Common Employee Classification Mistakes That Can Cause Tax Penalties

Sometimes, employee classification isn’t as easy as it sounds. You may wonder whether to classify a worker as an independent contractor or an employee, because their role seems to be a mixture.

Misclassifying employees can seem like an honest enough mistake, but it can result in tax penalties that will harm your firm.

These are a few common employee classification mistakes that you can avoid.

Classifying as Employee or Independent Contractor

The biggest question when it comes to classification is whether a worker is an employee or an independent contractor. An ’employee’ would be people who are essentially a part of your business and usually only works for you, working under your direction and control.

On the other hand, an independent contractor runs their own business. They provide services to more than one company, sometimes referring to you as a ‘client’ instead of an employer.

The IRS classifies workers based on the amount of control you have over them in the following categories:

  • Behavioral. How much control do you have over what a worker does?
  • Relationship with the parties. What is the relationship that is laid out in your contract?
  • Financial. Do you have the right to manage the financial or business aspects of a worker’s job?

When your answers to these questions differ and don’t fit into the neat categories, you may misclassify a worker. This will in turn expose you to tax penalties.

Even if your contract states that someone is simply an independent contractor, the IRS may not agree with this. This may be because the extent of their services to you financially and behaviorally go beyond a contract role, which makes them an employee. In this case, there will be different tax considerations and you may be vulnerable to tax liabilities.

The solution is to always consider all of the different factors of control. A worker’s contractual classification will not mean more than the other aspects affecting the working relationship.

Classifying as Freelancer or Contractor

The differences between a freelancer and a contractor are even more vague than that of an employee and an independent contractor.

Contractors, in this sense, mostly only work for one client at a time, and may sometimes work at the business premises. A freelancer is also an independent contractor. Their relationship with a business is defined by a greater control on the part of the worker. They can also serve multiple clients at once.

Neither of these individuals are full-time employees and are usually hired to work on a specific problem you face.

While these differences may not seem sizable, it does make a difference in how you pay the worker, and what tax forms they fill. For a contractor, you will fill in the W2 form. Namely, your payments will still include insurance or non-employment benefits sometimes.

In contrast, you will fill in the W9 form for a freelancer (or they will fill it in and send it to you), and payments between you and the worker will differ based on negotiation. They are usually not entitled to receiving employment benefits such as health insurance.

To ensure that you pay them and file the documents correctly, you will need to ensure that the worker’s roles fit their job description, and that they themselves understand the classification they fall under. This prevents any form of confusion and inaccurate documentation, which will invite more scrutiny from the IRS.

Consequences of Employee Misclassification

Incorrectly classifying your workers is a serious mistake, but what exactly will happen? These are the scenarios that may occur if the IRS deems that you have misclassified employees.

Fines or Back Payments

The most common – and perhaps most feared – penalty is in the form of fines. If you classified an employee as an independent contractor, the IRS will charge you for the actual tax amount you should be paying if they are an employee. On top of that, they will also levy a penalty for either documenting incorrectly or for not paying payroll taxes accurately and on time. These fines may not seem significant individually, but if they pile up across several employee misclassification instances, they will start hurting your business.

Employee Benefits

If your worker finds out that you have classified them wrongly, they may pursue a claim or a complaint about this, and will then be eligible for the benefits that they may not have had because of the misclassification. This includes aspects such as health benefits, overtime payments and more.

Reputational Damage

If your employee misclassification mishap occurs often or is significant enough to result in a huge fine, your reputation may also take a hit. Increased attention from the IRS can result in more common audits or even some lawsuits from your workers, which will jeopardize your credibility as a company.

Reputational damage will prevent you from employing the type of people your company will need.

Importance of Accurate Employee Classification

Employee classification is an innocent enough mistake that nevertheless carries a lot of damage to your company. To protect yourself from this, you will have to make sure you examine all the different aspects of your relationship with a worker, and also distinguish between a freelancer or a contractor. You will also have to ensure that your documents are filed according to these classifications.

If you want to know how to pay your contractors, Next Generation Payroll will assist you in managing accurate and effective payroll processes.

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