Lowering expenses is the name of the game. Classifying employees as ICs (independent contractors) and paying for services under the table have been long standing practices in many industries in order to avoid payroll taxes and related payroll expenses.
While these practices reduce expenses in the short-term, the risks associated in doing so outweigh any savings. This post will explain some of the risks, potential penalties, and ways to stay in compliance.
If an employer misclassifies an employee as an independent contractor or pays an employee off the books, the employer will face penalties, and they may be violating wage, tax, and employment eligibility laws. Business owners can be held liable for failing to pay overtime and minimum wage under the Federal Fair Labor Standards Act (FLSA) as well as under state wage laws. Employers are primarily responsible for seeing employees taxes are withheld – income taxes and Social Security and Medicare taxes
Independent contractors are considered self-employed for tax purposes and are responsible for their own tax payments.
Risks of Misclassifying Workers
Legal obligations on how a company classifies a worker is significant, particularly in terms of employee protections and tax revenue. Government agencies, on both state and federal levels, have been increasing audits of how companies are classifying their workers.
On February 10, 2022 the National Labor Relations Board (NLRB) announced they would strengthen information sharing, investigation, enforcement, training, and outreach efforts with not only the Equal Opportunity Employment Commission, but also its sister agencies the Occupational Safety and Health Administration, the Mine Safety and Health Administration, the Office of Federal Contract Compliance Programs, the Office of Labor-Management Standards, and the Department of Labor’s Wage and Hour Division.
This means all agencies involved in enforcing employee misclassification laws will increase efforts to reduce misclassification of employees and ensuring employers properly pay their employees and their employment taxes.
On both the federal and state levels, fines can be as much as 100 percent of the employment tax due. What are the penalties for employee misclassification? Penalties for misclassification or off-book payments include:
- Administrative fines and penalties for noncompliance
- Criminal penalties, including potential jail time, for intentional misclassification
- Paying back pay and benefits with interest
- Damages as part of a civil lawsuit, including punitive damages
Civil penalty: Up to $2,500 per employee for the first offense. Up to $5,000 per employee for each additional offense.
Criminal penalty: Penalties differ depending on the number of offenses.
The first offense is a misdemeanor with up to 30 days in jail, up to a $25,000 fine, and barred from performing public work for up to one year.
Additional offenses are misdemeanors with up to 60 days in jail or up to a $50,000 fine and barred from performing public work for up to five years.
Since the Covid Pandemic
More and more individuals are working as freelancers and independent contractors these days—and the IRS is not particularly happy with that. The IRS would generally prefer you to be an employee.
- The problem is that it is sometimes difficult to determine whether an individual is an employee or an independent contractor—and this leads to disputes with the IRS. Individuals’ work arrangements with customers and clients come in all shapes and sizes. But, regardless of what label you put on a relationship, the key issue as far as taxes are concerned is control—the more control a customer or client has over your work, the greater the chance you should be classified as an employee instead of an independent contractor.
The courts have considered many factors in deciding whether an individual is an independent contractor or an employee. These factors fall into three main categories: behavioral control, financial control, and relationship of the parties. In each case, it is very important to consider all the factors – no single one provides the answer.
- Behavioral control. An individual is an employee when the business has the right to direct and control the individual. Specific factors to consider include whether it’s setting work hours, requires reporting, provides instructions and training, and specifies order in which tasks are done.
- Financial control. These factors look at whether the worker operates as a business. One factor is how the person gets paid; are they paid on a regular timeline or do they submit invoices periodically? If the organization provides equipment to the contractor and whether they provide similar services for other organizations or are dependent on the company financially is another factor to consider.
- Relationship of the parties. These factors show how you and your customers or clients perceive your relationship. If the organization provides the worker with employee benefits and whether other employees are doing the same type of work and, even, how each party can end the relationship are examined.
A full list of the 20 factors is available on the IRS website.
How to Protect Your Business and Stay in Compliance
- Make sure to keep proper documentation and contracts for all employees and independent contractors
- Avoid the temptation to save money by misclassifying employees as independent contractors
- Don’t pay anyone under the table
- Perform an Internal Audit using A full list of the 20 factors is available on the IRS website as a checklist
The short-term cost savings of misclassifying employees is not worth the risks associated.
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