Top 5 Employee Misclassification Penalties to Avoid

By MBO Partners | May 17, 2024

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Key Points

Independent professionals provide access to high-quality talent, staffing flexibility, and cost savings.

When workers are classified as independent contractors, organizations must avoid treating these workers like full-time employees.

Regardless of whether worker misclassification is intentional, it puts organizations at risk for owing back taxes, benefits, and penalties.

Worker misclassification is often a big concern among enterprises who engage independent talent. While working with independent contractors can benefit business-savvy organizations, misclassification risks need to be mitigated and avoided in order to protect your business.

Independent contractors provide access to high-quality talent, staffing flexibility, and cost savings—as such, it’s no surprise that the use of this talent pool has become more common in recent years. However, one of the biggest risks in engaging independent talent is misclassification.

When workers are classified as independent contractors, organizations avoid paying the benefits that most employees are entitled to, such as health insurance, paid time off, and the employer’s side of payroll taxes. Regardless of whether misclassification is intentional, it puts organizations at risk for owing back taxes, benefits, and penalties for its misclassified workers.

Here are the top five employee misclassification penalties and what your company can do to remain compliant.

1. Wage, Tax, and Employment Eligibility Violations

There are a variety of tests and laws used to determine whether or not a worker should be classified as an employee or an independent contractor. The federal government, state government, and government agencies all apply different logic to determine misclassification, and these laws and tests lack uniformity. This complicates the hiring and vetting process as independent talent may be categorized as employees under one law, but as contractors under another.

Of course, this makes legal compliance difficult. If employers misclassify employees, they may be violating wage, tax, and employment eligibility laws. Organizations 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. Wage claims may go back as far as three years if a willful violation is found—when an employer knowingly violates the law.

2. Tax and Payroll Fines

When an employee is misclassified, federal and local governments lose out on tax and payroll revenue. Employers may be responsible for paying state and federal payroll taxes as well as Social Security and Medicare taxes for all employees found to be classified incorrectly. Penalties can also be imposed for failing to timely deposit payroll taxes.

Lastly, organizations must keep I-9s on record for each of their employees to prove their employment eligibility. If an independent contractor should’ve been classified as an employee, there are fines associated with not having an I-9 form on record for that worker.

Fines from the U.S. Department of Labor (DOL), IRS, and state agencies can total millions of dollars. Companies can be held responsible for paying back-taxes and interest on an employee’s wages as well as FICA taxes that weren’t withheld originally.

Failure to make these payments can result in additional fines. If the IRS believes you’ve intentionally misclassified workers, there is also the possibility of criminal and civil penalties and sanctions. Additional penalties and fines can be applied depending on the severity of the misclassification.

3. Legal and Punitive Damages

The media today is filled with ongoing class action lawsuits involving large, well-known organizations. These lawsuits can result in huge costs for your company—not only legal costs, but also punitive damages, compensation that goes above and beyond individual or government fines and payments.

When a company is involved in a lawsuit, representatives from legal, HR, marketing, and finance departments will need to assist in finding proper documents, defending claims, and complying with investigations. During this time, these key people generally can’t dedicate as much time to their primary work.

Loss of existing talent is also a potential consequence. Independent professionals may decide to end their relationship with your company or choose to not re-engage with you when their project ends.

4. Back Payments to Re-classified Workers

If a worker believes they’ve been misclassified, they can file a complaint with their state Department of Labor or with the DOL. If these claims are validated, workers are eligible to claim employee benefits including 401(k), severance, health and welfare coverage, stock purchase plans, and even overtime, PTO, and rest break time. This can result in additional fines and penalties as well as increased scrutiny from tax and labor authorities.

5. Reputation Damage

Not only can misclassification hurt your workers and your bottom line, but it can also damage your organization’s reputation. An audit or lawsuit can put your company in the public eye, which can lead to negative publicity that can damage recruitment efforts and the overall reputation of your brand.

Independent professionals may be hesitant to work with your organization if they know you’ve been involved in a misclassification lawsuit, and other businesses may shy away from partnerships due to negative media attention. Correcting reputational damage can be complicated and time-consuming, slowing down operational efficiency and disrupting talent pipelines.

Compliance Protects Your Company from Employee Misclassification

Misclassification carries serious penalties, risks, and consequences, so it is essential that organizations have a defined program in place for engaging and managing independent talent.

Firms that specialize in independent contractor engagement and compliance can assist in properly developing key policies and setting up a program for proper management of independent talent. MBO Partners has an established methodology for evaluating and engaging independent contractors, which serves to greatly minimize compliance issues.

For more information on how to protect your company, check out our guide:

How to Reduce Your Risk of Employee Misclassification

The information provided in the MBO Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs. Before acting on any information in the MBO Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.

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