Employee misclassification penalties: Examples and protections
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- Misclassification penalties depend on several factors, such as your business’s size and the amount of time a company avoided providing employment benefits and taxes.
- Penalties can include tax violation fines, federal law violation fines, and reputation damage.
- The penalties are also more severe if the Department of Labor (DOL) determines the misclassification is intentional.
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 classify a full-time employee as an independent contractor when those workers should have employment status and receive the benefits of being an employee.
While misclassification can often be an honest mistake, it can also be intentional and a way for companies to avoid providing workers with statutory employee benefits and paying payroll taxes. If workers suspect they have been misclassified, they can report it to the IRS. The IRS will then determine whether a company violated employment law and may face penalties, including class-action lawsuits, millions in fines for each misclassified employee, and even jail time.
What’s the difference between contractors and employees?
Independent contractor and employee relationships differ. Contractors typically set their work schedules and pay self-employment taxes. In contrast, employees usually work according to company-regulated schedules, receive statutory benefits, and have taxes withheld from their gross pay. However, it’s easy for the line to become blurred, especially since the definition of employee vs. independent contractor differs according to each government institution.
The federal government’s U.S. Department of Labor, state governments, and the Internal Revenue Service (IRS) each use a unique test to determine a worker’s status.
If you’re unsure which test to follow, use our misclassification assessment. We combine AI with award-winning research into employment court cases to help businesses classify workers with more than 90% accuracy, mitigating compliance risks.
Now we’ve covered the basics of independent contractor misclassification, let’s dive into the penalties of misclassification and how to protect your business.
3 employee misclassification penalties to avoid
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 that the misclassification is intentional.
1. Tax violation fines
When you hire a worker as an employee, their income is subject to FICA taxes, including Social Security and Medicare taxes, and 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 that the company failed to withhold from the employee’s 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 violates an employee’s federal protection. These protections ensure employment benefits like overtime pay and compliance with the minimum wage required by state law (under the Fair Labor Standards Act (FLSA) rules).
The DOL takes 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 you could also face criminal penalties, including:
- Payment penalties of 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 company’s reputation, cause existing employees to leave, and dissuade potential contractors and employees from working for you in case they're deprived of health insurance or overtime pay.
Properly classified employees may also protest in support of misclassified co-workers. And for especially high-profile instances, employees may want to avoid being 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 their protections and entitlements, 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. 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.
Workers suffer from several consequences, too. Workers with independent contractor status 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 full-time employment obligations (like attending work at specified times and completing mandatory training) without receiving those statutory benefits.
Real-life examples of misclassification penalties
The DOL regularly punishes businesses of all sizes for employee 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 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.
That same year, the owner of a construction company 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 avoiding tax, the owner of G&R Drywall and Framing was sentenced to almost two years of prison with a 12-month-long consecutive probation.
More recently, in 2023, the DOL investigated Arise Virtual Solutions and filed one of the largest misclassification cases in its history. The ongoing case alleges that the outsourced customer center service provider hired more than 22,000 workers as contractors but did not provide them full autonomy or say on their work.
Can you get misclassification protection?
First, correctly classifying your workforce in the first place is the best way to protect yourself from legal penalties and fines. 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.
When you hire through Deel, you'll be able to use any of our expert-reviewed contractor agreements combined with our AI-powered worker classification assessment, which uses relevant local laws and legal precedent to assess worker classification.
Finally, if compliance is a crucial component of your business, you can make use of Deel Shield, the most secure level of contractor compliance. With Deel Shield, we take on the responsibility of hiring and assume any misclassification liability from misclassification.
Discover how Project44 gets added peace of mind from misclassification and saves around $500,000 a year with Deel Shield.
Chloe Riesenberg, People Specialist, Project44
Unlike other providers, Deel specializes in localized compliance. We use a worker classification questionnaire and the help of local experts to review, correctly classify, and engage a contractor based on location, job description, and work setup.
On top of that, you can automate onboarding, invoicing, and payments and provide benefits to contractors anywhere in the world.
If you’re not a Deel user (yet), book 30 minutes with a product expert to learn more.