Worker misclassification and the Fair Labor Standards ActBy: Shaliz Sadig and Stephanie Westerman 

Misclassification of a worker occurs when an employer improperly treats an employee as an independent contractor or other nonemployee.  It happens all the time.  Sometimes intentionally, sometimes by mistake.  But regardless of how and why, worker worker misclassification is a serious and potentially costly matter for both workers and employers.

Why? 

Firstly, misclassified workers don’t get to take advantage of many workplace laws and protections such as the Fair Labor Standards Act.  Whether you call them “freelancers,” “consultants” or “contractors,” they’re not entitled to minimum wage, overtime, unemployment benefits, eligibility for healthcare coverage under the Affordable Care Act, or many other benefits afforded only to employees.

Secondly, misclassified workers have to pay all Social Security and Medicare taxes on their own, whereas employers are required to pay half of these taxes for employees.  These exceptions make sense for legitimate independent contractors.  However, they’re unfair and burdensome for workers who have been wrongly classified.

Misclassification is a big deal, not just for the IRS, but also for the U.S. Department of Labor, the New York State Labor Department and the New York State Attorney General, who signed a memorandum of understanding to crack down on misclassification.  According to the November 18, 2013 news release:

In the last two years, the Wage Hour Division has secured over $18.2 million in back wages for more than 19,000 workers where the primary reason for minimum wage or overtime violations under the Fair Labor Standards Act was that workers were not treated or classified as employees. This represents a 97 percent increase in back wages following the implementation of these agreements.

What could happen?

Misclassifying an employee as an independent contractor can result in significant financial and legal consequences.  Since employers pay taxes on employees but not on independent contractors, misclassification may result in tax evasion, punishable by heavy fines and potential criminal penalties.   If your business is selected by the IRS for an employment tax examination to determine whether you correctly classified employees, you may be held liable for employment taxes for that worker unless you have a reasonable basis for doing so.

Businesses must also comply with state and federal labor laws.  If you classify your workers as independent contractors, minimum wage and overtime requirements are not accounted for.  Fees can include reimbursement and back pay for unpaid wages, including overtime, workers’ compensation benefits, retirement contributions, and employee benefits for each misclassified worker.  This means that your mistake could cost far more than if you had correctly classified your workers in the first place. Depending on how many employees you have misclassified, the fines may be too much for your business to handle.  FedEx was required to pay $5.3 million in damages to misclassified workers plus $12.3 million in attorneys’ fees in 2006.  Lowe’s recently agreed to a settle $6.5 million settlement with installers at its home improvement stores.

New York imposes criminal as well as civil sanctions.  Recent legislation in NYS targets sectors with a higher rate of workplace misclassification.  In 2010 New York passed the Construction Industry Fair Play Act imposing potential high fines, misdemeanor criminal prosecution, jail time and disbarment from Public Work for up to five years.   In January 2014, New York also passed the State Commercial Goods Transportation Industry Fair Play Act which creates a new standard for determining the classification of a driver of commercial vehicles who transports goods.

With the threat of both civil and criminal sanctions, and penalties from the Department of Labor and IRS, it’s crucial to know how to correctly classify your employees.

How do you know if you have misclassified your workers?

Classifying your employees properly is a complex issue and businesses get it wrong all the time.  Part of the problem is that the standard is unclear.  In general, if you, as a business owner, have control over the work being performed, then your worker is likely an employee and not an independent contractor.  The independent contractor vs. employee test is inherently factual and there is no bright line rule or law that governs.  The circumstances as a whole need to be examined to determine the underlying “economic reality” of the situation.

The analysis at both the Federal and New York state level are similar and there are multiple factors to consider when determining which relationship exists.  Specifically, the issue turns on the level of control asserted by the employer and independence of the worker.   The IRS also has its own similar analysis based around control.  Employers have an option to file a Form SS-8 with the IRS to have them review the facts and circumstances and officially determine a worker’s status.

Independent Contractors are generally in business for themselves and operate free from supervision, direction and control in the performance of their duties.  In employer-employee relationships, the employer generally sets the location and schedule of work and the pay rate.  The employer typically gives directions to the employee and may oversee the work.  Employers often require employees to attend certain trainings or meetings and provide equipment and supplies. Employees are usually required to seek prior permission from the employer before he/she may take off from work.  These are just a few of the factors to consider.  Number of hours worked is not dispositive.  Note that just because someone may work only a few hours a week does not mean that they are an independent contractor.  It may just be that they are a part time employee.  Note also that it doesn’t matter if the worker prefers or agrees to be treated as an independent contractor.  The risk is on you.

What can you do to protect your business?

Be Proactive.  Don’t wait for your workers to look into their classification.  Their first step may be to get the government involved which could bring your entire business under scrutiny.  Instead, take a step back and look at all of your workers to determine if there is a need for reclassification.

Consult with an experienced business attorney.   If you are unsure, it may be prudent to speak with an experienced business attorney to assess your situation and mitigate risk.  You may also want to check with your accountant or tax counsel regarding any tax and IRS issues.

Look ahead.  Although misclassification can initially mean money saved for your business, it’s not worth it in the long run.   As your business grows, so does your potential for risk so don’t roll the dice.  Risk assessment and long-term planning can prevent serious penalties in the future that may be detrimental to your business.

Contributing Author:  Stephanie Westerman

Shaliz Sadig, Esq

Shaliz Sadig

Associate Attorney

(212) 865-9848

Email Shaliz

See my full profile

Leave a Reply

Your email address will not be published. Required fields are marked *