The Scarlet "M" – For Employee Misclassification

May 5, 2014


No one likes a cheater.  Especially in business, cheating contributes to a very uneven field of play. In this game, though, the winners are not the cheaters but the consumers of the product or service in question. Let me explain:

With many business owners and operators we encounter, we see a complete and utter misinterpretation of the difference between an employee and an independent contractor. Here are some of my favorites:

  • “We are going to hire him as a 1099 for six months and if he works out, we will make him an employee”
  • “We can’t afford employees while we are starting up, so we are only going to have 1099’s”
  • “She’s going to be a 1099 until she goes full time”

Clearly, there is a common misconception about what exactly a 1099 is. It seems as though some of the folks we meet during the course of our business mentally equate “Independent Contractors” with “Temporary Employees”.  True, they both don’t fall under the full definition of “Full Time Employee” –  but that doesn’t make them the same thing either.  Its like going to the dentist and expecting to meet the Tooth Fairy because they both work with your teeth.  And, of course, after a while you learn the tooth fairy isn’t real, either.  That’s what many of these business owners are learning.

According to the IRS, the definition of whether a person is an employee (W2) or independent contractor (1099) is focused on the following premise:

If the business has the right to control or direct the work, how it is to be done and when it is to be done, then the workers are most likely employees

If the business can direct or control only the result of the work done-and not the means and methods of accomplishing the result, then the workers are most likely independent contractors

There has been a recent re-emphasis on enforcement and collaboration between the US Department of Labor and IRS, as well as the departments of labor in states such as Massachusetts, Connecticut, Maryland, Minnesota, Missouri, Utah and Washington, with plans to include others such as Hawaii, Illinois, Montana and New York.  In its fiscal 2011 budget, the DOL requested $25 million dollars to fund its Employee Misclassification Initiative including the hiring of 100 full-time employees to conduct investigations, pursue litigation and issue grants to the states for increased enforcement efforts.

And always leading the legislative way, California has approved new laws that prohibit the intentional misclassification of individuals as independent contractors.  These could be punishable by civil penalties ranging from $5,000 to $15,000 for each violation, and much larger penalties up to $25,000 for employers engaging in a “pattern or practice” of violations.  Add on the penalties and interest on the IRS reclassifying their wages as W2 from infractions that date back many years, and you have the potential for driving companies out of business.

In addition to these fines, California also forces an employer, after being determined to be in violation of the law, to post on the company website or in a prominent public area, that the employer committed an infraction and has “changed its ways”.   The Scarlet M if you will!

But of course, this is the problem in the first place.  Employees who are not correctly classified presumably pay less taxes, or don’t pay them at all.  The tax laws for independent contractors don’t support this argument, but that doesn’t stop the proponents of the Employee Misclassification Initiative from using it anyway.

In Massachusetts, individuals classified as employees are protected by wage and hour laws and other benefits not afforded to independent contractors.  So in this case, misclassification hurts the employee in question.

But from another perspective, misclassification drives labor costs down for companies who misclassify what should be employees as independent contractors.  And this allows them to offer services for less cost than their compliant competitors, making for an uneven playing field.    Of course, lower costs mean lower prices for consumers.

So is lack of compliance a good thing, or a bad thing?  Comment below.




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