Misclassified Employees: The Mistake That Keeps on Giving

Feb. 26, 2018

Running a small business – be it a startup or an established firm – is challenging. The state and federal regulatory compliance requirements that come with running a business, including all the paperwork, payroll, benefits, record retention, not to mention the day-to-day snafus that come with hiring, firing, managing performance, it all adds up. As a business owner, you have to choose your battles, prioritize, multitask when you can, and tackle the rest of the challenges one at a time.


We know that putting employees on salary, rather than paying them hourly wages, sometimes is just easier. You do not have to worry about timekeeping, payroll is simple, and most employees actually prefer it. There is a certain status to being a salaried employee, especially if the employee is not pulling a lot of overtime. Making workers independent contractors can be even easier. In that case, you have fewer headaches and less overhead associated with having them as employees.


The classification of your workforce, however, – be it classification of workers as independent contractors vs. employees or exempt employees vs. nonexempt employees – is the last place you want to take shortcuts. Business owners must understand that they have no discretion when it comes to employee classification. Although there are gray areas in employee classification that may require analysis and expertise, in the end, you as the business owner do not get to decide to classify an otherwise non-exempt employee as exempt or a regular employee as an independent contractor. The government decides and in the area of employee classification, the government is unforgiving.


Misclassifying employees can create problems with the Internal Revenue Service (IRS), state and federal Departments of Labor, and employees themselves. The IRS will get involved because misclassification of employees as independent contractors can interfere with its effort to timely and fully collect income tax withholdings, Social Security, and Medicare. The IRS’s collection efforts are enhanced when the employer pays the withholding taxes. The potential for questionable deductions offsetting employment taxes is substantially diminished with the use of payroll withholding. In withholding, taxes usually are paid twice per month rather than once a quarter. Employers also pay unemployment taxes, the revenues from which terminated employees can benefit, rather than putting further strain on general assistance programs.


A 2009 study by the treasury inspector general estimated that misclassification costs the United States $54 billion in underpayment of employment taxes and $15 billion in unpaid FICA and unemployment taxes.” For these and other reasons, the government has a substantial interest in ensuring workers that should be classified as employees, not independent contractors.


The penalties for noncompliance with the employee classification requirements of the Internal Revenue Code vary depending on whether the misclassification was willful. If the employer can convince the IRS that the misclassification was a result of an honest mistake, the penalty on the business is “only”:


·         1.5% of the misclassified employee’s wages; plus

·         40% of the amount that should have been withheld for Social Security and Medicare tax from the employee; plus

·         100% of the employer’s share of Social Security and Medicare tax (the employer “match”); plus

·         $50 for each Form W-2 that the employer failed to file because of classifying workers as an independent contractor; plus

·         A “failure to pay taxes penalty” equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.


If the employer willfully misclassified the worker (a “knew or should have known standard”), the above reimbursements will apply but the penalties are much worse – an amount equal to the full amount of taxes that should have been withheld – income, Social Security, Medicare, and the employee match. The penalty can be assessed simultaneously on the company itself and on its officers personally, if they are deemed to be responsible. Finally, additional fines related to failure to file and failure to pay may result, as well as interest on the balance due. The employer cannot recover these taxes or penalties from the employee. There are also potential criminal penalties of up to $1,000 per misclassified worker and one year in prison.


If you misclassify employees, the IRS is not the only agency you need to worry about. The U.S. Department of Labor (DOL) and perhaps the applicable state counterpart will weigh in as well. (The IRS and the DOL do talk to each other). Misclassifying an employee as an independent contractor creates exposure on the employee benefits your company offers employees but not independent contractors. Failure to properly classify a worker as an employee could lead to a situation where the employer self-insures that employee for benefits (think health, disability, 401k, and life insurance) that the employee may otherwise have been entitled to if they had been properly classified as an employee.


It is easy to fall into the misclassification trap, especially in the early days of a startup: job positions and titles are rarely well defined, and the owners are still deciding what positions are needed. Employees often work long hours and perform duties across multiple positions.

Some startups operate under the illusion that they can create their own rules with respect to compensation. Often, cash flow is an issue, and start-up owners sometimes pay employees with non-cash compensation, such as shares of stock, phantom stock, stock appreciation rights, or other forms of equity. Or, they promise the employees a performance bonus if the company reaches certain milestones.


But startups are not exempt from minimum wage laws and must pay either the federal or state minimum wage, whichever is higher. Learn about Minnesota’s minimum wage here. And what about wages for all those extra hours? Many startups falsely believe that overtime laws do not apply to them, so they do not even consider paying their employees for overtime worked. While certain employees are exempt from being paid for overtime, startups are required to pay overtime to nonexempt employees.


If the Department of Labor gets wind of this, either through a complaint or an audit, it will impose penalties equal to a doubling of the unpaid wages owed to the employee, plus the employee’s private attorney’s fees, if any.


The consequences for misclassification of employees can disastrous to a business. Just look at the ongoing lawsuit that was filed against an on-demand cleaning startup, Handy Technologies. A seemingly insignificant violation may lead to large and damaging penalties.


As businesses grow – and their workforces expand – concerns over compliance becomes increasingly important. Particular attention must be paid to:


·         Classifying workers as exempt or nonexempt;

·         Workers who might be improperly classified as independent contractors;

·         Compliance with minimum wage and overtime laws; and

·         How payroll is administered.


In the end, business owners need to pay close attention to these classification issues early and revisit what their employees are actually doing from time to time, to ensure they are properly classified.

Written By:
Bill Egan

Bill Egan is a Seasoned Employment Law Attorney backed by over 33 years of proven, veteran experience. He specializes in navigating businesses through conflict resolution in the workplace.

Emilee Walters is a second year law student at the St. Thomas School of Law. Emilee is an Avisen Fellow exploring a legal career in business law.

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