Consequences of Worker Misclassification
You’ve answered the question: Are my workers employees or contractors? You know the treatment each kind requires. Still, one looming question remains: what happens if you label a worker incorrectly? Any employee who’s treated as an independent contractor is considered “misclassified”, and exposes the employer to a lot of legal risk.
How do you get caught?
IDES Audit: We’ve seen plenty of companies hit with back taxes, interest, and penalties this way. This often happens when an employee files for unemployment with the Illinois Department of Employment Services (IDES) and they list every company they’ve worked for, even as an independent contractor. At that point, if the employer hasn’t made unemployment contributions (because the worker was classified as an independent contractor), the IDES will become very interested in extracting those contributions and will start investigating the company’s worker classifications.
The IDES sends the company a questionnaire and/or conducts an in-person audit to inquire about the worker(s) and the company. If the IDES finds that one worker is misclassified, they will sometimes perform a second audit into how you classify your other workers.
Finally, the IDES calculates the amount owed for unpaid unemployment contributions, interest, fines, and penalties. If the misclassification was intentional, fines increase, and the responsible individual can be personally liable out of their own bank account.
IRS Audit: The IRS follows a similar process but, because they are mostly done by random selection, conducts audits less frequently. However, both state and federal governments take this issue very seriously, and these agencies have vast resources dedicated to classification audits.
The Worker Sues or Talks to a Lawyer: Workers can discover independently that they are improperly classified and seek restitution. In our experience, workers who are upset at a termination are especially motivated to take this kind of action against a previous employer. These workers may learn of their misclassification from a friend, from a lawyer, by researching employment laws, by Googling, etc. Once they know, workers can sue the company and/or report them to a government agency.
What are the penalties?
Fines: Both state and federal governments can and will issue fines to employers who misclassified their workers. These fines usually come from failure to report payroll taxes, failure to maintain the appropriate documentation for employees (such as the Form I-9), and failure to pay the employer’s share of Social Security and Medicare.
Paying Back-Taxes/Contributions: If a government agency finds out that you have treated an employee as an independent contractor, they will make you pay all of the overdue employment taxes and/or unemployment insurance contributions (sometimes for all of your misclassified workers, not just the one that started the investigation).
The amount owed from unpaid taxes and contributions can vary widely. Contributing factors include the number of employees, whether they are full- or part-time, and how many years they were misclassified. Examples of back-taxes/contributions owed in previous cases:
- With the IDES
- $670.46 ($107.84 of which was interest) (Emergency Treatment v. Department of Employment Security)
- $25,014.70 (EZ Movers, Inc. v. Rowell)
- $95,159.16 ($36,894.75 of which was interest) (SMRJ, INC. v. Russell)
- With the IRS
- $50,026.61 ($22,110.12 of which was interest) (US Department of Justice, Tax Div. v. Hudson)
- $62,852 (it would have been well over $1 million if the company was liable for its predecessor’s misclassification) (TFT Galveston Portfolio, Ltd. v. Commissioner)
Violations of Employment Laws: If you have unwittingly misclassified an employee as an independent contractor, you may be violating other statutes that you thought did not apply. Remember, independent contractors are exempt from many employment laws.
For example, if you didn’t pay overtime or minimum wage, or if you improperly withheld money from a worker’s paycheck (read our post Employers and Paycheck Deductions to learn when such deductions are permissible), you can also be sued for violating those laws.
Criminal penalties: It’s important to note that, while a rare occurrence, if the government can show that someone in the company purposefully and intentionally misclassified workers as independent contractors, that person can face criminal penalties.