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No one should want to get in trouble with the IRS. But, there’s difficulty aplenty if contractor classifications are incorrect. Workers, be they employees or contractors, typically work hard for their compensation. They don’t want nor deserve difficulties with the IRS. Similarly, businesses large and small should want their payroll and tax functions to work flawlessly and without unwanted penalties.


What’s an Employee? What’s a Contractor?


An employee is a person who performs services for a company that is in “control” of his/her work hours, work location, benefits, reimbursement of approved business expenses, time-off policies, dress codes, provision of tools or equipment and in general defines what and how work is to be done. These factors apply to both full and part-time employees.


A contractor is a person outside of the defined “controls.” Here, a business specifies only the results of work to be performed. Independent contractors are treated like vendors. Contractors provide their own equipment, work their own hours, use their own work location and are paid by the project, not by hours nor by salary. Contractors receive no insurance benefits, no vacation pay and no pension plan. And, they can simultaneously work for multiple companies as independent workers.


See this “1099 vs W-2, and IRS Checklist” article for 20 questions defining contractor classifications:


Consequences of Misclassification of Employees


Here’s the rub. It is estimated that more than 3.4 million workers are misclassified as independent contractors when they should be reported as employees. The IRS estimates that 10-20% of employers misclassify at least one employee as an independent contractor. Sometimes this is a mistake. On the other hand, contractor classifications are apparently misstated sometimes to reduce direct labor costs and to avoid paying state and federal payroll taxes. Consequences of these mistakes include:


  • Misclassified employees are denied access to normal protections of the law: minimum wage, overtime compensation, family and medical leave and unemployment insurance.
  • Federal and state governments lose significant revenues in the form of lower tax revenues and lower state unemployment insurance and workers’ compensation funds.
  • Significant employer fines and back payments may be applied.


What are the Penalties for Misclassifying Employees as Contractors?


Fines for wrongful contractor classifications include:

  • A $50 fee for each Form W-2 that should have been filed.
  • 5% of the misclassified employee’s wages, plus interest.
  • 20% of all employee wages paid.
  • 100% of the employer’s matching FICA contributions.
  • 40% of the employees FICA taxes that were not withheld from the employee.


Plus, criminal penalties amounting to $1,000 per misclassified employee.


In addition, a misclassified employee may file a complaint and he/she may be awarded benefits owed to them including health insurance, disability insurance, stock options, overtime, vacation pay, sick leave and 401(k) plan contributions.


Beyond these, a lawsuit filed by the IRS to resolve the misclassification problems can create a negative image for a company, reduce the value of its brand and cause a divergent strain on the time and focus of management. Compliance with all the government labor and tax regulations is clearly the right (and prudent) way to go to avoid problems with contractor classifications.


Get Expert Accounting and Tax Assistance


Avoid costly mistakes and save unwanted strain and pain. Contact Doerhoff & Associates CPA, based in Jefferson City, MO for professional accounting and financial assistance that will help you achieve the business success you are striving for. Doerhoff & Associates has one goal in mind, to provide comprehensive business accounting services—designed to meet your specific needs.