Avoiding the Pitfall of Employee Misclassification

Of all the decisions business owners face, classifying workers is often one that can be overlooked and/or undervalued. The issue of misclassification generally falls into two categories: determining whether workers are employees or independent contractors, and then for those individuals classified as employees, determining whether they are exempt or non-exempt from certain provisions of the applicable wage and hour laws.

Misclassifying workers in either case could have detrimental effects on your company, possibly resulting in some or all of the following: back pay, fines, penalties, attorneys’ fees, and/or owed taxes.  It is very important for business owners to take time and care when determining the appropriate classification(s) for its workers, including seeking legal counsel to assist when necessary.  This post will briefly outline the differences between some of the various employee classifications, tools to assist in classifying, and potential repercussions of misclassification.

When considering whether an individual working for you is an employee or an Independent Contractor (IC), it is important to recognize that the term “employee” is defined differently under different regulations.  There are three basic tests used to determine independent contractor status under a variety of laws: the IRS Control Test, the Common Law Test, and the Economic Reality Test. How the principles of the various tests are applied varies under different laws and in different states.  It is important to keep in mind that a worker may qualify as an independent contractor for tax purposes but not for other purposes (e.g., wage/hour, workers’ compensation, unemployment insurance, etc.). Conservatively, employers will want to verify that the worker’s status as an independent contractor meets the criteria of all applicable laws.

In general, an employee would be a worker who performs services for you where you have the right to control what will be done and how it will be done, even if the individual has been granted some freedom of action. Independent Contractors are generally in business for themselves providing services to other businesses and are considered self-employed. As the employer, you will usually only have control over the result of the IC’s work and not the method of how the work is completed.

A worker’s classification affects taxes (and who is responsible for paying them), eligibility for workers’ compensation and unemployment insurance, company fringe benefits, and other protections for employees established by federal, state, and local laws. When making a determination, you may want to err on the side of an employee classification to avoid potential back taxes, penalties, and fines associated with misclassification. It is always advisable to seek counsel if you are using an IC for services for your business, especially with the Department of Labor’s new initiatives to combat willful misclassification of employees as independent contractors. For additional information on this initiative please visit: http://www.dol.gov/whd/workers/misclassification/

For information on determining classification please visit: http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-(Self-Employed)-or-Employee%3F 

Once you have determined which workers are employees, another common classification question is whether the employees are exempt or non-exempt from minimum wage and overtime requirements under federal and state law.  Many employers think the determination of exempt versus non-exempt is as simple as asking whether they are paid “salary or hourly.” Although the method of payment is a part of the classification analysis, the analysis also considers the employee’s job duties and salary level, in addition to basis of payment.

Covered, non-exempt employees are subject to all provisions of the Fair Labor Standards Act (FLSA), the federal wage and hour law. Some workers, referred to as exempt employees, are excluded from the minimum wage and overtime provisions of the FLSA and some are only exempt from the overtime provisions. Those employees falling under the white-collar exemptions (executive, administrative, professional, outside sales, and certain skilled computer employees) are exempt from both minimum wage and overtime provisions of the FLSA. It is important to conduct this classification analysis carefully; if an employee is misclassified as exempt, it can lead to required back pay including any overtime hours worked for up to three years, as well as any applicable penalties.

These white collar exemptions are narrowly defined and may also be governed by your particular state, so employers are encouraged to review exact terms and conditions on the DOL website and/or by contacting your local governing agency. For more information and useful tools to assist in classifying, please visit: http://www.dol.gov/whd/regs/compliance/fairpay/fs17a_overview.htm

There is a lot to think about when it comes to properly classifying and compensating workers, and the process can be time consuming. But correctly classifying from the beginning can save you time and money in the long run. A great place to start is by building out an organizational chart for everyone who provides work and/or services for your company. Once you have the organizational chart, start drafting or reviewing already existing job descriptions for each position and during that process, make and/or review the classification determination. It’s better to take the time now to properly classify all employees, instead of potentially owing overtime and fines or penalties in the future. And remember, if you’re unsure how to classify a worker, seek legal consultation.

Erin Dillon
<div> Erin has 7+ years of experience in Human Resources and her PHR/PHR-CA certifications as well as a Masters degree in Management. Her expertise includes: employee relations, CA employment law, Federal employment law, leaves of absence, performance management and employee handbooks.</div> <div> <a href="http://www.paychex.com" target="_blank">Paychex.com</a><a href="http://www.score.org" target="_blank"> </a>|<a href="http://www.facebook.com/Paychex" target="_blank"> Facebook</a> | <a href="http://www.twitter.com/paychex" target="_blank">@Paychex</a> | <a href="/author/erin-dillon/all-posts" target="_blank">More from Erin</a>              </div>


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