Firm News

The Cost of Misclassifying Employees As Independent Contractors: What Small Business Owners Should Know About Embezzlement

Various employees and independent contractors traversing a subway station on morning commute.

While employers benefit from seeking the most qualified candidates, they must also consider payroll costs during the hiring process. These dual priorities often lead companies to the “compromise” of an independent contractor – especially when approaching project deadlines. What happens if a company classifies a new hire as an independent contractor when they really should be an employee? Whether an innocent mistake or a deliberate choice, misclassifying employees as independent contractors can pose numerous problems. Questions about properly classifying workers are common. Seek answers from the experienced employment attorneys at Schwab & Gasparini. Consider calling (315) 422-1333 to schedule a free consultation at one of their New York offices: Syracuse Office (315) 422-1333, Albany Office (518 )591-4664, White Plains Office or Hudson Valley Office (914) 304-4353. 

What Are the Ways a Person Performing Services Can Be Classified?

Whenever someone receives money for providing services, whether those services are provided to an individual or to an organization, they have been hired to perform those services. Being hired, however, does not mean the person hired is an employee. There are five ways that a worker can be classified for tax purposes, according to the Internal Revenue Service (IRS).

Independent Contractor

Independent contractors are individuals in a business, trade, or profession who offer their services to clients on a contract basis. Examples include doctors, veterinarians, accountants, contractors, lawyers, and dentists. In some cases, people in the same types of professions may be employees. Generally speaking, if they work for someone who has the right to direct or control the nature of their work to a fine degree, then the person performing the services will meet the federal guidelines for classification as an employee. If the party paying for the services only controls the result of the work (and not the work process), then the payee is self-employed, and the IRS typically considers their business activity to be independent contracting. 

Common-Law Employee

Common-law rules state that anyone performing services is an employee if the business or individual receiving the services can control what will be done and how it will be done. There are three categories the IRS considers when determining whether the business or individual has control over the person performing services: Behavioral control, financial control, and the type of relationship between the parties. 

Statutory Employee

Statutory employees are a subsection of independent contractors. These independent contractors are treated as employees by statute for certain employment tax purposes if they fall into one of four categories laid out by the IRS and also meet the following three requirements: 

  • There is a service contract that specifies that the individual must personally perform all services required of them. 
  • The individual does not need to make a substantial investment in equipment and property used to perform the services. 
  • The services are provided on an ongoing basis for the same payer. 

Statutory Nonemployee

Statutory nonemployees are another subsection of independent contractors, and they fall into three categories: direct sellers, licensed real estate agents, and some companion sitters. Direct sellers and real estate agents are considered self-employed, if substantially all payments they receive for services are based on volume of sales, or another form of output, rather than how many hours they worked. Real estate agents and direct sellers must also clearly indicate their services and independent contractor tax status on their written contracts. 

Companion sitters may or may not be employees. If a companion sitting placement service pays the salary of the companion sitter, then the companion sitter is an employee of the placement service. A companion sitting placement service that does not pay the wages of the companion sitter is not considered an employer, and the companion sitter may be self-employed in this instance. The IRS may consider a companion sitter to be an employee of the person for whom they are performing their services, however. 

Government Worker

IRS section 3401(c) states that government workers are officers, employees, or elected officials of the government are “employees” for tax purposes. These include public and elected officials, public officers, emergency workers, and election workers. The IRS notes that although the two processes are similar, running a public office is not the same as running an independent business or trade in the context of income tax reporting. Some specific examples of these workers include: 

  • Tax assessors and collectors
  • Judges
  • Sheriffs
  • Justices of the peace
  • County or city attorneys
  • Members of state legislatures, county commissions, city councils, school boards, and utility or hospital districts

What Are the Consequences of Misclassification of an Independent Contractor?

Correctly determining the classification of an individual hired to provide services is essential to maintaining employer tax compliance. The consequences of misclassifying employees can be significant for not only the worker, but also the business employing their labor. 

Potential consequences of employee misclassification can include: 

  • The business may be held liable for the employment taxes they have not paid on the employee. 
  • The employer may be charged with wage law violations
  • The business may face I-9 violations, face civil fines, or criminal penalties for charges like embezzlement. 
  • The employee may be improperly excluded from benefits. 
  • The employer may owe unpaid workers’ compensation premiums. 
  • The employer may face unemployment insurance shortfalls. 
  • The business may fail to provide job-protected leave required by law for employees. 
  • The business may be charged with anti-discrimination violations. 
  • The business may fail to provide the misclassified employees with certain notices required by law for employees. 

What Actions Could an Employee Take If They Believe They Have Been Misclassified?

While some employers may deliberately choose to misclassify employees as independent contractors in an attempt to shift tax obligations, misclassifications may also be made in error. However, the consequences remain the same whether it is intentional or not. When an employee recognizes that they may have been misclassified, they may pursue legal action, with potentially significant consequences for the employer. Note that many workers simply assume they are employees, and it is necessary to clearly inform these workers of how they are classified. If a worker believes they have been misclassified, or erroneously assumes they are an employee, they may take actions that could create significant issues for their employer:

  • The worker may begin by speaking with the employer to clarify their classification. This may not cause a problem if the classification is explained and corrected satisfactorily. 
  • The individual may file IRS Form SS-8 to request an IRS review of the circumstances to   officially determine their status. 
  • If laid off or fired, the worker may file an unemployment claim if they believe they are an employee. 
  • If injured while working, the worker may file a workers’ compensation claim if they assume they are an employee. 
  • The worker may submit an anonymous report to the New York Department of Labor Employer Fraud Unit regarding the employer misclassifying employees. 
  • The worker may file a lawsuit against the employer to recover damages. 

Businesses faced with workers who allege that they have been misclassified may wish to schedule a consultation with a New York labor and employment lawyer with   Schwab & Gasparini.

How Does the IRS Determine If Someone Is an Independent Contractor or an Employee?

At one time, the IRS used a 20-point criteria test to determine whether someone was an independent contractor or an employee. Today, they have reduced this complicated system down to a three-point   “common law test” that revolves around behavioral control, financial control, and the type of relationship the parties have. 

Behavioral Control

For this factor, the IRS considers the type and level of control the business has over how workers perform their tasks. This may include types of instructions given to the worker, the degree of instruction or training provided, and the evaluation systems used by the employer to assess the worker’s performance. The IRS looks at things like: 

  • Types of instruction: Does the hiring party tell the worker when and where to do the work, what tools and equipment they can use, where to purchase supplies and services, what workers they can hire, or the sequence of the work? The more instructions the employer offers, the more likely it is that the worker is an employee. 
  • Degree of instruction: The more detailed the instructions are, the more likely it is the worker is an employee. No instructions or few instructions may indicate the worker is an independent contractor. 
  • Training: If the employer trains the worker, this is strong evidence that they are an employee rather than an independent contractor. Training indicates that the employer wants the work done in a very particular way, suggesting significant control over the worker. 
  • Evaluation systems: If the work is evaluated based on how it is performed, the worker is likely an employee. If the work is evaluated solely on the result, the worker may be an independent contractor.

Financial Control

If the employer has significant financial control over payment dates, reimbursing expenses, or the provision of supplies, the worker is likely an employee. Factors the IRS considers when examining financial control include: 

  • Significant investment: Independent contractors often invest significant amounts of money in their equipment and tools. However, workers in some exempt fields (such as construction or academia) may invest in their own expensive tools and equipment and still be classified as employees due to meeting the preponderance of other criteria for employee classification.
  • Unreimbursed expenses: Independent contractors often have unreimbursed expenses related to their work, while employees are typically reimbursed for expenses. However, some employees may have unreimbursed expenses as well, and some independent contractors will negotiate to ensure that reimbursement for certain predictable expenses is included in the terms of their agreement with the hiring party, especially if the expenses are specific to a single client or contract.
  • Profit or loss opportunities: Employees receive salaries or wages for the work they perform. Due to their investment in equipment or tools, independent contractors may earn less than their expenses, and therefore incur losses.
  • Services available to the market: Independent contractors are often free to seek out other business opportunities. This means that they can advertise, maintain a physical place of business independent from any party for whom they perform their services, and take on work from other businesses. 
  • Payment method: Employees are typically paid a set hourly wage, while independent contractors are paid flat fees for projects. However, some independent contractors (such as attorneys or accountants) may also charge hourly rates.

Relationship Type

Relationship type refers to how the business and the worker interact while conducting business. There are four factors that the IRS considers in this regard: 

  • Written contracts: Written contracts often stipulate whether the worker is an employee or an independent contractor. While the IRS may consider this factor, they may also disagree with and override worker classifications in a written contract. The IRS will also consider how the parties work together and determine whether this relationship matches the status indicated in the contract. 
  • Benefits: Sick days, disability, health insurance, vacation, and pension plans are benefits most businesses only provide to employees. The presence of these benefits strongly indicates the worker is an employee, but the lack of such benefits does not necessarily indicate they are an independent contractor. 
  • Relationship permanency: While employees are always free to quit and may be fired by their employers, their employment relationships are typically ongoing. Independent contractors often take on specific projects within a given time period, frequently with a specified end date indicating the end of the working relationship. 
  • Services are key to the business: When the services provided are a core part of the business, it is more likely that the worker is an employee. 

What Are the Major Issues Concerned With Misclassifying an Employee as an Independent Contractor When They Are Really an Employee?

Misclassifying employees can cause significant problems for both employees and employers. A misclassified employee often struggles with limited income and endures financial insecurity while lacking access to employer-sponsored health benefits or pensions. Additionally, the employee may deal with decreased Social Security or unemployment insurance benefits, as well as paying higher income taxes.I, Workers have little control over how they are classified by the parties who hire them, as the responsibility for compliance with federal worker classification requirements rests with employers.

Employers may face numerous issues if they misclassify employees: 

  • Requirement to repay back wages, damages, penalties, owed overtime, lost benefits, and interest. The employer may also face the repayment of unpaid income tax, Social Security, and unemployment insurance
  • Individual or class-action lawsuits with expensive settlements or jury awards
  • IRS audits
  • Civil fines 
  • Criminal penalties for charges such as embezzlement – as the money that should have gone toward wages, taxes and other expenses may be considered misappropriated funds

Are You Concerned About Misclassifying Employees? 

Employers cannot pick and choose each employee classification based on their own preferences. Instead, they must carefully evaluate relevant factors to classify workers based on the facts and their alignment with federal guidelines. Misclassifying employees can have severe consequences that can lead to fines, loss of reputation, and potentially civil and criminal charges. For business owners and managers concerned about potentially misclassifying employees, an experienced employment attorney with Schwab & Gasparini may be able to provide guidance on this subject. They may also offer assistance in rectifying situations regarding misclassified employees. Consider calling one of their New York offices for a free consultation: The Syracuse Office at (315) 422-1333, the Albany Office at (518) 591-4664, or the White Plains/Hudson Valley offices at (914) 304-4353.

Sun Mar 17 2024, 12:00am