Misclassification mistakes — two words that sound almost innocuous, but which could result in substantial fines and legal headaches for a company if they get things wrong.

Put simply, misclassification mistakes arise most often when a company misclassifies an employee as an independent contractor.

Such a misclassification can have a serious impact if that person is, for example, supposed to be covered by insurance. Moreover, it happens more often than many people think.

“Misclassification of employees as independent contractors continues to be rampant, especially in traditionally low-wage industries such as home health care and janitorial services, but also remains prevalent in higher-paying industries such as construction and trucking,” Debra Friedman, a member of the labor and employment practice Group at law firm Cozen O’Connor, told Risk & Insurance®.

A 2000 study by the U.S. Department of Labor (DOL) found that approximately 30 percent of companies misclassify workers. Some of them may simply be ignorant of the law (although ignorance offers no legal defense).

More often, though, companies deliberately misclassify workers to save money. This is because companies do not pay Social Security and Medicare taxes, unemployment insurance tax, or workers’ compensation insurance for independent contractors, nor do they provide independent contractors with employee benefits such as health insurance, pensions or 401(k) matches, and paid time off.

Significantly, these costs can represent 20 percent to 40 percent of an employee’s total compensation.

Also, said Friedman, “independent contractors, unlike employees, are not protected under federal or state minimum wage or overtime laws or anti-discrimination statutes, and do not have the right to bargain collectively and join unions or obtain job-protected leave.”

Stakes Are High

Some recent cases have shown a wide variety of companies and plaintiffs.

In July of this year, FedEx Ground drivers won summary judgment in their misclassification lawsuit brought against FedEx under the Massachusetts Independent Contractor Act, with the judge ruling the workers were, in fact, employees.

And in October 2013, the Penthouse Executive Club in New York reached an $8 million settlement with a group of adult dancers who had complained that they had been misclassified as independent contractors and had not been properly compensated as a result.

“Historically, misclassification mistakes have been a very big issue in the trucking industry, or especially if you are dealing with contractors,” said Eric Silverstein, senior vice president and leader of Lockton’s risk management team.

“As a result, the trucking industry has put together the blueprint for how to deal with this. If you’re providing insurance for an owner/operator fleet, or you’re dealing especially with subcontractors, then there needs to be a clear contract and an arms-length agreement. From a risk management perspective this can be a lot of work — it must be very clear who’s working under contract.”

According to Friedman, misclassification of employees has serious implications for companies, as they are at risk for investigations and lawsuits from both federal and state governments, as well as private lawsuits from individuals or classes of individuals.

“Federal and state governments have been losing billions of dollars each year due to misclassifications and therefore have been putting more resources into identifying and prosecuting misclassifications.” — Debra Friedman, labor and employment practice group, Cozen O’Connor

In addition to taxes and benefits (including the value of lost benefits), a company may be liable for penalties (such as fines, liquidated damages and/or punitive damages), costs, interest, and attorneys’ fees, she said.

Companies also may be required to post notices about their wrongdoing in their workplaces, and, in California — even on their company websites.

“Importantly, federal and state governments have been losing billions of dollars each year due to misclassifications and therefore have been putting more resources into identifying and prosecuting misclassifications,” said Friedman.

“In 2011, the U.S. Department of Labor and the IRS entered in a Memorandum of Understanding [MOU] to share information for the purpose of identifying and reducing misclassifications of workers. Since that time, at least 14 states also have entered into MOUs with the U.S. Department of Labor to share information and reduce the incidence of worker misclassifications.”

The IRS also has an employment tax initiative in place to audit more than 6,000 employers, selected at random, with the objective of finding and correcting worker misclassifications.

Friedman pointed out that this increased government focus is resulting in millions of dollars in back wages and penalties.

In May 2013, for example, the DOL obtained a consent judgment against Bowlin Group LLC and Bowlin Services LLC, providers of infrastructure solutions, for more than $1 million in back wages and damages covering 196 employees.

Seventy-seven of the workers had been misclassified as independent contractors.

“On the state level, New York should serve as a cautionary tale,” Friedman added. “In 2013 alone, New York identified almost 24,000 instances of employee misclassification, uncovered more than $300 million in unreported wages and assessed nearly $12.2 million in unemployment insurance contributions.”

Other states also are getting increasingly tough on misclassification.

Massachusetts announced that in 2013, it collected more than $15 million in back taxes, unpaid wages, unemployment insurance contributions, fines and penalties related to employer fraud and misclassification. Earlier this year, a California state labor board ordered a logistics company to pay more than $2.2 million in back pay to seven drivers it misclassified as independent contractors.

With such high financial stakes it makes sense to avoid making these mistakes in the first place.

Sheryl Jaffee Halpern, labor and employment attorney, Much Shelist

“Employers should keep in mind that whether an individual can work for their company as an independent contractor is not the employer’s decision,” said Sheryl Jaffee Halpern, labor and employment attorney at law firm Much Shelist. “It’s the government’s decision. The challenge is that the tests used by the IRS and the U.S. Department of Labor are not identical. And the agency responsible for administering unemployment benefits in the worker’s home state may apply yet a different test — which in many states is more stringent than the IRS’ and Department of Labor’s tests.”

Employers should become familiar with these tests, she said, and then use the relevant factors to assess on an individual basis whether a worker can properly be classified as an independent contractor.

Early Connection

That classification should come at the outset of the business relationship, Friedman said. Generally, she said, independent contractors have specialized skills that are not focused on the company’s core business functions. If in doubt, classify the worker as an employee or consider working through a workforce management or staffing company and have them make the classification determination.

“Employers should keep in mind that whether an individual can work for their company as an independent contractor is not the employer’s decision. It’s the government’s decision.”  — Sheryl Jaffee Halpern, labor and employment attorney, Much Shelist

If such a mistake is made — and identified quickly — then what should a company do?

“Naturally, it’s best not to use the ostrich approach if a mistake has been made,” said Halpern. “That said, because reclassifying a worker can have unintended consequences, we recommend that an employer work with their legal counsel to devise the best strategy for correcting the mistake in a way that does not create additional exposure.”

Friedman said companies have various options for correcting misclassifications.

“If a company is acting on its own, a key consideration is whether to address the classification mistake retroactively by voluntarily paying back taxes or taking other remedial actions.

“Any decision on how to handle the mistake retroactively has risks of opening the door to employee claims and/or government investigations,” said Friedman.
If a company decides to voluntarily pay back taxes, it may want to consider working with the IRS, and possibly any applicable state governments.

Since 2011, the IRS has had a Voluntary Classification Settlement Program that is available to companies that voluntarily seek to reclassify independent contractors as employees and that are not under audit for misclassification by the DOL or a state agency, or under an employment audit by the IRS.

Under this program, companies have significantly reduced federal payroll tax liability, and no interest or penalties are assessed.

While this program clearly has some benefits for addressing misclassifications, Friedman said, companies may be exposed to lawsuits for unpaid wages (minimum wage and overtime) and benefits, as well as fines and penalties under other federal and/or state laws.

There may be companies that believe a misclassification mistake is not all that important.

But the growing number of firms that have been forced to pay substantial fines would loudly disagree.