Avoiding Employee Misclassification: Here’s What to Know

In 2020, 59 million Americans considered themselves freelancers; that’s 36% of the U.S. workforce. That number is expected to surpass 90 million by 2025.

This has attracted the attention of both the legal and tax systems. The difference in the legal obligations whether a company classifies a worker as either an employee or independent contractor is significant, particularly in terms of worker protections and tax revenue. Therefore, governments, both state and federal, have been taking a hard look at how companies are classifying their workers.

This has resulted in increased government involvement and has created a complex patchwork of evolving laws on how to classify a worker – and an increasingly aggressive framework of penalties for employee misclassification.

If your startup is misclassifying independent contractors, you can be liable  for significant taxes and fines as well as a damaged reputation.

What is Employee Misclassification?

Classifying each worker is a legal decision that defines the legal relationship between the company and the worker. Classification impacts everything from what taxes are owed to how the worker delivers services.

What is the Difference Between Employees and Independent Contractors?

In order to prevent misclassification, employers need to make distinction between employees and independent contractors. Among the most significant differences are payments and taxes. Although forms W-2 and 1099 are both information wage statements, the purposes they serve and the types of worker classification they represent are different.

Independent Contractor: An independent contractor provides a good or service to another individual or business, usually under the terms of a contract. The contractor retains control over how they provide the good or service and is not subject to the employer’s control or guidance.  Essentially, independent contractors often have multiple clients, are self-employed, pay their own taxes and provide their own benefits

• Form 1099-MISC is used for miscellaneous income paid to non-employees, such as independent contractors. Earnings from independent contractors are also subject to self-employment tax. Form 1099-MISC is used to report payments of $10 or more in gross royalties or $600 or more in rents or compensation, to both the IRS and the individual who received the payment.

Employee: On the other side, an employee is hired under an employment agreement. Employers withhold taxes from their wages, may provide benefits, and pay employment taxes for them.

• Form W-2 is a wage and tax statement employers issue to employees. This form includes information for the tax year about taxable income for the employee, Social Security, Medicare and FICA taxes, and state income taxes withheld from the employee’s paycheck.

How to Determine Independent Contractors vs Employees

It can be difficult for employers to draw a distinction between employees and independent contractors. The IRS provides guidance about how to correctly classify workers, and considers three major categories in determining whether they are employees or independent contractors:

1. Behavioral – Employers need to determine if their company controls workers as well as how they do their job.
2. Financial – It is necessary to establish who controls the economic aspects of the worker’s job and what the method of payment is.
3. Type of Relationship – Other important aspects are the length and terms of a relationship with a worker, as outlined in a contract, employment agreement, and other documentation.

Why has Misclassification Become Such a Serious Issue?

This massive growth in independent contractors, and the realization that soon enough non-payroll workers will make up for the larger share of the workforce has attracted the attention of the legal and tax systems. Employee misclassification is concerning to authorities for several reasons:

• No tax withholding
• Serious loss of public revenue
• Incorrect expense deduction
• Benefit deprivation
• Lack of employee protections
• Breach of industry agreements/awards

What are the Risks of Employee Misclassification?

Although the there are serious ramifications with the government for misclassifications, there are also potential negative implications for the business itself: Possible consequences include the following:

• Substantial back-taxes
• Financial penalties
• Legal action from employees
• Legal action from clients or insurers

The Bottom Line

Employee misclassification occurs when a business classifies a individual worker as an independent contractor or freelancer, for the purposes of tax and employee benefits, when they would be more accurately classified as an employee. Employee misclassification carries major risks for businesses. A failure to classify workers correctly could result in significant back-taxes, penalties or damages. To mitigate this risk, businesses need to carefully consider:

Get Your Legal Questions Answered In A Free Consultation

Contact Exemplar Law to take advantage of a free initial consultation with one of our skilled employment law attorneys. Send us an email at rise@exemplarcompanies.com to get started.