Employee Misclassification: What Happens When You Mistake an Employee for an Independent Contractor

Last week I wrote a piece on the difference between an independent contractor and an employee, which you can read here. However, what happens if you thought you had an independent contractor, but after a bit of research you come to find that the worker is an employee. Unfortunately, the IRS has become more strict on this issue in recent years after they discovered billions of dollars were being lost due to misclassification of workers. Not only are there IRS implications, you will also find yourself penalized by the Social Security Administration, and your state government. 

The Impact of Misclassification

When you misclassify a worker, intentionally or unintentionally, everyone from the business, to the employee, to the government is impacted. During the hiring process you need to do your research to ensure you are labeling your relationship in the appropriate manner. If you’re unsure what the difference between an employee and an independent contractor is, you can learn more about it here

As a business, misclassifying an employee can leave you liable for IRS penalties later on. For example, when you have an independent contractor you don’t have to pay benefits, social security and Medicare taxes, as well as other ‘standard employee costs’. But what happens when the IRS finds that your so-called independent contractor is an employee after all? Well, you’re going to end up paying quite a bit in penalties. The amount you’ll pay the IRS depends on whether or not they find that you were intentional in the misclassification or not, but we’ll talk more about that later.

An employee who is misclassified loses out on a lot of benefits of the typical employer-employee relationship. Some common things they may not receive if they are misclassified as an independent contractor are:

  • Minimum wage
  • Overtime pay
  • Employer-sponsored benefits
  • Unemployment insurance
  • Workers’ compensation
  • Tools to perform the job

Also, if misclassification occurs it could double the amount of social security tax due from workers. 

The government also suffers from the misclassification of employees. When you have mistakenly marked someone as an independent contractor, you don’t pay social security, Medicare, and other employment taxes on behalf of that individual. This results is a major loss for the government which makes taxpayers suffer and hurts the economy. 

Misclassification and the IRS

The IRS handles misclassification differently based on whether they can prove it was done intentionally or unintentionally. If the misclassification of an employee was unintentional the Internal Revenue Code has special assessments for tax reduction:

For not withholding federal tax income, the tax assessed is 1.5% of wages paid. If the employer failed to file an information return (Form 1099) with the IRS, the assessment is 3%. 
For not withholding the employee’s share of social security and Medicare taxes, the tax assessed is 20% of the employee’s share. If the employer failed to file an information return (Form 1099) with the IRS, the assessment is 40%. The employer’s share of social security and Medicare taxes must also be paid. 

If an employer misclassified an employee as an independent contractor even after they determined an employer-employee relationship existed, the above assessments do not apply. In the case that the misclassification was intentional, the employer is responsible for the full amount of federal income tax that should have been withheld and the full amount of the employee’s and employer’s share of social security and Medicare taxes. Not only that, but the employer can also face penalties for failing to file returns and pay taxes. The employer can also face penalties at the state level for failure to withhold and pay taxes. 

The IRS has a few chosen methods that help detect the misclassification of workers. For example, if an individual only files one Form 1099 with their tax return the IRS will investigate that. A person who only receives payment from one company could actually be an employee rather than an independent contractor. The IRS also watches for workers who submit both a 1099 and a W-2 from the same company within the same year. While it is ok for a worker to be an employee and an independent contractor for the same business within the same year, the IRS will look into it. Also, the IRS does an audit to uncover employment status designations. 

How to Convert an Independent Contractor to an Employee

If you do discover you need to switch your independent contractor to an employee there will be a little bit of work involved in doing so. You will need to notify the contractor in writing of your intent to convert them from their current status of ‘contractor’ to ‘employee’. They may need to provide additional identification in order for you to implement this change. It is a good idea to provide a timestamp on this written document in case you need that information in the future. 

You will need to set up a new employee file within your database and indicate whether the employee will be salary, salary exempt, or hourly non-exempt. It is recommended that during this process you check the US Department of Labor guidelines to be sure you are choosing the right classification. Next, you will set up a pay frequency for the contractor-turned-employee. If the employee will be hourly, or salary exempt, be sure to set up overtime calculations within your payroll software in the event that the employee works more than 40 hours in a given week. 

Do not forget to the have employee fill out a W-4 Form so that you will know their tax withholding information. If you are currently using software to run your payroll, this information will need to be entered into the payroll software in order to accurately calculate tax withholding amounts. At the end of the year will you be responsible for producing a W-2 Form for your employee by January 31st. As with any other employee, you will need to also send this W-2 Form to the IRS and other tax authorities as well.

If you’re unsure whether or not you need to adjust the classification of an independent contractor you should first run through the tools and tests provided by the IRS.