10 Myths of Worker Misclassification (Independent Contractor or Employee)

Man and woman in a coffee shop

As the deadline to file your W-2s for employees approaches at the end of January 2017, many business owners have probably found themselves wondering whether or not certain workers should be labeled as employees or independent contractors.

With these uncertainties come many myths about the rules of classifying workers as independent contractors versus employees. This becomes a risky game as the implications of reporting a worker under the wrong classification can have severe financial consequences on your business, such as penalties for filing the wrong forms (i.e. a 1099 versus a W-2), payroll tax assessments for incorrectly classifying workers as contractors, and missing the filing date for your W-2 employees, which is January 31, 2017.

As the deadline to file W-2s approaches, it is imperative that you take the time to understand the distinction between W-2 employees and independent contractors to properly classify your workers to an audit. We compiled a list of worker classification myths that many business owners tend to fall for in order to help prevent any future misclassification mishaps.

Myth #1: It makes no difference whether or not a worker is classified as an independent contractor versus an employee.

The key reason to ensure workers are classified correctly can be summed up with the following issues: payroll tax liability, workers’ compensation insurance liability, and benefits owed to employees.

Workers classified as employees typically enjoy access to certain protections and benefits under federal, state, and local policies. Overtime pay, family and medical leave, workers’ compensation, and unemployment insurance are just a few of the many benefits enjoyed by employees who would otherwise see these protections disappear should they be misclassified by a business entity.

For an employer, the cost of misclassification can be disastrous to a business’ financial performance. Employees who are misclassified as independent contractors result in not only billions in lost payroll tax revenues each year, but also warrant a costly and time-consuming audit for a business. Many business owners who believe the classification of workers does not matter end up mistakenly doing so and avoiding payroll taxes, only to be assessed those taxes later on in the future.

Myth #2: An independent contractor under one law is also an independent contractor under other laws as well.

While a contractor is legitimately classified under one law, they still might be an employee under other laws. Federal and state protections differ depending on compensation, labor standards, family and medical leave, and Internal Revenue Code. These laws can all have an effect on workers’ compensation on their tax filing forms as well as their deductible benefits.

Individual states have different regulations and policies in place as well that determine employer-worker relationships, so an independent contractor in one state may not be classified as such in another state. Businesses who operate in multiple states should pay close attention to the labor laws in each state they conduct business in to ensure that they do not incur any punishment for classifying employees or independent contractors incorrectly.

One example of this is the Fair Labor Standards Act (FLSA) and Internal Revenue Code (IRC). Since FLSA guarantees minimum wage and overtime pay, the definition of employment is designed to be broad to provide as much coverage for workers as possible. IRC, on the other hand, focuses mainly on the degree of control an employer has over a worker to determine classification status and various tax benefits. To ensure compliance, examine your workers under federal law and the laws of each state where your business operates.

Myth #3: Independent contractors are not eligible for unemployment insurance.

While many independent contractors might not qualify for unemployment insurance, simply being classified as an independent contractor does not prevent one from being eligible. A business entity could consider a worker to be an independent contractor but each state’s respective unemployment insurance board can make its own determination under its own laws on whether or not a worker is an employee or not. Because of this, workers who are classified by businesses as contractors and not as employees by the unemployment insurance boards does qualify these workers for unemployment insurance despite their classification by the business.

Myth #4: Filing a 1099 tax form for a worker automatically classifies them as an independent contractor.

As we mentioned in our “Employees vs. Independent Contractors” post, it is important to know which workers require a 1099 and which workers require a W-2 tax form. Similarly, simply filing a 1099 for a worker does not automatically classify one as an independent contractor. An independent contractor’s work does not fall within the law’s definition of employment, and whether a 1099 is filed or not simply depends on the business’ classification of each worker. This is a risky pitfall for business owners who think that automatically filing a 1099 for a worker classifies them as an independent contractor.

For example, under federal tax law, receiving a 1099 does not classify a worker as an independent contractor. The 20-factor test published by IRS determines whether or not a 1099 recipient is an independent contractor or an employee. Every business owner should diligently examine these 20 factors in order to file the correct forms for their workers to avoid an incorrect classification.

Myth #5: A worker who signs a contract agreement is automatically classified as an independent contractor.

Many employers view this as a failsafe method in classifying their workers, as they believe a legally-binding contract can come to the defense should they run into any trouble from state or federal taxation boards. However, under the Free Labor Standards Act, Family and Medical Leave Act, and many other worker protection statutes, a worker is an employee if his or her work indicates economic dependence on the employer.

To put it simply, any label given to a worker by the employer in the relationship is irrelevant. Under state and federal laws, it is the reality of the employer-worker relationship that dictates whether or not a worker is an independent contractor or an employee. While a contract has the benefit of specifically dictating the duties and services outlined by a contractor, it is the contractor that maintains control of the label in an employer-worker relationship.

Myth #6: A worker that is not on payroll is not an employee.

The Free Labor Standards Act requires that employers keep records for their employees such as classification, identification, work hours, and any earned wages. As previously mentioned, the only factors affecting a worker’s classification is the reality of the relationship between worker and employer – which party maintains control over the work.

If an employer leaves an employee off payroll thinking that it will count as contractor classification, they are in violation of FLSA. Workers who are paid only in cash also tend to fall under this category, but this does not always mean that they are in fact employees. If the nature of the relationship between contractor and employer meets the correct criteria (see “Independent Contractors vs. Employees”) it is perfectly legal for an employer to leave these workers off the payroll and not keep the usual records kept for employees.

Myth #7: Possession of an employer identification number (EIN) or paperwork stating that one is performing services as a Limited Liability Corporation (LLC) is sufficient to be classified as an independent contractor.

It is true that most independent contractors have EINs or operate as an LLC, corporation, or sole proprietorship. However, many employers will also require contractors to file business paperwork and obtain a business name to further advance the job done by the contractor. This requirement in and of itself is a violation of the specifications that dictate the relationship between a contractor and an employer as the worker is not in control over how they conduct their business.

Myth #8: Off-site workers and teleworkers are independent contractors.

Location of a worker’s job performance rarely affects the classification of an employee or independent contractor. Working away from a worksite does not necessarily make one an independent contractor. Conversely, working on-site does not necessarily make one an employee. The fact of the matter is that both employees and independent contractors can work either on-site or at home. The only factor affecting their classification should be the work they conduct and the amount of control within the employer-worker relationship.

Myth #9: A long history of classifying a worker as either an employee or an independent contractor means it is correct to continue with either classification.

For workers that have consistently provided services for an employer on a contractual basis, a switch in classification might be in order if the business relationship changes between the worker and employer. Similarly, employees who have enjoyed the benefits of their employee classification who wish to provide similar services as a contractor cannot rely on their employment seniority to maintain their employee classification. It may be helpful to also examine the industry you operate in to see how other similar businesses classify their workers.

Thus, an employer cannot get away with a worker’s past classification – no matter how long it may be – if the nature of the employee-worker relationship changes, as slightly as it may be. Many factors are considered when determining the status of a worker for tax purposes, and it is important to analyze these factors should the business relationship change.

Myth #10: Federal and state taxation boards will accept late filings if the reason is due to accidental misclassification.

Though misclassification of workers happens rather frequently – the Department of Labor has found that between 10-30% of audited employers misclassified workers – the pressure still rests on the employer to ensure that the existing relationship and conditions for a worker lead to a correct classification and a timely filing of the correct tax form. Employees should have a W-2 filed by January 31, 2017 while independent contractors’ 1099s are not due until February 28, 2017. Due to these differences in dates, it is a top priority to ensure your workers are classified correctly as soon as possible for tax reasons to avoid any late filings and triggering a state or federal audit.

The information contained in this article is only intended for information purposes and is not intended to be legal advice. Should you have an EDD or IRS audit, or a legal question, please contact Milikowsky Tax Law at (858) 450-1040.