Misclassified Employees: The Mistake That Keeps on Giving

Misclassified Employees: The Mistake That Keeps on Giving

We get it. Running a small business, be it a startup or an established firm, is hard. The challenges, paperwork, day-to-day snafus, are this. Employee payroll, benefits, recordkeeping, hiring, firing, managing performance, it adds up. As a business owner, if you choose your battles, prioritize, multitask what you can, and tackle the rest of the challenges one at a time.

Putting employees on salary, rather than hourly wages, it is just easier. You do not have the timekeeping to worry about, payroll is easy, and most employees actually like it. There is a certain status to being a salaried employee, especially if the employee is not pulling a lot of overtime. Easier still is making workers independent contractors, and then you have none of the headaches and the overhead associated with employees.

But, in the words of Lee Corso, Not so fast, my friend! The classification of your workforce, be it independent contractor vs. employee, or exempt vs. nonexempt employee, is the last place you want to take shortcuts. Business owners must understand that they have no discretion – none – when it comes to employee classification. There are gray areas, to be sure that, that can require analysis, knowledge of law regarding classification and good judgment. business owner, but in the end senior management does not have discretion in deciding how to classify workers. The government decides, and in this area, the government can be rather unforgiving.

Misclassifying employees can create problems with the Internal Revenue Service, state and federal Departments of Labor, and employees themselves. The IRS makes this its business because misclassification of employees as independent contractors can interfere with its efforts to the timely and accurate collection income tax withholdings, Social Security and Medicare. A 2009 study by the treasury inspector general estimated that misclassification costs the United States $54 billion in underpayment of employment taxes and $15 billion in unpaid FICA and unemployment taxes.

The IRS’s collection efforts are enhanced when the employer pays withholding taxes. The potential for questionable deductions offsetting employment taxes is substantially diminished with the use of payroll withholding. Also, withholding taxes usually are paid twice per month rather than once a quarter. Employers also pay unemployment taxes, the revenues from which terminated employees can benefit, rather than putting further strain on general assistance programs. For these and other reasons, the government has a substantial interest in ensuring that workers should be classified as employees, not independent contractors, are properly classified.

The penalties for noncompliance with the Internal Revenue Code vary depending on whether the misclassification was willful. If an employer can convince the IRS that the misclassification was a result of an honest mistake, the penalty on the business is “only”:

·         1.5% of the misclassified employee’s wages, plus

·         40% of the amount that should have been withheld for Social Security and Medicare tax from the employee, plus

·         100% of the employer’s share of Social Security and Medicare tax (the employer “match”), plus

·         $50 for each Form W-2 that the employer failed to file because of classifying workers as an independent contractor,

·         plus, a failure to pay taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

If the employer willfully misclassified the worker (a “knew or should have known standard”), the penalties will equal the full amount of taxes that should have been withheld (income, Social Security, Medicare and the employee match) and the penalty can be assessed simultaneously on the company itself and on its officers, personally, if they are deemed to be responsible. Finally, additional fines related to failure to file and failure to pay may result, as well as interest on the balance due. The employer cannot recover these taxes or penalties from the employee.

Then there is the small matter of potential criminal penalties of up to $1,000 per misclassified worker and one year in prison.

If you misclassify employees, the IRS is not the only agency you need to worry about. The U.S. Department of Labor will weigh in as well. (Note: the IRS and the DOL talk to each other about violations.)  If a business misclassifies an employee as an independent contractor, it may be deemed to have deprived them of certain employee benefits the business offers it regular employees.

It is easy to fall into the misclassification snare. Especially in the early days of a startup, job positions and titles are rarely well defined; the owners are still figuring out what positions are needed. Employees often work long hours and perform duties across multiple positions.

Some startups operate under the illusion that they can create their own rules with respect to compensation. Often pay is an issue, and start-up owners may be tempted to compensate employees with non-cash compensation, such as shares of stock, phantom stock, stock appreciation rights, even beer. Or they will promise the employees a performance bonus if the company reaches certain milestones.

Startups are not exempt from minimum wage laws and must pay either the federal or state minimum wage, whichever is higher. Learn about Minnesota’s minimum wage here. And what about wages for all those extra hours? Many startups falsely believe that overtime laws do not apply to them, so they do not even consider paying their employees for overtime worked. While certain employees are exempt from being paid for overtime, startups are required to pay overtime to nonexempt employees.

If the Department of Labor gets wind of this, either through a complaint or an audit, it will impose penalties equal to a doubling of the unpaid wages owed to the employee, plus the employee’s private attorney’s fees, if any.

In the end, small businesses open themselves to significant wage and hour law violation liability if they do not educate themselves about and comply with wage and hour laws. Just look at the ongoing lawsuit that was filed against an on-demand cleaning startup, Handy Technologies. A seemingly insignificant violation may lead to large and damaging penalties. As startups grow – and their workforces expand – the concerns over compliance become increasingly important.


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Bill Egan

Bill Egan

I have 30+ years of experience representing executives, business owners, private enterprises and small-to-midsize public companies as an advisor, counselor and advocate on matters relating to the employment relationship. Informed by years of experience with both routine and unusual employment relationships and workplace situations, I bring a pragmatic, realistic and results-oriented perspective to issues arising in the workplace. Read Bill's Bio.

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