Miscategorizing Employees as Independent Contractors Carries Serious Consequences

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It is vital that all employers understand how seriously both the IRS and state agencies take the issue of miscategorizing employees as independent contractors. Any appearance of impropriety is assumed to be the case. It’s understandable when you consider how much money a business can save by classifying an employee as a contractor: employer contributions to Social Security, Medicare, unemployment insurance, and worker’s compensation are non-existent in an independent contractor relationship.

That is why NY State has begun to crack down on the improper classification of employees as consultants or contractors. Luckily, they have given ample guidance to businesses and employees/contractors by looking generally at three areas:

Behavioral Control: How much direction and control does the business have over the individual in terms of things like core hours, the sequence of actions, whose premise, tools, or equipment to use, where to purchase supplies, and who to hire as assistants? If the business exerts considerable control over these things, it may be an employer-employee relationship. Another consideration is whether or not the business put the individual through a specific training program.

Financial Control: What is the nature of the financial relationship between the business and the individual? If the individual has made an investment in the business, shares in profits and losses, and does not get reimbursed for expenses, it may be a bona fide consulting relationship.

Relationship of the parties: If the individual receives health insurance or other benefits, that is a sign that the relationship is an employer-employee one.

A more detailed guide authored by the IRS can be found here.

The financial penalties for incorrectly categorizing employees as consultants are harsh:

  • $50 for every Form W-2 that the employer neglected to file because of classifying workers as an independent contractor.
  • Since the employer failed to withhold income taxes, it faces penalties of 1.5% of the wages, plus 40% of the FICA taxes (Social Security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
  • A Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

Source: Just works payroll service

The only way to ensure that you are not miscategorizing your workers—even if you had them sign a contract explicitly stating that they are contractors—is to consult with an attorney experienced in contracts and labor issues. For more information, contact me here.

Aaron Pierce
(212) 882-1752
299 Broadway, Suite 1405
New York, NY 10007

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