Risks of Misclassifying Independent Contractors and Employees

Man and woman looking at a laptop

Risks of Misclassifying Independent Contractors and Employees

Is the person you just hired a 1099 contractor or an employee? Making a false assumption could be costly. In California, there is a fine line separating these two categories of workers and significant penalties for misclassification. 

Here are some of the consequences you might have to face for mislabeling your contractors and employees, and tips on how to ensure that you classify workers correctly. 

Possible Consequences of Misclassification

Companies in California that mislabel their workers could face steep penalties from both state and federal agencies. Therefore, businesses of all sizes should take special care in ensuring they are in compliance with state employment laws and not taking risks. 

Here are just some of the consequences you may face for a violation:

  • Employers can face state-imposed fines of $5,000 to $15,000 for each known misclassification. The fines increase to anywhere from $10,000 to $25,000 if an employer displays a pattern of illegal behavior. 
  • Violators are required by California state law to post a notice about their infraction in a prominent location on the business website for one year. If a website doesn’t exist, the notice must then be posted at the physical place of business where the infraction occurred. 
  • IRS may require employers to pay both their share and the employee’s share of FICA tax, as well as the employee’s portion of FUTA and income taxes. 
  • Penalties may be assessed in the amount of 1.5% of the employee’s federal income tax liability, plus a 20% penalty against the amount of FICA tax that should have been withheld.
  • Companies caught misclassifying workers may have to pay an additional penalty equal to 10% of the unpaid unemployment and disability insurance that was supposed to be withheld. 
  • Companies can be charged with a misdemeanor that carries a $1,000 fine, a one-year jail sentence, or both. 
  • Companies may be required to pay the unpaid state income tax, unemployment insurance, and disability insurance that would have applied during the period of misclassification. 
  • Finally, the employee that was misclassified can also take legal action against the employer and seek up to three years of unpaid wages and penalties.

The exact amount a small business may pay in violations depends on the circumstances of the violation and the discretion of the enforcement agencies. However, in all cases, the financial and reputational damage is too great to ignore. If you have any questions regarding worker classification or you’re facing an EDD audit, contact Milikowsky Tax Law to schedule a consultation right away.

Properly Classifying Workers

The best thing you can do to remain in compliance is to never assume whether someone is a contractor or an employee. You should have a clearly outlined process to determine exactly how you classify workers. This may take time and consideration, but it’s absolutely worth it to avoid the aforementioned federal and state penalties. 

Here are a few tips:

  • Operate on a case-by-case basis. Don’t base your classifications solely on job title or past precedent. Evaluate the facts of each employment relationship individually before deciding whether someone is a contractor or employee. 
  • Apply “Right-to-Control.” The law determines whether or not someone is a contractor largely on the amount of control the employer has over them. The EDD evaluates three factors: behavioral, financial, and the nature of the working relationship. Using these criteria to make classifications ensures that new hires are compliant. 
  • Partner with Experts. Given the penalties for misclassification, small businesses can’t afford to make a classification mistake. Rather than trying to learn the intricacies of employment and tax law, most small businesses choose to work with outside experts who take a methodical and systematic approach to worker classification.

While the IRS does make distinctions between intentional and unintentional violations, there isn’t a clear precedent for what constitutes either — and hefty fines can be issued no matter what. The best-case scenario is one in which you onboard all new employees using the same process and correctly classify them as either contractors or employees, thereby avoiding violations altogether.

If you have questions on this matter, please reach out to Milikowsky Tax Law for guidance. Our team is well-versed in worker classification and can help you address your concerns or prepare for an upcoming EDD audit.

The information contained on our website and in blogs is provided for information purposes only and does not constitute legal advice