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Employers, beware misclassification of workers

Beginning in approximately 2009, the U.S. Labor Department (DOL) began a crackdown on misclassification of workers. In 2011, the Internal Revenue Service (IRS) joined the effort. Under an agreement between the two departments, the DOL will provide information to the IRS for investigation of potential misclassification.

If this double teaming, weren’t enough, the Alabama Department of Labor (ADOL) has now joined the effort. On October 2, 2014, the DOL and the ADOL signed a memorandum of understanding which allows the two agencies to cooperate in exposing misclassifications.

What is misclassification?

Workers can be classified as employees or independent contractors. If a worker is an employee, an employer must do several things. First, the employer must withhold income taxes on the employee’s wages, withhold Social Security taxes (FICA), and withhold Medicare taxes. Second, the employer must transfer the withholding to the IRS, pay unemployment compensation taxes (FUTA), and pay the employer’s share of Social Security and Medicare taxes.

If a worker is an independent contractor, the employer does not withhold income tax, Social Security tax, or Medicare tax and does not have to pay the employer’s share of the Social Security and Medicare taxes. In short, it’s cheaper to pay an independent contractor than to pay an employee because the employer’s share of the Social Security and Medicare taxes don’t have to be paid.

Well, cheaper so long as the classification of the worker is correct.

What happens if an employee is misclassified?

If the IRS determines that an employer has misclassified a worker as an independent contractor, the employer will probably have to pay at least three things: back wages to the worker, back withholding of the Social Security and Medicare taxes, and a penalty. For the Bowlin Group, LLC, and Bowlin Services, LLC, of Kentucky, this resulted in payment of approximately $1 million.

Why the crackdown on misclassification?

The answer is very simple: The IRS and various federal study groups have estimated the IRS doesn’t collect from $2 to 3 billion a year because of misclassification. Facing a deficit, the federal government is looking for ways to collect more taxes. Misclassification also results in the Alabama Department of Revenue not collecting some taxes that are due as well—which explains why the DOL and the ADOL signed the memorandum of understanding.

What to do?

Although not inherently illegal, classification of workers as independent contractors must be done carefully and not simply as a way to reduce payroll overhead. If an employer has large numbers of independent contractors, especially in low-paying jobs, the employer is probably more likely to be investigated for misclassification and is therefore well advised to check with its accountants and attorneys to make sure the classifications are legitimate. The IRS has good general guidance available.

Items on this web page are general in nature. They cannot—and should not—replace consultation with a competent legal professional. Nothing on this web page should be considered rendering legal advice.

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