law, PLLC at (480) 320-2310.

What Is the Difference Between Employees and Independent Contractors?

Employees and independent contractors have distinct legal differences related to benefits, taxes, and the applicability of labor laws. The key method for identifying whether an individual is a company employee or an independent contractor involves determining the degree of control between the person and employer, with some states also considering whether a person financially depends on the business. Per the Department of Health & Human Services (HHS), the relationship between companies, employees, and independent contractors differ in the following ways:

• Employment laws: State and federal labor and employment laws protect the rights of employees, whereas independent contractors do not gain the same safeguards.
• Hiring procedures: Employees often interact with an organization’s human resources department throughout the hiring process, culminating in the signing of an employment agreement and receiving an employee handbook. Contractors may only come into contact with the department or individual requesting the completion of a task or service, resulting in the signing of a contract or work statement.
• Taxes: With employees, the employer withholds Social Security, Medicare, and income tax from the individual’s wages. For independent contractors, however, employers carry out no tax withholding.
• Company Reporting requirements: Employees obtain a W-4 form, containing their name, address, tax filing status, Social Security number, and certain exemptions, as well as an account of their earnings during a tax year via a W-2 form. For independent contractors, companies ask these workers to complete a W-9, which includes the person’s name, address, backup withholding certification, and Taxpayer Identification Number; if the worker earns more than $600 within a year, they should get a completed Form 1099.
• Payment terms: Employees may earn either a salary or compensation at an hourly rate, but in either case generally receive payments on a regular schedule specified by their employment contract unless a formal agreement takes place to change this. Their payments are usually dealt with by payroll staff. Conversely, independent contractors earn amounts specified in their contracts and may be paid on certain dates, at milestone completions, or at the end of the job, either in increments or via a one-time payment. An organization’s accounts team typically handles these payments per the terms of the individual’s work statement or contract.

Learn more about the impact of misclassifying employees as independent contractors, and explore how a seasoned Arizona business law attorney may aid businesses with employment-related legal issues by arranging a consultation with Harrison Law, PLLC.

What Is an Example of Worker Misclassification?

Worker misclassification occurs when an employer improperly categorizes an employee as an independent contractor, usually by having a worker whose relationship with the business is more accurately aligned with employee status sign a commercial agreement instead of an employment contract. The correct categorization of workers is important, as independent contractors lack the same legal rights and entitlements as employees. A typical example of worker misclassification involves classifying an individual as an independent contractor but failing to provide the freedom traditionally given to workers in this category.

What Happens if You Misclassify an Employee as an Independent Contractor?

Whether intentional or simply a mistake, misclassifying employees as independent contractors can be costly. Organizations that misclassify employees as independent contractors can face Internal Revenue Service (IRS) penalties and other consequences, as outlined below.

What Are the IRS Penalties for Misclassifying Workers as Contractors Rather Than Employees?

The income of employees incurs Federal Insurance Contributions Act (FICA) taxes, which include Medicare and Social Security deductions; alongside this, the employer withholds income tax from the beginning of their employment. If the IRS decides to audit an organization and determines that they have incorrectly classified employees as independent contractors, the IRS could issue the employer with the following penalties:

• A maximum of 3% of the misclassified worker’s wages and 40% of FICA taxes not withheld
• All of the FICA taxes not paid on behalf of the employee
• A $50 fine for every unfiled W-2 tax form

What Are the Economic Costs of Worker Misclassification?

In addition to possible IRS penalties, misclassifying workers can potentially lead to fines for violating federal laws and reputational damage, as outlined below:

• Federal law infringement fines: Misclassifying workers violates the federal protections offered to employees under the Fair Labor Standards Act (FLSA) that safeguard employee benefits, such as paid overtime and minimum wages. The Department of Labor (DOL) frequently conducts audits to spot and punish employers that misclassify workers. These employers could receive criminal penalties, such as fines of a maximum of $10,000 per miscategorized employee, up to one year of jail time, punitive damage payments, and the repayment of benefits insurance, alongside more regular audits; moreover, these employers can face civil penalties in some states, ranging between $5,000 and $25,000 per employee misclassification depending on whether the misclassification was deliberate.
• Reputational harm: Consistent and intentional work misclassification could damage an organization’s reputation, impacting employee retention (either because correctly classified employees do not agree with the misclassification of others, or they do not want to risk their chances of finding work in the future if they continue working for an organization known for misclassifying workers). Worker misclassification can also dissuade workers from joining due to the possibility of missing out on employee benefits.

What Is the Most Expensive Result of Misclassifying Employees as Independent Contractors?

Generally, the more deliberate the misclassification and the more incorrectly classified employees, the higher the fines issued by both the IRS and DOL. Minor worker misclassification cases can result in penalties in the thousands to tens of thousands of dollars, whereas significant cases involving many employees may lead to hundreds of thousands to millions of dollars worth of penalties. For example, in 2016, per the DOL, two Massachusetts-based construction firms deliberately miscategorized more than 400 employees, resulting in over $2,000,000 in damages and overtime repayments.

Contact an Arizona Business Law Attorney Today

Bringing in independent contractors may provide companies with a competitive edge; however, if these individuals should be classified as employees instead, this can present employers with severe consequences. Consider seeking professional assistance with navigating the laws linked to worker classification and crafting sound independent contractor agreements. Understand the implications of misclassifying employees as independent contractors in greater detail, and find out how an Arizona business law attorney from Harrison Law, PLLC might assist firms with this legal matter by calling (480) 320-2310.

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This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.