Employee Misclassification Penalties

Employee Misclassification Penalties, Examples, and Protection

Misclassifying employees as independent contractors is a severe breach of law. Learn more about the consequences of this act and how to avoid them.

Stefana Zaric
Written by Stefana Zaric
January 31, 2022
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In the US, up to 30% of employers have misclassified at least one worker. The most common form of employment misclassification is when companies wrongfully define a full-time employee as an independent contractor. In reality, those workers should have employee status and the benefits that come along with it.

Employee relationships are indeed blurry at times. Even the definition of employee vs. independent contractor differs according to the federal government’s Department of Labor, state governments, and the IRS. Each of these institutions uses a unique test to determine a worker’s status.

But sometimes, this worker misclassification is intentional misconduct. If the employer claims a worker as an independent contractor instead of a full-time employee, they are exempt from statutory employee benefits and payroll taxes.

Employers have the right to report potential misclassification. If the IRS determines a company violated employment law, they may face penalties including class-action lawsuits, millions in fines for each misclassified employee, and even jail time.

We’ve already covered the basics of independent contractor misclassification. This article breaks down those penalties and explains how to protect your business against misclassification. Let’s dive in.

3 employee misclassification penalties you don't want to face

Misclassification penalties depend on several factors, such as your business’s size and the amount of time you avoided providing employment benefits and taxes. The penalties are also more severe if the Department of Labor (DOL) determines the misclassification is intentional.

1. Tax violation fines

When you hire a worker as an employee, their income is subject to Social security and Medicare taxes, FICA taxes, as well as income tax withholding from the contract signing date.

Suppose the IRS conducts an audit and discovers you’ve misclassified an employee as an independent contractor instead of honoring an employer-employee relationship. In this case, you may be subject to the following penalties:

  • Up to 3% of the misclassified employee’s wages
  • 100% of the FICA taxes you didn’t pay for the employee
  • Up to 40% of the FICA taxes not withheld from the employees’ wages (also called back taxes)
  • $50 per W-2 tax form you didn’t file for the misclassified employee

2. Federal law violation fines

On top of avoiding mandatory taxes, misclassification itself violates an employee’s federal protection. These protections ensure employment benefits like overtime pay and compliance with the minimum wage required by the state law (under the Fair Labor Standards Act (FLSA) rules). 

The DOL takes the federal labor law violations very seriously. This department hires auditors to identify and penalize independent contractor misclassification. At a minimum, consequences include paying back wages. But if the DOL discovers the misclassification, you may also face criminal penalties, including:

  • Payment penalties up $1,000 per misclassified employee
  • Jail time of up to a year
  • Class-action lawsuits seeking punitive damages (plus associated attorney fees)
  • Benefits insurance repayment (including paid leave, pension plan, workers’ compensation, severance pay, unemployment insurance, and more)
  • Additional wage claim audits looking for further punishable irregularities in the past three years
  • Individual misclassification claims, which can include punitive and special damages, as well as all benefits, wages and expenses proven due to employees

Note that some states may have specific laws regarding misclassification of employees.

For instance, California courts charge a civil penalty if the misclassification was willful. These fines range from $10,000 to $25,000 per misclassified employee. If you’ve made an honest mistake, the penalty ranges from $5,000 to $15,000 per employee.

Read more about independent contractor laws in California.

3. Harmed reputation

A high-profile misclassification case might damage your reputation, cause current employees to leave, and dissuade potential contractors and employees from working for your company. 

Workers may have concerns about getting misclassified and facing unpaid overtime or a wrongful lack of health insurance. Properly classified employees may also protest in support of misclassified co-workers. And for especially high-profile instances, employees may not want to be associated with companies involved in misclassification to protect their chances of future employment.

Why do governments care about misclassification?

When companies fail to pay payroll taxes, two things happen.

First, true employees lose the rights they deserve, which the government tries to prevent. Second, the burden of covering the taxes falls to the contractor and leads to lost tax revenue for the government.

Many misclassified independent contractors aren’t aware of their tax responsibilities and don’t pay taxes timely or accurately. And as the gig economy grows, unpaid employment taxes are becoming an increasingly severe issue for the government.

There are estimated millions of misclassified workers in the US, which translates to millions of dollars of unpaid employment taxes. Exact numbers are difficult to find, but in 2008, New York alone lost over $4.8 million in unpaid unemployment taxes. It’s not just about the government: unpaid taxes damage medicare and social security funds, affecting every taxpayer in the country and the economy.

On the other hand, workers suffer from several consequences, too. Independent contractors are not entitled to employee benefits such as healthcare, social security, overtime pay, minimum wage, worker’s compensation insurance, and more. Misclassification occurs when workers fulfill all of the obligations of full-time employment (like attending work at specified times and completing mandatory training) without receiving those statutory benefits.

Real-life examples of misclassification penalties

Employee misclassification penalties aren’t theoretical: the DOL regularly punishes businesses of all sizes for misclassification.

Here are a few recent examples of companies that misclassified their employees as contractors and faced fines and legal consequences. Spoiler alert: it’s not just Uber.

In 2016, two Massachusetts construction companies intentionally misclassified over 400 employees. The consequence was $2,360,000 in fines (overtime and damages).

In 2021, Holland Services misclassified 700 employees. The DOL’s investigation of this case led to almost $43,277,000 that the company owed in back wages and damages.

Another case from 2021: Servant’s Quest violated the FLSA by misclassifying 50 workers. Due to unpaid overtime hours, they had to pay $358,675 in back wages.

A construction company’s owner was found guilty of misclassifying 30 construction workers who should have been employees. Since the authorities determined this act was intentional with the objective of not paying the taxes, the owner of G&R Drywall and Framing was sentenced to almost two years of prison, with 12-month-long consecutive probation.

Can you get misclassification protection?

The best way to protect yourself from legal penalties and fines is to classify your workforce correctly. Learning the difference between independent contractors and employees is a good start. The next step is to tailor your contracts to local laws and get legal experts to review them.

Deel Premium is a world-first for misclassification protection. To provide an additional layer of confidence, Deel can offer financial coverage in the case of misclassification arising from our legally vetted, localized contracts. That’s how confident we are! These contracts are critical to hire employees or contractors in countries with stringent employment laws, such as France or Brazil. 

If you already use Deel, learn more about whether Deel Premium is the right next step for your business and how to upgrade to it.

And if you’re not a Deel user (yet), what are you waiting for? Book a demo today and learn more about the benefits of outsourcing your global payroll and compliance matters.

This post is provided for informational purposes and should not be considered legal advice. Talk to a legal professional such as an employment lawyer for more info.

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