Employee or Independent Contractor? Misclassification Can Be Costly

The prospect of hiring workers, while exciting, can be intimidating to new business owners, Employment law can be a confusing and time-consuming minefield, and the consequences of making a mistake can range from costly to financially devastating. Generally, employers must consider a number of new responsibilities, including withholding income taxes, paying Social Security and Medicare taxes,unemployment tax and insurance not to mention the bevy of registration and compliance requirements at the local, state and federal level. 

Independent Contractors do not come with the same baggage, so to speak. Generally, companies do not have to withhold or pay any taxes on payments to independent contractors, and are not subject to the numerous compliance issues present when hiring employees.  So naturally, many employers, especially smaller ones greatly prefer to treat their workers as independent contractors instead of employees. However, failure to classify a worker correctly can lead to some severe consequences and substantial fines.  So,it's crucial for employers to classify their workers correctly to avoid lawsuits and substantial government penalties.

Employee v. Independent Contractor

Generally, the test to determine whether a worker is an employee or contractor boils down to one central issue: control – does the employer control where, when and how the work is performed?

Take an example most homeowners have to face at some time or another- replacing the roof. Say you need a new roof. You do the research and find a company that has good reviews. They come out and give you a good price, and you're on your way. Understandably, you don't give the roofing contractor many directions other than replace the roof (after all, you hired him or her because they have that expertise). You don't tell them which days to show up or what times they can work. You don't require them to hire certain workers to complete the job. You don't require them to submit time cards to you at the end of the day, require them to come to periodic staff meetings, or provide them the tools to replace the shingles on top of your house. You simply hire them to do a job and pay them when it's done. Everything in between is up to them. That's a contractor.

When you begin dictating how and when the work must be completed, the contractor line begins to blur into the employee classification, and that's when things can begin to get dicey. On a general level, it's about control,  but,  test is much more complicated, and employers ideally would hire employment counsel before classifying workers because the penalties for misclassifying employees as contractors can be huge.

In Illinois, for example, the classification defaults to employer status. An individual performing services for a contractor is considered to be an employee except if is shown

  1. the individual has been and will continue to be free from control or direction over the performance of service,

  2. the service performed is outside the scope of the usual course of services performed by the contractor and

  3. the individual is engaged in an independently established trade or business or the individual is deemed a legitimate sole proprietor or partnership under subsection c of Section 185/10.

The penalties are steep for misclassification. In Illinois, a fine of up to $1,500 per day (!!!) can be imposed for each violation, with a separate violation being considered for each person improperly classified and for each day on which a violation continues. So, for example, if a contractor misclassifies two persons for two days the maximum penalty is $6000. A contractor who willfully violates the Act or who obstructs an investigation can be subject to penalties of double the amount.

On top of that, the IRS imposes additional penalties from 1.5 to 3 percent of the employee’s wages.

Obviously, misclassification can be tremendously costly, especially to small businesses with limited resources. So, if you're an entrepreneur considering hiring some help, make sure to discuss the structure of the relationship with your attorney. 

Michael F. Brennan is an attorney at the Virtual Attorney™ a virtual law office helping clients in Illinois, Wisconsin, and Minnesota with estate planning and small business legal needs. He can be reached atmichael.brennan@mfblegal.com with questions or comments, or check out his website atwww.thevirtualattorney.com.

The information contained herein is intended for informational purposes only and is not legal advice, nor is it intended to create an attorney-client relationship. For specific legal advice regarding a specific legal issue please contact me or another attorney for assistance.



employee vs contractor