Employee Misclassification: What It Is and How to Avoid It When Processing Payroll

Filip Dimkovski - TBR writer
By Filip Dimkovski
Michelle Meyer - Editor for TBR
Edited by Michelle Meyer

Published October 4, 2022.

Woman sitting at a desk in front of a laptop holding her hand to her head in concern

Having your payroll process properly handled as a business is an absolute necessity. Unfortunately, the truth is that the payroll process is often overlooked even though it's probably the most important function in a business. If the payroll process is handled incorrectly, it could lead to unsatisfied employees at best or significant legal trouble at worst.

What Is Employee Misclassification?

In simple terms, employee misclassification refers to the act of incorrectly characterizing an employee as an independent contractor. According to Harvard Business Review, almost 20% of employers will misclassify at least one employee in their lifetime—even accidentally. The truth is that misclassifying employees can be quite damaging to a business, as it leads to big legal issues and hefty fines.

Why Is Employee Misclassification Immoral?

Apart from it being illegal to misclassify an employee as an independent contractor, it's also morally wrong.

Non-compliant With Tax Laws

The most important thing to know about employee misclassification is that it's non-compliant with tax laws. Businesses that choose to misclassify their employees will face significant penalties from the IRS.

Additionally, they will also be required to pay back any taxes that were not properly withheld from their employees' paychecks. Businesses pay different taxes for independent contractors and full-time employees, which is why an institution like the IRS could get involved. This can be a very costly mistake for businesses, as the penalties can quickly add up. In addition to the fines, your company's reputation will be permanently stained, which might make your clients and prospective employees run elsewhere.

» How do you remain tax compliant? Follow these tips for payroll compliance to avoid penalties

Calculating Incorrect Deductions

Another big problem with employee misclassification is that it can lead to businesses calculating incorrect deductions. This is because businesses are required to withhold different amounts for independent contractors and different ones for their employees. Therefore, when businesses misclassify their employees as independent contractors, they may withhold too little in taxes and benefits, which can lead to big problems down the road.

» What taxes must employers pay? Discover the difference between payroll tax vs income tax

Depriving Employees of Benefits

Employees who are misclassified are also deprived of certain benefits. This is because businesses are not required to provide benefits for independent contractors, including health insurance, paid time off, and more.

Normally, this can be a big problem for employees, as they may not be able to get the benefits they expected. Additionally, it can also lead to issues for businesses, as they may be required to provide these benefits retroactively if they're caught misclassifying their employees.

» What are employee benefits? Discover the differences between employee compensation and benefits

How to Avoid Employee Misclassification

Now that we've seen the problems that can arise from employee misclassification, let's take a look at how businesses can avoid it.

Professional Employment Contracts

It's important to have professional employment contracts in place that outline the employment terms between the business and the employee. This should include the employee's duties and liabilities, as well as how they will be paid, both in compensation and benefits. This is important because it will help to avoid any misunderstandings down the road. After having a well-defined contract, it's beneficial to also track workers' compensation and make sure that everything is properly calculated.

Company Employment Policy

Another important step is to have a company employment policy in place. This policy should state the classification of each type of employee. Having this policy will help ensure that everyone is on the same page and that there is no confusion about who is an employee and who is an independent contractor. Normally, it's recommended that an employment policy is reviewed on a regular basis and updated as needed.

Regular Audits

Conducting regular audits is another good way to avoid employee misclassification. In the majority of cases, these audits should be conducted by an independent third party. They will review the employment contracts, company policies, and payroll records to ensure that everything is in order. If any discrepancies are found during the audit, it should be addressed immediately.

» Can you prevent fraud in your business? Discover which internal controls to implement

Contract a PEO

Contracting a Professional Employer Organization (PEO) has many benefits outside of payroll management, including handling some HR and payroll responsibilities for your business like employment contracts, company policies, payroll processing, and more. This can be a great way to avoid employee misclassification as the PEO will be responsible for ensuring that everything is in order.

» How do you choose a PEO? Consider the different types of PEOs

Consequences of Employee Misclassification

In addition to being morally wrong, employee misclassification can lead to big legal consequences for businesses.

Paying Outstanding Tax Amounts

Probably the most common consequence of employee misclassification is that businesses are required to pay outstanding tax amounts, including any taxes that were not withheld from employee paychecks, in addition to interest and penalties on these amounts.

Receiving Fines

Businesses may receive fines and penalties for employee misclassification. In general, the fine and penalty amount will vary depending on the jurisdiction. In some cases, businesses may be required to pay a percentage of the outstanding tax amount, while in others, businesses may be fined with a flat rate.

Finally, employees may take legal action. This can include things like filing a lawsuit or a complaint with the Department of Labor. For example, if an employee expected to have health insurance but they were misclassified, you might receive a lawsuit from both the employee and the insurance company.

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