It’s Monday morning: Employees make their way to their workstations, the Keurig whirrs in the break room and the office starts to hum along as usual. Then, an employee approaches you and says that he’s done some research and discovered that his exempt job has been misclassified, and he’s actually nonexempt. What? No one has ever questioned their job status before, and your company’s job titles and descriptions are all in order. Is this employee correct? Are there others? How is a misclassification fixed? Or do you need to do anything about it? If he’s right, does the company owe him money? Are there tax penalties?
It’s going to be a long week.
Employee misclassification is a big problem among US employers, one that can lead to big tax penalties in addition to payments of back wages and even punitive damages. According to a the Economic Policy Institute, “studies report that, across most states, the prevalence of misclassification ranges from 11 percent to 30 percent depending on the method used by state unemployment insurance agencies to select companies for audits.”
Do Your Classifications Pass the Tests?
Exempt vs. Non-exempt
The key to staying on the correct side of employment law is to know the difference between non-exempt and exempt employees and to classify accurately. Non-exempt employees are entitled to earn minimum wage and overtime for working more than 40 hours in a week, in accordance with the Fair Labor Standards Act (FLSA). Certain types of jobs are considered exempt from this requirement: Executive, administrative, professional, computer, outside sales employees and independent contractors.
While the list of exempted jobs looks clear enough at first, it can become pretty confusing as you get into the details of the job in question. Department of Labor tests help you make the determination (and don’t forget that your state may have different laws about this matter too). The employee’s salary amount and how it’s paid (not less than $455 per week) as well as his or her performed duties (as opposed to the job’s title or written description) determine their status.
Independent Employee vs. Contractor
Classifying someone as an independent contractor vs. an employee can be extremely confusing, and errors abound. Our next blog will be solely devoted to do's and don'ts for classifying independent contractors.
Reclassify to Comply
The bottom line is that it’s illegal to misclassify employees, knowingly or not, so compliance is vital. Penalties abound in the form of back wages, back taxes (plus interest) and potentially even reimbursing court and attorney fees for employees. Class action suits are common in cases where companies are found to willfully misclassify employees.
One way to address tax liability due to misclassification is through IRS’s Voluntary Classification Settlement Program (VCSP), which offers partial relief to eligible employers. According to the IRS website, “a taxpayer participating in the VCSP will agree to prospectively treat the class or classes of workers as employees for future tax periods. In exchange, the taxpayer will pay 10 percent of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year, not be liable for any interest and penalties on the amount, and not be subject to an employment tax audit with respect to the worker classification of the workers being reclassified under the VCSP for prior years.” Nash notes that even though classification errors are corrected under this program, an employer is then left with more employees and associated administrative costs like taxes and benefits.
Another tax relief measure is Section 530 of the US tax code, known as the “safe harbor” provision. As CPA Claire Y. Nash of Tax Advisor explains, “a taxpayer can rely on the safe harbor provisions of Section 530 to obtain relief from the retroactive assessment of federal employment tax liabilities when the taxpayer has consistently classified workers as independent contractors, consistently reported workers as nonemployees, and has had a reasonable basis for doing so.” In this case, “reasonable basis” implies that the employer was acting in good faith and following long-standing industry-wide practice, judicial precedent, published rulings or a past IRS audit that failed to identify misclassification.
VCPS and Section 530 apply under different circumstances, so your best bet is to consult with legal counsel to figure out how to proceed. For more details and case law examples, see Phyllis Horn Epstein’s 2017 article on misclassification in Tax Notes.
Be aware, however, that even if your tax burden is reduced or eliminated, you may still be liable for back wages owed to your workers. This is often calculated as 1.5% of unpaid wages plus a penalty for each unfiled W-2. Recent high-profile cases include Walmart’s multi-million dollar settlement over back wages and DirecTV’s settlement with its cable installers.
Employee classification is a complex issue you can’t afford to ignore. Learn more about this critical part of human resource management from Horizon Payroll Solutions.