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The Consequences of Misclassifying Employees

By Elizabeth M. Rice, SPHR 

There are two types of classification disputes that can involve employers and their employees. The first is whether the workers are bona fide independent contractors. The second is whether the workers are bona fide exempt employees under the wage and hour laws. This article briefly examines the two areas.

The IRS has a 20 question test it has adopted to determine if workers are independent contractors or employees. The answer to these questions can impact the employer’s obligation to withhold taxes and pay payroll taxes like FICA and FUTA. Similar issues arise under state worker’s compensation and unemployment tax laws. Misclassification of employees as independent contractors can have both financial and legal repercussions. Nevertheless, failure to properly characterize workers is extremely commonplace in the U.S. The IRS estimates the underreporting of self-employment taxes due to misclassification of employees accounts for $148,000,000,000 per year and 43 percent of the gross tax gap. Since misclassifying employees can cost a company a devastating loss of time, effort and money, it is essential that companies are educated on the causes and how it can be prevented.

The other type of misclassification is of employees to determine whether they are entitled to minimum wages and overtime compensation. The most important statute here is the Fair labor Standards Act (FLSA). We interviewed Daniel Abrahams, Partner at Epstein, Becker & Green, P.C., to learn more about the consequences of improperly classifying as employees as “exempt” from federal and state wage laws and what companies can do to avoid this costly mistake.

According to Abrahams, the most common reason for misclassifying employees is misunderstanding the law and not knowing what makes an employee exempt. While a non-exempt employee is entitled to be paid minimum wages and overtime, an exempt employee is excused from minimum wage and overtime provisions of law. In order for a position to be exempt, employers must pay a salary rather than an hourly wage and typically only executive, administrative, and professional fit this criteria. Abrahams also points out that even though only about 10% – 20% of the United States workforce is excused from the coverage of the federal wage laws, a much larger percentage is classified as exempt from the minimum wage and/or overtime provisions.

Employers often mistake workers as exempt because they are salaried. However, in addition to being salaried, the employee must also perform a certain high level of duties. For example, an exempt bona fide executive would include any employee who has the authority to hire or fire other employees or whose suggestions and recommendations in regards to hiring, firing, advancement, promotion or any other change of status of other employees are given particular weight. To be a bona fide independent contractor some of the issues the IRS would look at are whether the worker manages and invests in his/her business and/or whether they have an opportunity for profit or loss. The second cause for misclassification is for financial considerations. Sometimes employers will classify employees as exempt purposely, so they don’t have to pay them overtime.

Depending on the size of the organization, employee classification is either handled by human resources or in the case of a smaller company, the controller or CFO. The employer makes judgments upon hiring an employee and often classifies his or her workforce as a group.

Misclassifying employees is critical, and for many companies it can mean the difference of thousands of dollars. Abrahams offers the following suggestions to ensure that companies are properly identifying employees:

  • Read over the legal regulations for exemptions and devise a clear job description for each job classification. Based on these explanations, you can make reasonable determinations as to whether the employee is exempt or non-exempt.
  • Review personnel manuals and payroll practices to ensure you’re not making improper deductions in the salary of otherwise exempt employees. Under the Fair Labor Standards (FSLA) there are complicated rules that regulate deductions in pay to be made to the salary of an exempt worker. Making the wrong deduction will turn workers into non-exempt employees.
  • Visit the Department of Labor and the IRS websites. The IRS offers an in-depth review of how to correct the reporting of misclassified employees.
  • Attend workshops to gain an understanding of the financial impact of misclassifying employees.
  • Seek professional advice. If you’re unsure about how to classify an employee, consult a professional. Although their services may include a fee, this is sure to save you money in the long run.

According to Abrahams, there were 4,500 Fair Labor Standards Act (FLSA) lawsuits filed last year. Additionally, numerous legal actions were made by the U.S. Department of Labor, along with thousands of labor investigations. As an employer you are required to post a notice in your workspace, notifying employees of the right to file a complaint through the U.S. Department of Labor. The department currently employs close to 1,000 U.S. Department of Labor investigators scattered around 150+ offices that take complaints.

Misclassifying workers can have tremendous financial consequences for companies. If it is an independent contractor situation, they may have to endure an audit from the IRS or a state department of taxation. If it is a wage and hour matter, they may find themselves in class action and individual lawsuits and be taken to court. The organization will not only have to pay back wages and overtime owed, but a variety of penalties and in many cases, attorney fees. Non-complying employers may also be required to pay amounts that should have been withheld or paid on the employees’ behalf. For example, taxes, FICA, FUTA, benefit contributions or the value of lost benefits, plus penalties, interest, other damages, and/or attorney fees. Employees who are misclassified as independent contractors and who have work-related injuries and would normally rely solely on workers’ compensation benefits, may be able to file a negligence claim against the employer.

Misclassifying employees is a costly-mistake that can happen to any company. However, by taking the right preventative measures, you can save yourself and your company a great deal of money and negative exposure in the long run.