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The Many Potential Pitfalls of Worker Misclassification

Worker misclassification (generally defined as the case where a worker is incorrectly classified as an independent contractor when they should have been an employee) is a growing area of concern for US employers. In 2015 we saw significant federal and state regulatory agency activity around worker classification, and this trend is likely to accelerate in the coming year.

The Department of Labor led the charge with their Administrators Interpretation, which essentially deemed “most workers” should be considered non-exempt employees under current guidelines. Those regulations, along with continuing enforcement action by the National Labor Relations Board and the IRS, highlight why proper worker classification and enforcement should be a top priority.

Effectively managing the risk of worker misclassification presents companies with the challenging task of managing flexible worker relationships to meet their changing business needs while also ensuring proper worker classification under a confusing array of federal, state, and local regulations.

The negative effects of worker misclassification, and possible reclassification, can wreak havoc throughout an organization’s Human Resources, Procurement, Finance, and Employee Benefits functions. There are many issues that a company must deal with if they are found to have misclassified a worker. Below is a partial list of issues that must be resolved if an independent contractor is deemed to be an employee:

  • Back pay (e.g., minimum wage and overtime pay)
  • Failure to withhold and underpayment of Federal and state/local income and employment taxes
  • Failure to provide proper wage statements, such as Forms W-2
  • Failure to provide employee benefit coverage and appropriate remedial action
  • Failure to make employer and employee contributions to retirement and other employee benefit plans
  • Failure to provide required benefit plan disclosure and administrative notices
  • Excise taxes under the Affordable Care Act (the “ACA”) for failure to provide required health plan coverage
  • Civil tort liability to a misclassified worker as well as third parties who are injured as a result of a misclassified worker’s negligent acts
  • Violations of state, federal and/or foreign labor laws, which may include civil penalties and/or notice requirements imposed by the government agency

In addition to these legal implications, there are a number of other issues (with significant associated costs) that often accompany a worker misclassification action:

  • Fees paid to outside employment law counsel to help defend the case
  • Management time and distraction to build and defend audit files
  • Class actions
  • Negative press and damage to employer brand

After reviewing the above list it should be very evident that worker misclassifications can be nasty business and are best avoided, if at all possible. Luckily, independent contractor compliance and engagement experts, like Synergy Services can help mitigate the risk of worker misclassification.

There are other worker misclassification risks for companies to evaluate and consider taking preemptive steps to avoid issues:

  • Affordable Care Act: The very foundation of the ACA is built upon classifying workers correctly. Employer coverage responsibilities and the calculation of penalties for failure to provide compliant health coverage, all depend on whether an individual is properly classified as an “employee.” Misclassified independent contractors can trigger large adverse consequences. In addition, a single misclassified worker can trigger the assessment of ACA excise tax penalties based on the employer’s entire full-time workforce. The ACA has also resulted in many employers struggling to resolve “joint employment” and “co-employment” issues with their staffing or other human capital service providers. Companies are advised to be extra cautious with worker classification in this area as a mistake could result in both ACA non-compliance as well as all the liabilities for misclassification as listed above.
  • Treatment of Misclassified Employees in Health Plan Document: Most health plans (both insured and self-funded) exclude independent contractors from coverage. Without an express provision stating otherwise, an independent contractor that is reclassified as an employee may become eligible for coverage under a health plan. This could also include retroactive coverage. Some employers address this issue by including language in their health plans which excludes reclassified workers from coverage.
  • Nondiscrimination Testing: The data that an employer uses to perform nondiscrimination testing for self-funded health plans and cafeteria plans specifically excludes independent contractors. In the event of a reclassification, depending on the size and attributes of the misclassified worker group, it is entirely possible that the testing results could change. Therefore, as a part of its overall response to a worker misclassification, an employer should assess and potentially re-run prior plan testing.
  • Legally-Required Employee Notices: Employers have the responsibility to provide a variety of health plan notices to their employees at different stages of the employment cycle. In the event that an employer has independent contractors reclassified as employees they must evaluate which notices should have been provided, but also how to address the prior lack of notice. One example: an employer must consider the extent to which COBRA notices or a Summary of Benefits Coverage that is required under the ACA should have been provided, and then determine the impact of failing to provide those notices to the affected workers at the required time.

The “Other” Worker Misclassification

We often hear about the form of worker misclassification which involves improperly classifying a worker as an independent contractor instead of an employee. However, there is another common form of worker misclassification: improperly classifying an employee as being exempt from overtime pay and meals and rest breaks. Both forms of worker misclassification are very common, and both leave the company exposed to big future potential risks.

It is very common for a worker misclassification audit to begin with a misclassified independent contractor who files an unemployment or workers comp claim. In many cases, this single worker filing a wage claim with the state is enough to prompt an audit of the entire company by the state employment department. These audits are often extremely burdensome for the company, both in terms of staff time and resources, and typically include a review of all of the company’s “independent contractors” and pay practices. Since many states, the DOL, and the IRS have information sharing agreements, these audits often result in additional agencies conducting a similar audit leading to back wage payments along with the various tax penalties as discussed above.

Smart Next Step to Avoid Misclassification

Companies that utilize flexible workers in any capacity are wise to take preemptive steps to help avoid worker misclassification issues. One smart tactic is to conduct a thorough investigation into the entire flexible workforce providing services to the company in order to determine whether contractors are properly classified. Organizations are advised to set up strict requirements and processes for engaging contractors and through proper policy and procedure they must be ever-vigilant in adhering to those requirements. The most strategic organizations elect to engage with a third party IC Compliance and Engagement solution provider, like TalentWave, to screen and engage its contractors in a safe, efficient, easy, and cost-effective manner.

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