What Are the Penalties for Misclassification of an Employee?

Misclassifying an employee as an independent contractor can lead to intense penalties and fines. Employers may face penalties of up to 3% of the employee's wages, up to 40% of FICA taxes that were not withheld, and up to 100% of the matching FICA taxes. There is a $50 fine for every W2 that was not filed, and employers may also be liable for unpaid overtime costs, minimum wage deficits, and unpaid worker's compensation. 

Additionally, businesses that misclassify employees may face civil penalties for I-9 violations and liability exposure for failure to provide benefits, running afoul of anti-discrimination laws, not providing job-protected leave, and not abiding by legal requirements to provide notice. On top of that, there may also be state fines or penalties for misclassifying workers, and larger employers may even face class action lawsuits.

The consequences of misclassifying an employee are severe, and unfortunately, they apply even if you don't understand the rules. The penalties can be even worse if you willfully misclassify an employee. To help you avoid misclassification penalties, this post outlines the differences between employees and independent contractors. Then, it looks at the penalties in more depth and provides tips on how to classify your team correctly and what to do if you're unsure.

What Is Employee Misclassification?

Employee misclassification is when a business classifies an employee as an independent contractor. Although it can also apply in reverse (when an employer classifies an independent contractor as an employee), penalties only come into play when someone who should be classified as an employee is classified as an independent contractor. 

That's because employees have rights that independent contractors don't have. They are entitled to minimum wage, unemployment insurance, worker's compensation, and other benefits under state or federal law. Additionally, employees and independent contractors are taxed differently. Independent contractors are responsible for all of their FICA taxes, while employees pay half of these taxes and their employer pays the other half. 

Sometimes, misclassification happens by accident. The employer and the worker may not understand the law, and they may think that the classification they are using is correct. In other cases, the misclassification is purposeful, and the employer does it to avoid regulatory requirements and to save money on taxes and benefits. 

Although the penalties apply to both willful and non-willful misclassifications, willful violations can lead to higher fines and a greater risk of lawsuits.

The Difference Between Employees and Contractors

Employees are people who draw a paycheck and often receive paid time off or other benefits from their employers. Independent contractors are self-employed business owners who bill clients for their work. Businesses withhold taxes from employees' paychecks and make matching Medicare and Social Security contributions. In contrast, businesses simply cut a check that generally involves no withholdings for independent contractors. 

That's a basic breakdown of the difference, but to determine which workers are employees and which are independent contractors, you must look at the classification rules from the Department of Labor (DOL) and the Internal Revenue Service (IRS). Although these rules overlap, they have slight differences. The IRS tends to focus on the taxation of workers, while the DOL focuses more on the working relationship between the worker and the business. 

The DOL’s Final Rule

In January 2024, the DOL issued the Final Independent Contractor Rule on Misclassification of Workers under the Fair Labor Standards Act (FLSA), and the rule went into effect in March 2024. It replaced the 2021 rule, and it says that you should consider the following six factors when classifying a worker.

Opportunity for Profit or Loss

An employee receives a paycheck. An independent contractor is a business owner who charges clients for their services, incurs expenses, and has their own opportunity for profit or loss. 

Typically, if a worker can negotiate their pay for each project and decide when and how to do the work, they are an independent contractor. In contrast, if a worker earns a set wage or salary and their employer tells them when and how to complete the job, they are an employee.

Investments by the Worker and the Business

Does the worker make substantial investments in support of an independent business? For example, does the worker provide their own computer or tools? If so, they are likely to be an independent contractor. In contrast, employers traditionally provide all of the tools and supplies for employees. 

Degree of the Relationship’s Permanence

Typically, employees have a relatively permanent relationship with their employer. Independent contractors tend to have temporary, sporadic, or project-based relationships with their clients. 

Nature of the Work Relationship and Degree of Control

The more control a business has over a worker's activities, the more likely the worker is to be an employee. For example, someone who works remotely but must clock into a computer system at a set time every day and do very specific tasks is likely to be an employee. However, someone who works remotely on their own timeline and does tasks in the order of their choice tends to be an independent contractor.

Significance of the Worker’s Role in the Business’s Primary Operations

This rule looks at whether the work performed is an integral part of the business. If the work performed is central to the business's activities, the worker is likely to be an employee, but if the work they do is not critical or central, they are likely to be an independent contractor. 

For example, imagine an accounting firm. The accountants who work for the firm take care of its central business activity, accounting, and thus, they are employees. In contrast, the person who comes in to clean the office at the end of the day is not performing a central role and thus may be classified as an independent contractor. 

To flip the scenario, imagine a cleaning company that hires a crew of cleaners to go out on jobs at specific times with set lists of duties. The cleaners are integral to the company's central activities, and thus, they should likely be classified as employees. However, if this company engages an accountant to do their tax returns, they are performing work that is not central to the business and can be classified as an independent contractor.

Skills and Initiative

Both employees and independent contractors may bring specialized skills to the table. But if the skills are paired with a business initiative, the worker is most likely an independent contractor, and if the skills are directed by a supervisor, the worker is most likely an employee. Similarly, if a business trains or coaches a worker to develop specialized skills, they are more likely to be an employee. 

The IRS Three-Factor Test

The IRS uses three factors to determine if someone should be classified as an independent contractor or an employee. 

Behavioral Control

Independent contractors have more control over their behavior. Although they may have client deadlines, they largely determine how and when they complete tasks. Employees tend to have less control. They are generally subject to a fixed schedule or working under supervision.

Financial Control

As a quick litmus test, independent contractors have more financial control over their activities than employees. However, this category can get a bit murky, and you must consider several different subcategories. 

First, you must consider significant investment just as it's included in the DOL's Final Rule, but you also must be aware that there are exceptions to the rule. According to the IRS, many construction workers, in particular, spend thousands of dollars on tools and equipment but are still considered to be employees, and similarly, some independent contractors don't have a significant investment because their work doesn't require a lot of expensive tools.

Then, look at unreimbursed expenses. Independent contractors incur their own expenses, while employees are typically reimbursed for their expenses. Again, there are exceptions to the rule. This category also includes the opportunity for profit or less which is fleshed out in the DOL's rules as well. 

Finally, it looks at the services available to the marketplace and the method of payment. Employees typically work for one employer, while independent contractors may advertise for multiple clients or have a visible business location. Finally, employees tend to get a set wage or salary even if they earn commission or bonuses on top. Contractors charge flat fees or hourly rates for their services.

Relationship

Employees typically have ongoing, permanent relationships with their employers. Contractors, in contrast, have temporary relationships. Employees receive benefits, while contractors do not.

As you can see above, the rules have a lot of grey areas, and there are workers who may arguably fall into either category. If you're unsure about how to classify a worker, you can ask the IRS to decide. To do that, submit Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). 

Unfortunately, it can take up to six months for the IRS to respond to these requests. If you want to be on the safe side, consider consulting with a tax professional who has experience with employment laws. 

Penalties for Misclassifying W-2 Employees as Contractors

As indicated above, misclassifying your employees can lead to back taxes, penalties, lawsuits, and other consequences. The following sections look at the different consequences based on their category.

Employee Misclassification Penalties Under Federal Law

Under FLSA rules, misclassified employees are entitled to wages and overtime pay that they would have received if they were classified correctly. 

To give you an example, imagine that a business misclassifies an employee as an independent contractor, and they pay them $200 for 60 hours of work. If the worker had been an employee, they would have been entitled to the minimum wage of $7.25 for the first 40 hours and overtime pay of time and a half for the next 20 hours. That is a total of $507.50. As a result, the business owes the worker the difference. 

In addition to back wages and overtime, misclassified employees may be entitled to liquidated damages to compensate them for the delay in payment and interest on unpaid wages and overtime. 

Employees will also be liable for unpaid federal taxes, federal unemployment premiums, and any state payments they didn't make such as state worker's compensation or paid time off. Employees may also be able to bring lawsuits against their employer for breaking federal anti-discrimination laws or other laws.

I-9 Violations

Independent contractors do not have to complete I-9 Forms, but employees do. If you are subject to an I-9 audit and the government finds out that you do not have these forms, you can face fines and, if applicable, lose your ability to get government contracts.

IRS Penalties

The IRS can assess the following penalties on businesses that have misclassified employees as contractors:

• 3% of each misclassified employee’s wages
• 100% of all unpaid FICA taxes
• 40% of all FICA taxes that were not withheld
• $50 for every unfiled W-2 Tax Form

Here's an example of how those penalties may work. Let's say that you paid a contractor $1000, and the IRS determines that they were misclassified. For the purposes of this example, imagine that you don't have to make any payments related to unpaid overtime or minimum wage deficits.

Based on the $1000 payment, the 3% penalty is $30. The employer should have withheld $76.50 from the pay for FICA taxes. So, they owe that amount plus a 40% penalty which is $30.60. Then, they should have made a matching payment of $76.50 and the penalty for that is 100%. 

When you add the unpaid tax to the penalties, you get a total of $290.10. When you consider an employer dealing with tens or hundreds of thousands in misclassified wages, that amount increases substantially. 

Consequences of Misclassifying 1099 Contractors as Employees

Sometimes, businesses misclassify independent contractors as employees. This mistake tends to be rare because employers generally don't benefit from this type of misclassification. However, there are exceptions. 

In particular, during the COVID pandemic, some employers misclassified their contractors as employees so that they could claim the Employee Retention Credit (ERC). If this error is discovered in an ERC audit or through another means, the employer will need to repay the credit and may also face fines and penalties. 

How To Correct an Employee Misclassification

Worried that you misclassified a worker? Know for sure that you misclassified someone and looking for a way to fix the situation? Then, you may want to look into the IRS's Voluntary Classification Settlement Program. 

The voluntary disclosure program lets you reclassify contractors as employees and avoid penalties. If you qualify, you don't have to pay penalties or interest, and you only have to pay 10% of the employment tax liability that would have been due on the employee's wages in the last year. To qualify, you must not be under an employment tax audit, but you can be involved in a general audit of your tax returns. 

You also must have consistently classified the employee or employees as independent contractors or some other type of non-employee, and you must have filed their 1099 Forms for the last three years. Finally, you must not be contesting the classification of that employee in court. 

To apply, file Form 8952 (Application for Voluntary Classification Settlement Program) at least 120 days before you want to reclassify the contractors as employees. 

If you're under audit, you may be able to get similar relief through the IRS's Classification Settlement Program. However, the rules vary. To get clarity, talk with a tax pro who's experienced with employment law and worker classification.

How to Avoid Misclassifying Your Workers

If you want to stay on the right side of the law and avoid unwanted penalties, lawsuits, or other issues consider the following tips:

A job description that clearly articulates elements that appear on the DOL's Final Rule or the IRS's rule can help to ensure that you are protected if you're subjected to an audit or a complaint. Make sure to outline issues related to payments, working relationships, expense reimbursement, and other essentials.

Relationships with your workers may change over time. Make sure that you keep tabs on changes and re-classify workers as relevant.

1. Stay up to date on state/national employment regulations.

   If you own a small business, consider outsourcing payroll and worker classification to a business tax specialist. If you have a large company, insist on accreditation for your HR team.

2. Create clear job descriptions.

   A job description that clearly articulates elements that appear on the DOL's Final Rule or the IRS's rule can help to ensure that you are protected if you're subjected to an audit or a complaint. Make sure to outline issues related to payments, working relationships, expense reimbursement, and other essentials.

3. Review worker relationships periodically

   Relationships with your workers may change over time. Make sure that you keep tabs on changes and re-classify workers as relevant.

Frequently Asked Questions

Do states penalize employers for misclassification?

Yes, many states have laws that penalize businesses for misclassifying workers, and you will have to deal with these penalties on top of the federal and legal issues that you may face. For example, in California, employers can face civil penalties ranging from $5,000 to $25,000.

What should I do if my employer misclassified me?

Talk with the employer about reclassifying you. If they don't agree, you can file Form SS-8 to ask for a determination from the IRS. 

Are there other consequences of misclassifying workers?

In addition to the direct financial and legal consequences, you may also face reputational damage to your business and issues with worker dissatisfaction. 

Get Help With Employment Tax Concerns

Running a business is always challenging, and as an employer, you have special obligations that add even more challenges to the mix. To get help with penalties for misclassifying workers or other business tax concerns, reach out to a tax professional. TaxCure's curated directory of tax pros makes it easy for you to search for a local pro who has the experience you need.