Employee Misclassification Penalties and How to Avoid Them

The recent technological developments and advances influence our lives in ways few people could have envisioned a few years back. 

Just try to think about it. We carry a powerful computer, connected to the internet wherever we go. We use it to shop (for almost everything), communicate, work, and stay in touch with the world. Moreover, the entire world seems to revolve around user-generated content and anyone with a smartphone has the chance to gather a loyal audience.

Even more, technology is changing the work environment. Companies now have the possibility to dip their toes into a global talent pool, and they don’t even have to hire people. Remote workers and work-from-home are on the rise, as people seek to find better methods to balance their personal and professional lives. Moreover, the trend allows businesses to be more flexible with their costs and practice a more flexible approach to their hiring process. 

While all these sound amazing (and they are), entrepreneurs and business managers everywhere must pay attention to easy-to-make mistakes like employee misclassification. If this happens, it comes with heavy penalties and consequences. 

What is Employee Misclassification?

The surge in freelancers and independent contractors makes it difficult for the legal and tax systems to follow through with rules and regulations. As a result, there are loopholes and ambiguities that confuse both business owners and workers.

On the surface, both freelancers and employees are hired by a company to do a specific task (they are workers). However, from a legal standpoint, these two entities have different roles and obligations, which is why it’s crucial to understand the details between classifying a worker as either an employee or an independent contractor.

Therefore, classifying your employees correctly is a task that should be done with the help of a legal or a tax professional. At least, until you understand all the differences and can clearly differentiate between the two.

Why is Employee Misclassification so Important?

Tax Withholding

By law, employers have to withhold tax intake from an employee’s paycheck and submit it to the proper authorities. On the other hand, independent contractors (freelancers, consultants, and other external collaborators) have to submit their own taxes, which is a lot more difficult to monitor by the authorities.

Therefore, if a company misclassified an employee-employer relationship as an independent contractor-company relationship, the overall income tax will drop. 

Expense Deduction

Independent contractors have the right to deduct certain types of business expenses from their gross income. Employees, on the other hand, don’t have this right. Therefore, misclassified individuals mean a lower tax amount. 

No Benefits

The employee status comes with a series of benefits and protections that must be ensured by the employer. So, if the relationship is misclassified, the employee doesn’t have the same rights but their obligations stay the same. 

Employee Misclassification Penalties

Back-Taxes & Other Financial Penalties

If the authorities identify a case of misclassification, the company may be requested to pay the owed income and payroll taxes for the entire period. Additionally, the company may be fined as a form of penalty (especially, if the mistake was intentional).

Lawsuits from Misled Employees

As we mentioned before, employees have specific benefits and rights that are void if the relationship is misclassified. Therefore, if people thought themselves employed, they wouldn’t have submitted their taxes or performed other legal obligations, which puts them at risk. In this case, they will bring legal action against the company that misled them.

Loss of Reputation with Partners

A company that is thought of as being intentionally misleading with their employees will not be considered a trustworthy business partner. 

How to Avoid Employee Misclassification

To better understand the difference between independent contractors and employees, we took a look at the factors considered by the IRS. Here is what they look for when checking if the relationship is well-classified:

  • Control – Employers have the right to control the behavior of their employees. So, if your company decides an individual’s work schedule and the type of work they’ll be doing on a daily basis, we are talking about an employee.
  • Training – Independent contractors are already considered experts in their field, so there is no need for on-the-job training. Employees, on the other hand, tend to receive different types of training, so they’ll understand the company’s culture.
  • Financial Freedom – Independent contractors are free to seek out other collaborations while having an active collaboration. Employees can also get a side gig, but they are more limited in their choices and available time. 
  • Payment –  Employees are paid regularly, and the amount doesn’t vary from one month to another. On the other hand, independent contractors are paid based on the type of work they do and the existing agreement (so the dates and amount will vary). 
  • Permanency – An indefinite collaboration period may indicate an employee rather than an independent contractor.
  • Benefits – Companies don’t pay benefits such as health insurance, retirement, and others on the same note to independent contractors.

Key Takeaways

In summary, when you work on your business’s finances, make sure you understand the role each member of your team will play. And, while independent contractors can be a part of your team, they are also an organization that has legal obligations employees don’t.

Planet Compliance

Planet Compliance is a marketplace where institutions and corporates can discover RegTech and LegalTech solutions. Planet Compliance also operates a content platform that provides information and insights on technology, regulation, compliance, finance and innovation.

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