Employee Misclassification Penalties and How to Avoid Them

By increasing your reliance on independent contractors, the more access you have to highly skilled talent, greater agility, and cost savings. However, the more contractors you enlist, the more vulnerable your company is to employee misclassification penalties. 

When a worker is classified as an independent contractor, the hiring company isn’t required to provide the benefits that they are compelled to offer regular employees, such as health insurance, paid time off and general workplace protections. Companies are also exempt from paying the employer’s side of payroll taxes. That’s why government agencies like the Internal Revenue Services (IRS) and Department of Labor (DOL) take misclassification so seriously.

If your company misclassifies workers as contractors — even by accident — it can face significant penalties that far outweigh the benefits of hiring them.

This article is part of our guide on Employee Classification.

What is employee misclassification?

Workers classification mistakes occurs when an organization characterizes its relationship with a worker as an independent contractor, while the nature of his or her work relationship qualifies as an employer-employee arrangement according to the country or state the worker or the company HQs reside in.

If it is determined that a company has incorrectly classified a worker as an independent contractor instead of an employee, it can face serious employee misclassification penalties from the tax authorities, the governments or from the legal system if the worker sued the company for misclassification.

Why does employee misclassification occur?

In some instances, employers deliberately misclassify employees to avoid paying for employee benefits and taxes. These cases, when uncovered, will incur the most severe employee misclassification penalties. But sometimes, misclassification happens due to confusion or if the nature of a work relationship with a contractor changes over time. 

One of the main reasons for accidental employee misclassification is a lack of clear, consistent guidance. 

The federal government, state governments, and government agencies offer inconsistent laws and tests for categorizing workers, which makes the process of vetting and hiring workers complicated and risky. While a worker may be classified as a contractor under one law, he or she may be considered an employee under another. 

Companies are currently requested to audit their relationship with their non-workers every 6 months to ensure they are properly classifying them. Unless you are automating your workforce classification process, manual audits can become very expensive. However, the potential penalties are equally high to ensure organizations will invest time and resources to ensure IC compliance.

3 main employee misclassification penalties

Here’s an overview of the three most pertinent employee misclassification penalties.

1. IRS penalties

Penalties levied by the US tax authority can be expensive and even devastating for companies. If the IRS determines an employer-employee relationship exists, the company could be required to pay back FICA (Social Security and Medicare) taxes, as well as income tax withholdings. 

Specifically, the company could be subject to:

• A $50 fine for each W-2 Form the employer failed to file for the relevant employees
• A penalty of 1.5% of the employee’s wages
• 40% of the FICA taxes that were not withheld from the employee as well as 100% of the matching FICA taxes the employer was supposed to pay

In the case of deliberate misclassification, the IRS may require companies to pay back 100% of the FICA and income taxes that should have been withheld from the employee. Under section 6672 of the Internal Revenue Code, additional fines and interest may be imposed on an employer due to its failure to file necessary tax returns, and the subsequent failure to pay the required taxes and withholdings. 

2. Legal authority penalties

Employee misclassification is an area of intense focus by the Department of Labor. In recent years, the DOL has gone so far as to hire additional auditors who are dedicated to identifying and penalizing companies that misclassify workers. 

Companies that have misclassified employees and therefore violated the Fair Labor Standards Act’s (FLSA) guarantees for minimum wage, overtime, and other protections are liable for criminal penalties and back wages. The cost of damages and attorney’s fees can be equally as high.

Specifically, companies may be subject to:

• Class-action lawsuits: Punitive damages, compensation, and legal costs could far exceed the costs of government-imposed fines and payments.
• Criminal penalties: Penalties of up to $1,000 per misclassified worker and one year of prison time could occur if the IRS suspects intentional misconduct.
• Wage claim audits: If it has been found that an organization willfully violated minimum wage and overtime protections under the FLSA, wage claim audits may go back as far as three years. Penalties could include unpaid overtime costs and minimum wage deficits.
• Worker’s compensation violation penalties: Employers that violate state worker’s compensation insurance laws by withholding worker’s compensation from misclassified employees are liable to pay back workers’ comp premiums.
• Repayment of benefits: Employers who improperly excluded misclassified workers from employee benefit plans could be forced to repay these benefits, including pension, health insurance, paid leave, and severance pay.  
• Repayment of FMLA benefits: Companies that misclassify workers and therefore did not provide paid leave to staff under the federal Family and Medical Leave Act (FMLA) could be forced to provide compensation.

3. Tarnished company reputation and failed audits

In addition to financial and legal risk, companies that misclassify employees also jeopardize their reputations and potential for future business deals. 

In-demand talent will be hesitant to get involved with companies that are known to misclassify workers and get tangled up in legal troubles. Freelancers and independent contractors work hard to build up their portfolios, and most don’t want to tarnish that with companies enshrined in scandal. 

Failed audits that are brought on by suspected employee misclassification can also derail crucial business initiatives, such as pursuing funding, going public, or getting acquired. Considering the expense of employee misclassification penalties, companies that are discovered to have widespread employee misclassification violations appear less valuable, less stable, and less attractive.

How to avoid employee misclassification penalties

The simplest and most effective way to avoid employee misclassification penalties is to adopt an objective and standardized system of classifying all of the independent contractors you hire. 

Usually, leaving this up to company legal or HR teams is not sufficient, as the nature of work relationships can change over time, and many companies are increasing their freelancer ranks. Manually assessing your relationships with a growing volume of independent contractors is usually not feasible. However, if you can automate this work, that’s a game changer.

With a freelance management system (FMS), you can automatically and continuously monitor the nature of your work relationships with independent contractors in accordance with state and federal laws to ensure total compliance and zero risk, not to mention pay contractors and better collaborate within your company. An FMS alleviates your staff from the burden of ensuring compliance and eliminates the risk of unintentional mistakes.