The Consequences of Treating Employees as Nonemployees

When running a business, hiring workers provides the flexibility to grow and adapt to changing needs. However, how you classify those workers—as employees or independent contractors—matters a great deal. Misclassification is not just a technical mistake; it can lead to significant financial penalties, legal troubles, and reputational harm.

What Is Worker Misclassification?

Worker misclassification occurs when a business treats an employee as an independent contractor, intentionally or by mistake. While independent contractors are self-employed and handle their own taxes, employees are subject to payroll tax withholding, workers’ compensation coverage, unemployment insurance, and labor law protections.

The IRS, Department of Labor, and many state agencies closely monitor worker classification because it impacts tax collection and worker rights. Misclassifying employees allows businesses to avoid employment taxes and benefits obligations, but the risk far outweighs the short-term savings.

The Consequences of Misclassification

  1. Back Taxes and Penalties:
    If the IRS determines that your business misclassified workers, you could be responsible for the employee’s share and the employer’s share of Social Security and Medicare taxes, unemployment taxes, and possibly income tax withholding. On top of that, penalties and interest can dramatically increase your liability.
  2. Employee Benefits Claims:
    Misclassified workers may claim entitlement to benefits such as health insurance, retirement plan contributions, and paid leave. Businesses may be forced to make retroactive contributions, which can be expensive.
  3. Wage and Hour Violations:
    Under the Fair Labor Standards Act (FLSA), employees must be paid minimum wage and overtime. If a misclassified worker should have been paid overtime but wasn’t, you could owe back pay, double damages, and attorney’s fees.
  4. State-Level Action:
    States are aggressive about protecting their tax base and workers’ rights. State labor departments and tax authorities can audit your business, assess penalties, and even pursue criminal charges for intentional misclassification.
  5. Loss of Business Reputation:
    Public exposure of misclassification issues can damage a company’s reputation. Customers, partners, and potential employees may lose trust, impacting business opportunities and long-term growth.

How to Properly Classify Workers

The IRS uses a three-factor test to determine a worker’s status:

  • Behavioral Control: Does the business control or have the right to control what the worker does and how the worker does the job?
  • Financial Control: Are the business aspects of the worker’s job controlled by the business (such as how the worker is paid, whether expenses are reimbursed, who provides tools/supplies)?
  • Type of Relationship: Are there written contracts or employee-type benefits? Is the relationship ongoing, and is the work performed a key aspect of the business?

No single factor is decisive. It’s important to look at the entire relationship and consider the degree of control and independence.

Protecting Your Business

To avoid misclassification problems:

  • Carefully review roles before engaging workers.
  • Use written contracts that reflect the actual relationship.
  • Regularly audit your workforce to ensure proper classification.
  • Seek professional advice if unsure about how to classify a worker.

Misclassification might seem like a minor administrative issue, but the consequences can be severe. Taking the time to classify workers correctly not only protects your business but also ensures you treat your team fairly and legally.