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We’ve compiled a list of the 100 most commonly asked questions we have received on the federal Fair Labor Standards Act (FLSA) overtime regulations.
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February 05, 2003
How to Avoid Misclassifying Independent Contractors

For a Limited Time receive a FREE Compensation Special Report on the "Top 100 FLSA Q&As," designed to provide you with an examination of the federal FLSA Overtime Regulations in Q&A format, including valuable tips for FLSA Coverage, Salary Level, and Deductions from Pay. Download Now
If a worker is an employee, rather than an independent contractor, the employer is required, among other things, to withhold and remit the employee’s tax to the federal government. How do you know when the worker is an employee? In general, if the employer controls not only what is to be done but also how it is to be done, then the worker is an employee, and the employer has to withhold.

The Treasury Department prefers to have an employer withhold; the fewer returns from independent contractors, the better. The fact is, however, that more and more employees are joining the ranks of independent contractors. Some do this voluntarily, but for most, it is a result of the downsizing going on in corporate America. Corporations, on the other hand, having downsized for financial reasons, are hesitant to hire someone as a permanent employee unless it is absolutely necessary. And so, when new projects require an increase in workforce, they hire independent contractors.


The result is that companies are hiring workers for specific projects and sometimes incorrectly classifying them as independent contractors, thus incorrectly leaving the withholding up to them. Why does this misclassification happen? That is a question we will consider later in this article. At this point, let us consider some of the penalties that employers are subject to as a result of this misclassification.

One of the worst consequences of incorrectly classifying workers as independent contractors is found in the case of Vizcaino v. Microsoft, 97 F.3d 1187 (9th Cir. 1996), reh’g en banc 120 F.3d 1006 (9th Cir. 1997), discussed in our March issue (#643). In that case, the misclassified workers won, among other things, the right to participate in Microsoft’s employee stock purchase plan.

Even where options to purchase stock are not at stake, however, misclassification of workers can prove costly to employers. The Internal Revenue Service (IRS) has a whole arsenal of civil and criminal penalties that it can impose upon employers, whether the misclassification is merely negligent or willful. Some, but not all, of these penalties are listed below.

Negligent Failures

Failure to withhold income taxes. The employer is subject to the penalty of 1.5 percent of wages paid, plus interest compounded daily.

Failure to withhold FICA (Social Security) taxes. The employer is subject to the penalty of 20 percent of the FICA tax on the employee, plus interest compounded daily.

Failure to report workers’ wages or other payments on Forms W-2 or 1099-MISC. The employer is subject to the penalty of 3 percent of wages paid and 40 percent of the FICA tax.

Willful Failures Failure to file tax return relating to employment taxes. The employer is subject to the penalty of paying the employer share of Social Security and unemployment taxes, as well as a penalty equal to 5 percent of the tax for each month of the failure to pay, up to a maximum of 25 percent of the tax.

Failure to pay employment taxes. The employer is subject to the penalty of 0.5 percent of the tax, for each month of the failure to pay, up to a maximum of 25 percent of the tax.

Understatement of Employment Taxes The employer who, either negligently or willfully, understates its liability for Social Security and unemployment taxes is subject to the penalty of 20 percent of the understatement.

Fraudulent Understatement of Employment Taxes The employer who fraudulently understates its liability for Social Security and unemployment taxes is subject to the penalty of 75 percent of the understatement.

Criminal Penalties Willful failure to collect and remit withholding taxes and the employee portion of FICA taxes. Each such failure is a felony that, on conviction, results in a fine up to $10,000 or imprisonment up to five years, or both.

20 Questions and Three Main Categories

The Internal Revenue Service (IRS) considers20 factors in determining whether a worker is an employee or an independent contractor. (See It should also be noted that the IRS revised the manual that its auditors use in analyzing worker classification issues. The manual notes that "because of the difficulty in applying the 20-factor test and because business trends have changed over the years, the Service has recently begun using a new approach with respect to worker classification. Rather than listing items of evidence under the 20 factors, the approach now is to group the items of evidence into the following three main categories: behavioral control, financial control, and the relationship of the parties."

This may not be all that helpful, but it does show that the IRS recognizes that "business trends have changed over the years," and now more and more independent contractors are being hired. One of the IRS’s 20 factors is whether there is a continuing relationship between the company and the worker. With respect to this, the Manual states that "a long-term relationship may exist between a business and either an independent contractor or an employee."

A New Approach

Why do employers misclassify employees as independent contractors? There are, of course, the willful misclassifications, done deliberately to save money. For instance, there probably have been cases where companies knowingly treated workers as employees and yet represented to these workers, and to the world, that they were independent contractors. To any employers who contemplate such a charade, we can only say that they run the risk of severe civil and even criminal penalties.

How can we explain the unintentional misclassifications? If a company knowingly hires independent contractors, how does it happen that, after a few years, the IRS conducts an audit, and the company is shocked to learn that the independent contractors are, under common law standards, employees?

An answer is suggested by a recent article entitled "New Mentality Required for Corporations Hiring Independent Contractors," (The Journal of Taxation of Employee Benefits, Jan/Feb 2000). The author, Jeffrey Rodriguez, tells companies that, to avoid problems with IRS, they have to develop a new mindset; they have to stop feeling the old corporate need to exercise direct control over the independent contractors.

This suggests a misclassification scenario. The company starts out intending to treat its independent contractors as such, but it does not have the requisite "new mentality" described by Rodriguez. It may have intended at the outset to simply tell the workers what it wants them to do and to leave them alone to do it, but then the corporate need to control manifests itself. As time passes by, the company begins to exercise more and more control over the way in which the workers perform the job.

One day, without realizing it, the company is, in effect, treating the workers as employees and thus running the risk of IRS penalties for not withholding, among others. Well, at least that’s one possible scenario.

The New Mindset

Rodriguez suggests that, with respect to the 20 factors used by the IRS to determine whether workers are employees, the company should try to modify its behavior as well as its mentality. For instance, one of the factors indicating an employer-employee relationship is whether the employer gives the worker lots of training. Rodriguez suggests the following:

"[T]o the maximum extent possible, Company X should retain workers who require little or no training. If training is necessary, it should require workers to obtain training at their own expense. If the training is only available from Company X, it should charge workers for the training at the same rate that it would charge any unrelated entity. Workers should not be trained by having an experienced employee work with them or by requiring attendance at meetings. Periodic training or training at frequent intervals should be avoided.…"

Then again, maybe it really would make more sense just to hire these people as full-time employees. Only kidding.

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This article reprinted with permission by the publisher Business and Legal Reports, Copyright 2000, BLR.

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