Penalties of Misclassifying Employees as Independent Contractors

If you are a business owner hiring or contracting with other individuals to provide services, you must determine whether the individuals providing services are employees or independent contractors. 

The Department of Labor and IRS target businesses that use independent contractors. 

Thus it is critical that business owners correctly determine whether the workers providing services are employees or independent contractors.


Determining Whether Employee or Independent Contractor

In determining whether the individual providing service is an employee or an independent contractor, the factors of degree of control and independence must be considered.

Common Law Rules dictate that the degree of control and independence fall into three categories:

  1. Behavioral: Does the business control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer? This includes factors such as how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc.
  3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Is there a written Independent Contractor Agreement in place? 

Business owners must weigh all these factors when determining whether a worker is an employee or independent contractor. It’s important to note that there is no “magic” or set number of factors that make the worker an employee or an independent contractor, and no one factor stands alone in making this determination. 

The key is to look at the entire relationship, consider the degree or extent of the right to direct, and control and consider all of the factors in coming up with the determination. 

 

Form SS-8

If it is still unclear whether a worker is an employee or an independent contractor, business owners or the worker may file Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. The IRS will review the facts and officially determine the worker’s status. Please note that this application may take at least six months to get a determination. 

 

Differences Between the Two For Employers

According to the IRS, the difference between to the two is that for employees, employers “must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid.” However, this does not necessarily apply to independent contractors.  

 

Benefits of Independent Contractors

Independent Contractor Agreement is perfect for companies or businesses that are looking to hiring an independent contractor on a temporary basis. Hiring an independent contractor is a great way for start-up businesses to acquire a specialized talent that is needed for a temporary assignment. 

Generally, paying an independent contractor means no wage withholding, no employment taxes, no unemployment insurance, no workers’ compensation, and no liability for pensions and fringe benefits. As you can see, there are many clear and tangible benefits of labeling a worker as an independent contractor.

 

Penalties for Misclassifying Workers

When you look art the advantages of using independent contractors and the vague issue of which workers are considered employees, it is no surprise that some businesses push the envelope. 

With tax revenues in California suffering, California’s Labor and Workforce Development Agency have created strict enforcements of the classification of independent contractors. 

In 2011, California passed SB 459 increasing the penalties for misclassifying workers:

  • California’s Labor and Workforce Development Agency can fine you for “willfully misclassifying” an employee from $5,000 to $15,000 per violation.
  • The penalty goes up to $25,000 per violation if you commit a “pattern and practice” of “willfully misclassifying” workers. Willful misclassification means avoiding employee status for an individual “by voluntarily and knowingly misclassifying that individual as an independent contractor.” 
  • There’s joint and several liability for consultants (not including lawyers) who advise employers on such independent contractor engagements.
  • It’s unlawful to charge misclassified independent contractors any fee or take deductions from the compensation paid to them. Companies cannot deduct fees for goods, materials, space rental, services, government licenses, repairs, etc. provided to contractors who are reclassified.

These penalties are in addition to existing penalties, interest and taxes for misclassifying employees. Further, if a business has willfully misclassified an independent contractor, a prominent public notice must be posted for one year on a website or worksite reciting the misclassification.

 

How to Protect Yourself from Misclassifying Workers

While there are no sure ways to classify workers as employees or independent contractors, there are reasonable steps you may take to avoid possible penalties for misclassifying workers.

 

1. Talk to a business attorney for specific legal advice. 

While every case is fact-dependent as do the circumstances of individual businesses, you are advised to talk to a business attorney for specific legal advice.


2. Create a written Independent Contractor Agreement for your workers

Independent Contractor Agreement is perfect for companies or businesses that are looking to hiring an independent contractor on a temporary basis. Hiring an independent contractor is a great way for start-up businesses to acquire a specialized talent that is needed for a temporary assignment. 

Start an Independent Contractor Agreement here.


Sam Mollaei, Esq. from Mollaei Law can be reached @ (818) 925-0002 or by visiting www.mollaeilaw.com