One responsibility of being an employer is learning how to properly classify employees. Employee classification determines what payroll taxes you are required to pay, how much an employee is paid, how much control you have over your workers, and more. The Fair Labor Standards Act has guidelines for employee classification to make sure you know what types of workers your company is employing. Complying with proper employee classification is federal law, and if one mistake is made, it could cost your company thousands of dollars in penalties, fines and more.
Types of Classifications:
- Independent contractors
- Employees (common-law)
- Statutory employees
- Statutory nonemployees
Generally, most workers fall within the first two categories. In order to determine how to treat payments you make for your workers’ services, you need to determine what category in which they fit. The Internal Revenue Service (IRS) states that to determine if a worker is an employee or an independent contractor, you must consider the degree of control and independence of a worker. The more control exerted, the more likely the classification should be an employee. Facts that provide evidence of the degree of control and independence fall into three categories:
1. Behavioral: Does your company control or have the right to control what your worker does and how your worker does his or her job?
2. Financial: Are the business aspects of your worker’s job controlled by your company? Such as, how your worker is paid, whether expenses are reimbursed, and who provides supplies.
3. Type of relationship: Are there written contracts or employee-type benefits like insurance, pension pay, and vacation? Will the relationship continue and is the work performed a key aspect of business?
Penalties for Noncompliance
Various government agencies have concluded that 20 to 35 percent of employers have erroneously or intentionally misclassified workers as independent contractors when they should have been classified as employees. The IRS and the Department of Labor have created a new agreement called the Memorandum of Understanding. Under this agreement, these two agencies will work together and share information to help reduce the incidence of misclassified employees. Some employers purposely classify their employees as independent contracts to skirt minimum wage, tax liabilities, and overtime pay requirements. Other companies simply misclassify their employees because they do not understand the differences between categories. However, the misclassification of employees leads to the government losing millions of dollars in payroll tax and other revenue, and workers losing benefits such as health insurance, Social Security, unemployment insurance, worker’s compensation, overtime pay, and family and medical leave.
If you believe your company may have erroneously classified an employee as an independent contractor, you should conduct an in-house audit to ensure that your employees are classified correctly. The new Memorandum of Understanding has allowed the IRS to hire approximately 100 new enforcing agents to help conduct audits of businesses in all states to find incidences of misclassification. If found guilty of breaking federal law, employers are subject to paying thousands of dollars in penalties and fines to multiple jurisdictions, plus paying restitution in wages, payroll taxes, unemployment taxes, or any overtime owed if an employee files a claim.
Voluntary Classification Settlement Program
The IRS has instituted the Voluntary Classification Settlement Program for companies who are erroneously or intentionally guilty of misclassifying employees. This program offers partial amnesty to offenders, and participants of the program will have to pay slightly more than one percent for the wages paid to misclassified workers during the previous year. Additionally, participants will not be subject to audits from previous years. For complete information, please visit the IRS page that details the program http://www.irs.gov/businesses/small/article/0,,id=246013,00.html
There is no one set of rules to govern how to classify an employee, so the entire business relationship must be evaluated to make the correct determination. The IRS recommends documenting all factors used in how the determination was made. Please visit the IRS website or contact Merit Resources for help in complying with classification laws.
