Employee Misclassification: Laws and Penalties

Last Updated on  December 31, 2020  By  Freelance Central Editorial Team
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Employee misclassification causes substantial revenue loss in the form of lower tax revenues, unemployment insurance, and workers’ compensation funds for the government. In this article, let us take a detailed look at employee misclassification and penalty rates, and how you can avoid both by proper classification practices. 

What is employee misclassification?

If you are managing a business, the people that work for you are termed as employees under federal and state statutes. If you hire permanent employees, you are entitled to enforce rules over them, such as the employees function at your company, how they perform that function, when they are expected to perform it, what they should or should not do, and salary & benefits. However, if you hire a contractor, many of these rules don’t apply. You also don’t need to offer them benefits and overtime compensation that your employees enjoy.

Employee misclassification happens when you mislabel employees as independent contractors. When you misclassify employees, you prevent them from having access to benefits and protections, minimum wage, overtime compensation, family & medical leave, unemployment insurance, and safe workplaces.

Furthermore, companies are mandated to withhold taxes from employees. So when you misclassify an employee, it significantly lowers the federal and state government’s tax revenues and reduces funding to social insurance systems. That’s why companies that misclassify their employees are met with harsh penalties if governing bodies find them guilty.

How is an employee different from a contractor?

Employers need to make clear distinctions between employees and independent contractors
in order to prevent misclassification. Here are some of the most notable differences between an employee and a contractor.


Independent contractor 

Employees are hired under an employment agreement and are eligible for insurance, leave, overtime compensation, paid leave and other benefits. The employer must provide benefits, and pay employment taxes for them. 

Independent contractors are hired temporarily to handle a specific project or function in a company. They are self-employed professionals and pay self-employment taxes.

Employees have federal and state tax withholding from their wage. They receive a W-2 form which has information about taxable income for the employee, Social Security, Medicare and FICA taxes, and state income taxes withheld from their paycheck. 

Independent contractors are not taxed under the law. They might be subject to backup withholding under certain circumstances. Employers provide a W-9 form to the contractor in which he has to fill out his SSN, contact information and other details. 

The employer manages the employee and has total control in how work is done. An employee cannot provide his services to other companies. 

An independent contractor has total control over his work, and is not subject to the client’s control. Independent contractors often work with multiple clients at the same time. 

Employees get paid a standard 40-hour workweek wage. They are eligible for overtime compensations and paid leaves. 

Independent contractors are paid based on the number of hours they work. Their hours can fluctuate depending on their client’s requirements.

Employees fill out a W-4 form to let employers know how much tax to withhold from their paycheck based on filing status, dependents, anticipated tax credits and deductions, etc. 

Independent contractors will receive a W-9 form that he needs to furnish and give back to the client. The client will also send him copy 2 of Form 1099-NEC which has details of his nonemployee compensation.

How to avoid misclassification

There are many steps that you can take to ensure that you do not misclassify the independent contractors that you work with:

  1. Review your company’s worker classification by conducting an internal audit to understand your current classification practices and whether or not you are compliant.
  2. Cross check your records and refer to services performed by contractors and confirm if they have federal tax ID numbers.
  3. Rely on a freelancer management service like Freelance Central for engaging and managing your independent contractors.
  4. When you work with a contractor, ensure that you keep a record of documents that support a classification decision such as license, business cards, or insurance certificates that can be used as proof of self-employment.
  5. Draft a freelancer contract and have it signed by the independent contractor and the hiring manager outlining the terms of contract and his/her classification.

What is the penalty for misclassifying employees?

If the US Department of Labor confirms that you have misclassified employees, you will be required to pay wages for up to three years. Additional fines will be levied improper recordkeeping.

If the IRS finds out that you intentionally misclassified your employees, they may seek a criminal conviction with up to a year in jail and a fine as high as $500,000. You will also be audited that might reveal other wage and hour violations which will further increase the penalty amount.

Final Thoughts

Employee classification can be a confusing and tricky road to navigate. But considering the repercussions of misclassification, it is better to mitigate compliance risk and take time to classify your workers properly. Apart from costly penalties and fines, your company’s reputation will be tarnished if you are found guilty of tax evasion. Implementing a better system to manage and interact with independent contractors helps you stay on the right track and avoid unwanted penalties.

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