The way you classify your employees determines a lot of things: how much you pay in taxes, whether you need workers’ compensation insurance, and how much you pay for workers’ comp.

Whether through an honest mistake or outright payroll fraud, 20 to 30 percent of businesses misclassify at least one worker as an independent contractor when they should be considered an employee.

As a result, the U.S. Department of Labor has been cracking down on misclassification. Getting caught, even though it may have been a mistake, is expensive. In 2014 alone, companies around the country paid $79 million in back wages to 109,000 employees as a result of misclassification.

How to Classify Your Employees

According to the U.S. Department of Labor, there are three fairly simple ways to decide if a worker is an independent contractor or an employee:

  • To be an independent contractor, the worker must be in business for themselves.
  • To be an employee, the worker must be economically dependent on their employer.
  • Any agreement between the worker and employer that states otherwise is irrelevant.

Ultimately, it comes down to a worker’s autonomy. If they have it, they’re an independent contractor. If they don’t, they’re not.

Often, the misclassification is a simple mistake, but other times it’s a result of payroll fraud. When a business owner seeks to save money by avoiding taxes and benefits and purposefully classifies an employee as an independent contractor, they’re committing fraud. It takes a variety of forms:

  • Paying workers off the books
  • Requiring a worker to form a LLC as a condition of employment
  • Requiring a signed contract from the worker that states they are an independent contractor even if their employment doesn’t meet the requirements to be classified as an independent contractor

Misclassification Gets Expensive

Regardless of how or why an employee is misclassified, getting caught is going to be expensive. You can be found out in one of two ways – during an audit or if your worker reports you for any reason to the Department of Labor. When you’re caught, the money will add up quickly.

  • $50 for each W-2 you didn’t file
  • 5 percent of all wages paid, because income tax wasn’t withheld
  • 40 percent of the FICA (Social Security and Medicare) taxes the employee should have paid
  • 100 percent of the matching taxes you should have paid as an employer
  • Another 0.5 percent of unpaid tax liability for each month, up to 25 percent of the total tax liability as a “failure to pay taxes” penalty
  • If the IRS suspects fraud, you’ll pay fines up to 20 percent of the worker’s wages and 100 percent of the FICA taxes – your’s and your employee’s

One misclassified employee would be very expensive. Now imagine if you have multiple employees you’ve hired, temporarily or not, over the years that were misclassified. There is no insurance policy that will cover misclassification. You’ll have to cover the costs yourself. It would be a hard hit for any company. A small business could go bankrupt. The best solution is to hire carefully and classify your employees correctly.