Labor is a business’ biggest expense. In addition to hourly wages or salaries, employees may be entitled to costly benefits including health insurance, paid sick leave, and paid vacation days. To manage labor costs and staffing needs, many businesses supplement their workforce with independent contractors. In the past decade, companies have increasingly relied on contractors such as freelancers and independent consultants to handle tasks that may not be core to their business model such as marketing, HR, and accounting work.
In some cases, small business owners misclassify employees as 1099 contractors in an effort to reduce labor costs, but employee classification is not always straightforward. Federal and state agencies use a variety of tests to determine whether a worker is an employee or an independent contractor, and the rules can vary depending on the state and the agency reviewing the relationship. As a result, some employers unintentionally misclassify workers despite acting in good faith, which can put them in jeopardy. If a state or federal agency determines that a worker was improperly classified, the business may be responsible for back wages, unpaid taxes, penalties, interest, and other costly consequences.
How to Know the Difference Between an Independent Contractor and an Employee
It is important for employers to know that the label does not determine status. A worker can be called a “contractor” in a signed agreement and still legally be an employee.
True independent contractors typically:
- Operate their own business.
- Offer services to multiple clients.
- Control how the work is performed.
- Provide their own tools and equipment.
- Bear a risk of profit or loss.
Signs someone may really be an employee:
- The business controls how, when, and where the work is done.
- The worker uses the company’s tools, equipment, or workspace.
- Most or all of the worker’s income comes from that business, with little opportunity to work for others.
- The work they provide is a regular, ongoing part of the business, which means the relationship is indefinite rather than project-based.
The Hidden Cost of Misclassifying Employees as Independent Contractors
Classifying a worker as a 1099 contractor when they should be treated as an employee may seem like a way to reduce labor costs, but it can quickly become an expensive mistake.
If a worker files a complaint or a state or federal agency investigates the arrangement, the employer may be held responsible for a wide range of costs, including:
- Back payroll taxes, including Social Security and Medicare contributions
- Interest and penalties assessed by tax authorities
- Unpaid overtime wages and other compensation owed to the worker
- Unemployment insurance contributions that should have been paid
- Unpaid workers’ compensation premiums and related penalties
- Employee benefits that may have been improperly denied
- Legal fees and administrative costs associated with defending audits, investigations, or worker claims
Real-World Cost Examples
To put these risks into perspective, here are examples of what misclassification has actually cost employers:
- IRS tax penalties alone can range from 1.5 percent to over 40 percent of wages paid, depending on whether the mistake was unintentional or willful.
- Employers may also owe the full 7.65 percent employer share of Social Security and Medicare taxes, plus up to 40 percent in additional FICA penalties and interest.
- The IRS can assess penalties of up to $660 per incorrect or missing 1099/W-2 form, with no cap in cases of intentional disregard. [irs.gov]
- A U.S. Department of Labor case required one employer to pay $139,000 in back wages and damages to 21 misclassified workers.
- In another case, misclassified workers recovered $2.4 million in unpaid overtime, with individual payouts up to $28,000.
- Even smaller claims can add up quickly, with typical misclassification-related wage claims ranging from $5,000 to $50,000 per employee.
- A delivery services case resulted in a $4.6 million settlement tied to misclassification and unpaid wages.
- A retail misclassification case led to an $11 million settlement for improperly classified managers.
- Some states impose $5,000 to $25,000 per misclassified worker in addition to federal penalties.
The financial consequences can add up quickly, especially if multiple workers have been misclassified or the practice has continued for several years. For employers, the safest and most cost-effective approach is to properly classify workers from the beginning. Taking the time to evaluate a worker’s role and level of independence can help avoid costly disputes and compliance issues down the road.
Protect Your Business from Costly Employee Misclassification Errors with Professional HR Support
Seay HR provides a broad range of HR services designed to support your business’s growth and ensure compliance with all state and federal employment regulations to eliminate financial exposure in these areas.
If your company hires a mix of employees and contractors, Seay HR can provide a proactive classification review to help you properly classify workers, develop compliant employment practices, and reduce the risk of costly audits, penalties, wage claims, and other legal issues that can arise from employee misclassification.
We’re ready to help! Contact us today to learn more about how we can support your business.
Please note: This article is for informational purposes only and does not constitute legal or professional advice. Seay HR makes no representations or warranties, express or implied, regarding the accuracy, completeness, or applicability of the information contained herein.
Seay HR disclaims all liability for any actions taken or not taken based on the information in this article. Readers are solely responsible for their own interpretation and use of this information.
