The Risky Business of Misclassifying Employees

6-minute read

It’s happened to Uber, FedEx and Lyft, huge companies that found themselves paying huge settlements, including fines, after facing class action lawsuits claiming they misclassified employees as independent contractors.

Is there more on the horizon? Very likely.

The U.S. Department of Labor recently announced an initiative to add 100 investigators to its Wage and Hour Division — a clear signal of closer scrutiny and enforcement to come.

These WHD investigators will be busy with a number of jobs, including supporting efforts to combat worker retaliation and worker misclassification as independent contractors.

Misclassification of employees is often done to avoid carrying workers’ compensation insurance on the employee, and it’s surprisingly common.

When a business misclassifies an independent contractor, it classifies a worker who should be considered a direct employee of the business as a self-employed independent worker who receives a 1099 form for tax purposes rather than a W-2 form.

This misclassification is often done to avoid carrying workers’ compensation insurance on the employee, and it’s surprisingly common.

According to various studies, between 10-20% of employers misclassify at least one worker as an independent contractor.

While it might be tempting to misclassify an employee as an independent contractor to avoid paying for workers’ comp insurance, we definitely don’t recommend it for a number of reasons including the potential for serious penalties.

The IRS, for one, may impose fines as high as 100% of the employment tax outstanding and your company may also be held liable for Social Security taxes, federal income tax, and unemployment tax insurance.

Misclassification also hurt employees, of course, depriving them of benefits they are often entitled to, such as health care, overtime, and workers’ compensation benefits if they’re injured on the job.

The DOL’s Worker Classification Test

Several tests exist to determine whether a worker is an employee or an independent contractor. The DOL favors using what’s known as the “economic realities” test, which looks at whether a worker is economically dependent on the employer or engaged in business for themselves.

According to the DOL, if the worker is economically dependent on the employer, the worker is an employee and should be protected by employment laws, including the Fair Labor Standards Act (FLSA) and the Family and Medical Leave Act (FMLA).

Factors to consider under the economic realities test include:

  1. The extent to which the services rendered by the employee or contractor are an integral part of the principal's business.
  2. The permanency of the relationship.
  3. The nature and degree of control by the principal.

The place where work is performed, the absence of a formal employment agreement or whether a worker is licensed by the state or local government play no role in determining the status of an employee. Additionally, the time or mode of payment does not affect the determination of employee status.

The general rule is that an individual is an independent contractor if the company hiring that person has the right to control or direct only the result of the work and not what will be done and how it will be done.

To avoid misclassification, you’ll also want to make sure to assign the correct workers’ compensation class codes to your employees.

Workers’ compensation classification codes are three- or four-digit codes – there are more than 700 of them – that distinguish between types of job duties and different levels of risk. Most businesses use several workers’ compensation class codes. For example, a home builder would submit roofers under class code 5551 and clerical staff under code 8810. Because someone who works on a roof face greater risks of injury than a deskbound employee, the different class codes give the insurer a more accurate view of how risky your company will be to insure.

A business owner found to have made a classification error during an audit – even an accidental one – would have to pay the outstanding amount owed on their workers’ compensation premium.

On the flip side, misclassifying employees could mean your business is spending more on premiums than it should. A clerk or office worker would have a lower risk code than someone who works in construction.

While an annual audit will likely catch the error, business owners can save some money upfront – and the potential of legal trouble – by taking the time to properly classify employees from the start. If you’re making changes in payroll, job roles, locales and pretty much anything else involving operations, your best bet is to reach out your insurance team to do a quick code classification review and make sure all is right.

The Mahoney Group is one of the largest independent commercial insurance and employee benefits brokerages in the U.S. For more information, contact us online or call 877-440-3304.

This article is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel or an insurance professional for appropriate advice.

Scroll to Top