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Consequences of Misclassifying an Employee as a Contractor

For small business owners, classifying a worker as an employee or as a 1099 contractor is important for federal and state employment tax purposes. If your worker is considered an “employee,” you must withhold income taxes and pay Social Security, Medicare taxes, and unemployment tax on wages. You must also provide Workers Comp Insurance and possibly offer benefits. However, if your worker is an independent contractor, you do not have to withhold or pay any taxes on their income as they would be subject to self-employment tax.

Understanding the legal difference between hiring an employee and hiring a contractor is integral to your business.

After January 1, 2020, approximately 2 million independent contractors in the state of California had classification changes and are now considered employees under state law.  As “employees,” the state’s and city workplace laws and regulations will now apply to these workers.

How to determine what to classify those you hire:  

The IRS uses a three-part category test, to determine the classification of workers. This test includes the categories: Behavioral, Financial, and Relationship, focusing on facts related to the degree of control the employer has over the worker.

  1. Behavioral: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.
  2. Financial: Does the business have a right to direct or control the financial and business aspects of the worker’s job?
  3. Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another.

More recently, the state of California also adopted a new way of determining employee status, Assembly Bill (AB) 5,  by applying an “ABC Test.” Under this test, a worker would be considered an independent contractor if:

  1. The worker is free from the control and direction of the employer when it comes to the performance of work
  2. The worker performs work outside of the employer’s business
  3. The worker is engaged in an independently established trade, occupation, or business that is involved in the work they were hired to perform

All three of these factors must be satisfied to legally classify a worker as an independent contractor.

This information was sourced from the IRS and State of California Department of Industrial Relations (DIR). For more details on these three part-tests, please visit the IRS website. You can also find FAQs on Assembly Bill (AB) 5 and how the California Supreme Court recommends that you apply the ABC test here.

What happens if you misclassify an employee as an independent contractor?

If you are an employer who has misclassified an employee as an independent contractor, you may be liable for employment taxes and owe up to three years of back taxes on the misclassified employee’s wages. Unemployment tax, workers’ compensation benefits, and premiums on state-run insurance programs may also apply.

We recently spoke with HR Consultants Catherine Mattice Zundel and Rebecca Del Secco of Civility Partners and they provided us with a bit of insight:

“Small businesses are under attack in California. Failing to comply with new laws like this one can result in large fines, lawsuits, and sometimes even put an organization out of business entirely.  In addition, consider the message you send employees and clients about your ethics if you don’t follow the law. This is a great example of how culture and compliance intersect. It’s absolutely imperative for organizations to review their current practices regarding independent contractors, or have an HR expert or Employment Law Attorney review them instead. In doing so, you protect your business and you communicate to employees that doing the right thing is important.”

Here are more best practices to put in place if you are concerned about misclassification:

  1. Always have accurate and to-date job descriptions written with the classification in mind. The way a job is defined can help determine the relationship between the employer and the worker.
  2. Have written agreements between independent contractor and employer that describes the scope of work to be performed
  3. Conduct internal audits
  4. Keep managers and supervisors trained on legal standards

If you need HR support, Payroll Systems may have the right solutions for you. Fill out the form below for more information!

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This article provides general information and shouldn’t be construed as legal or HR advice. Since employment laws may change over time and can vary by location and industry, please consult a lawyer or HR expert for advice specific to your business. You can also contact Payroll Systems to inquire about our HR support services.