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Employers: It is not worth it to misclassify your employees as contractors

On Behalf of | Oct 7, 2021 | Corporate Taxes |

An important decision every employer must make, with each individual providing any service to the company, is how to classify that person. Whether to classify someone as an employee or an independent contractor is an extremely important decision for employers.

While there are numerous temptations to label employees as contractors – including tax benefits and reducing liability exposure – it is not worth the risk. There are serious consequences to mislabeling individuals as independent contractors.

What is the difference?

The difference between independent contractors and  employees is simple. An independent contractor is truly independent. He or she can set the terms of the contract for work, including scope of work, how the work is done and how the worker is compensated. The contractor also does not receive employer-provided insurance, vacation, overtime pay or other standard employee benefits. The contractor provides his or her own tools and is generally left to perform the work independently.

Conversely, for an employee, the employer truly is the boss. The employer has to provide certain benefits and has a lot less control and independence over the work.

Why are the benefits of working with independent contractors?

There are numerous benefits to working with contractors rather than with employees. The most important benefit is financial. When paying a contractor, an employer does not have to withhold any Social Security or Medicare taxes, which represent a significant percentage of an employee’s compensation. Further, employers are not required to carry unemployment or workers’ compensation insurance, which can be extremely costly.

Finally, working with contractors minimizes exposure. Without the requirement to provide overtime pay, minimum wage and other benefits, and reduced liability for discrimination lawsuits, working with contractors could present considerable cost benefits.

What are the risks?

Although the benefits of classifying workers as contractors rather than as employees can be tempting, there are significant risks involved, as well.

First, there is increased exposure to personal injury claims from independent contractors. Since employees fall under workers’ compensation, they are generally barred from bringing these claims against their employers. Independent contractors, however, do not fall under workers’ compensation laws, and are thus able to bring lawsuits if injured while on the job.

The most important risk involved with the independent contractor classification involves getting it wrong. When a company has numerous independent contractors, it is more likely to be audited. And an audit that uncovers any instances of misclassification against a company could be disastrous.

Penalties for misclassification can include:

  • Exposure to lawsuits which could result in repayment of all benefits and punitive damages
  • IRS penalties, which can include fines, 1.5% of employee wages for each employee misclassified, 40% of the FICA taxes not withheld and 100% of the employee’s FICA taxes meant to be paid by the employer

These are just the tangible, immediate consequences of misclassification. Employers are wise to work with experienced, trusted legal counsel to make sure they are properly classifying their employees. The risk of misclassification is simply too high.

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