For small businesses, correctly classifying workers is crucial. Companies that misclassify employees may face investigations and audits by government authorities.
A business must understand the nature of the relationship between itself and its workers. This relationship is generally defined by behavioral and financial control, in addition to the perceived employer/employee relationship.
Employees or contractors?
The Alabama Department of Labor defines the relationship of an employer and an employee as a “master/servant” relationship, further stating that an employer has a “right of control” over its workers. This affiliation may sound draconian, but it gives a clear-cut picture of the nature of the connection.
Independent contractors, on the other hand, may serve similar purposes but are not bound by the rules of the employer. For example, an accountant may provide a lot of work to a single business. But if that accountant has his or her own office, bills by the hour and can subcontract work to another individual, he or she is most likely an independent contractor.
Penalties of misclassification
Employers are responsible for withholding employees’ taxes, so when a business misclassifies its workers, it isn’t paying the correct amount of employment tax to the IRS. The U.S. Department of Labor and the Internal Revenue Service audit and investigate entities with misclassified employees. If the investigations show the company misclassified its workers, it is responsible for the unpaid tax.
Some companies with misclassified workers may have the opportunity to prove they had a justifiable reason. Others may be eligible for the IRS Voluntary Classification Settlement Program, which allows businesses to find some relief from their outstanding employment tax if they qualify.