Consequences of Employee Misclassification

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Published in the ECHO Journal, June 2008

Many associations are tempted to classify a worker as an independent contractor so as to avoid payroll taxes, health benefits, and workers’ compensation insurance. Doing so is now more risky due to the federal government’s implementation of its new initiative: Questionable Employment Tax Practice (QETP). [Editor’s note: Questionable employment tax practices are employment tax schemes or practices that have no objective other than to avoid federal and/or state employment taxes].

Consequences of Misclassification

Under QETP, federal and state auditors scrutinize independent contractor agreements. If the auditors determine that a worker is improperly classified, the employer may be required to pay penalties, including the following:

  • Federal and state income tax for the previous three years;
  • Employee’s share of Federal Insurance Contributions Act (FICA) taxes and the employer’s matching amount;
  • Federal unemployment taxes of 6.2% of each employee’s compensation up to $7,000.00, and state unemployment insurance equal to 3.4% of compensation up to $7,000.00; and
  • 0.5% of the total amount of the debt per month for up to 50 months (6% annually) with the possibility of additional penalties for substantial understatement or fraud (applicable in cases where the employer failed to file correct information returns, furnish correct payroll statements, and comply with information reporting requirements).

How to Determine Employee Status

In classifying a worker’s status, the IRS generally focuses on the following three factors:

  1. Behavioral Control. The higher degree of control an employer exercises over a worker by regulating the following factors, the more likely the worker will be classified as an employee instead of an independent contractor: how to perform the work (e.g., the amount of supervision or training); when and where to do the work; what tools or equipment to use or buy; and whether or not to hire assistants.
  2. Financial Control. The more control a worker has over his/her business finances, the less likely he/she will be classified as an employee:
  3. Relation of the Parties. Contracts between the parties may help distinguish the type of business relationship, i.e., whether the parties intended to enter into an employment relationship or independent contractor relationship.

No one factor is conclusive, but, as a general rule, a worker is an independent contractor when the association has the right to control only the result of the work and not the means or methods of performing the work. See IRS Publication 1779

Example

Painters are generally classified as independent contractors because they are hired on a project basis; supply their own painting supplies and equipment; and do not have set working hours where they need to clock in and out. In other words, the painters control the process. However, not all painters are independent contractors. Some (i) work solely for one association and do not seek or advertise for additional work; (ii) the association controls the means by which the painting is performed by instructing the painters where, when, and how to paint; and (iii) the association supplies the painters with supplies. Such painters are employees, not independent contractors.

Avoiding Misclassification

To avoid misclassification, associations should limit the use of “full-time” independent contractors and instead hire workers on a specific project basis. Additionally, associations should treat workers similarly in similar situations. In other words, if the job duties of two employees are the same or similar, do not hire one as an independent contractor and the other as an employee. Lastly, use agreements that highlight the components of independent contractor status so as to withstand the scrutiny of federal and state auditors.


Tina Wang is an attorney with the Los Angeles law firm Adams & Kessler. This article is reprinted from www.davis-stirling.com by Adams Kessler.