Risks of Misclassifying Employees as Independent Contractors
You might refer to your staff as “independent contractors,” but that doesn’t make it so.
Even if your staff sign “independent contractor agreements” that require the contract to be governed as an independent contractor arrangement, that still does not ensure that your staff will be classified as such.
The tests for whether your staff are independent contractors are complex, case-by-case, and varied for different purposes.
Next week I will focus on the independent contractor tests, but this week I am focusing on the four big buckets of liability for companies that misclassify employees as independent contractors.
Consequences of Misclassification
How can a company be liable for misclassifying an employee as an independent contractor?
Four key buckets of liability:
1. Employment Tax – Misclassifying employees as independent contractors can lead to non-payment or underpayment of payroll taxes, including Social Security, Medicare, and unemployment taxes. The business may be responsible for paying the owed taxes, penalties, and interest.
2. Wage and Hour – Employees are entitled to certain protections under wage and hour laws, such as minimum wage, overtime pay, and meal and rest breaks. Misclassifying employees as independent contractors may result in claims for unpaid wages, including overtime, along with penalties for non-compliance.
3. Employee Benefits – Employees may be eligible for various benefits, such as health insurance, retirement plans, and paid time off. Misclassification can result in denial of these benefits, leading to potential claims or legal disputes.
4. Workers Compensation Laws – Employees typically have coverage under workers’ compensation insurance, which provides benefits in case of work-related injuries or illnesses. Misclassifying employees as independent contractors can leave them without adequate insurance coverage and potentially expose the business to liability for medical expenses and other damages.
Mitigating risk of Misclassification
What should companies do to mitigate the risk of misclassifying an employee as an independent contractor?
First, you can read my newsletter next week to determine how the law defines an independent contractor.
Second, think about which factors in the independent contractor test are pointing toward employee status for your employees. Identify all areas where your staff look more like employees than independent contractor.
Third, try to make as many changes to your operations as possible. You can’t have every factor in the test pointing toward independent contractor status, but you may be able to get most of them, or at least most of the important factors. However, if most factors point toward employment status, then that is probably the correct status.
Fourth, you can change your contracts. Even if your contracts with staff say independent contractor, it does not necessarily make it so, if the reality of the relationship does not reflect the agreement documented in the contract. However, the documentation in the contract is certainly helpful in many cases, and so it is recommended to move the needle toward an independent contractor.
Fifth, after you have analyzed all the changes you can make, or you have finished making them, you need to re-assess whether you are dealing with employees or independent contractors. If you are certainly dealing with a misclassification, you should almost certainly change the classification and treat the employees as employees. On the other hand, if it is a close call, you should assess the risks carefully and then make an informed decision based on your risk tolerance and other methods of mitigation such as insurance.
Adam Yohanan represents entrepreneurs, investors, freelancers, startups, small businesses, artists, and entertainers in a wide variety of transactional and regulatory matters, with an emphasis on complex commercial contracts, business formations, corporate governance, M&A, finance, intellectual property, and entertainment law. His office can be reached at 212-859-5041.
This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.