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Employee Classifications: How NOT to Misclassify Employees

An office with multiple workstations.  A black woman with glasses is facing the camera while working. Another person is working at a computer with their back to the camera.  in the background are a number of other people sitting, standing, and working.

So, what's the big deal? Misclassification is considered wage theft, whether you knowingly or accidentally misclassify employees. It could put your business at risk of an IRS audit for back taxes, severance and health care coverage for misclassified workers, in addition to legal fees, reputation damage, and even criminal and civil penalties.

Misclassifications and their fallout

Payroll calculations involve hours worked, paid time off and deductions. With so much data to manage, you might accidentally pay your employees the wrong amount. In other words, overpayment or underpayment of wages can occur. Note that state requirements may differ from federal law, so check with your state for the most updated information.

One of the most common misclassifications is related to whether the employee should be exempt from overtime or not. Here's where the Fair Labor Standards Act comes in: All employees must receive overtime pay for any hours worked over 40 hours per week, unless they are classified as exempt. Classifying a nonexempt employee as exempt opens your organization to FLSA-related fines while causing an employee to miss out on overtime pay.

An individual is classified as an independent contractor rather than an employee. It may be tempting to do so as you work to reduce labor costs to avoid paying payroll taxes and providing benefits, but it can have serious consequences. This looks like a great workaround to rules governing minimum wage, overtime pay, workers' compensation and unemployment insurance, as well as job-protected leave. But the legal consequences of pretending an employee is a freelancer are very serious.

In 2019, the wage-and-hour division of the Department of Labor recovered $322 million in back pay for misclassified employees. Misclassifying workers could create trust issues among your employees. It can also cost your company a mint; misclassified workers, besides losing morale, may be able to take legal action, and your company will face financial penalties and legal fees.

Getting employee classifications right

Want to avoid payroll errors? Many states have adopted the ABC test to determine employee status. The individuals being classified generally must meet all aspects of the rubric. The individuals are independent contractors if

  • They work by themselves, that is, not under the employer's control. (A = Alone)

  • They maintain their own place of business. (B = Business)

  • They work at an established trade and exercise control over their own schedule and method of operation. (C = Control)

That's a very general series of conditions; other rules may apply. However, it's a good place to start. Meanwhile, there are other things companies can do.

  • Establish clear policies for payroll.

  • Conduct an internal audit on your documentation process. Check state laws.

  • Train managers and HR staff to correctly classify employees and independent contractors and to spot potential misclassification issues.

  • Carefully document any changes you make.

  • File Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

  • To be safe, treat the worker in question as an employee until you know otherwise for sure.

  • Work with legal and employee classification experts, talent acquisition specialists and/or employment consultants.

  • Consider using automated payroll software to identify potentially incorrect paychecks. Time tracking software will make tracking employee hours easier as well. 

  • Outsource your payroll to a payroll processor.

Worker roles can evolve over time, as do the rules around worker classifications. It's a good idea to review each worker's classification annually and adjust as needed. You can work with a firm that specializes in independent contractor compliance and engagement to help your company meet compliance standards, reduce misclassification risk and successfully manage independent workers.

If you process payroll yourself, it can be challenging to keep up with new laws and stay compliant. According to the IRS, nearly 30% of employers make payroll errors each year, with the number jumping to 40% for small-to-mid-sized businesses. The average penalty for an incorrect payroll filing is $845. Stay informed of the latest payroll laws to avoid costly mistakes.

Contact our Nuance Workforce Solutions team for HR support.


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