The Cost of Misclassification of Employees
September 29, 2016
Author: Hope Freund, Account Manager
Big issues in the forefront of motor carriers right now are driver shortage, CSA, fuel costs, and soft freight. However, an overlooked rising issue for motor carriers is the way that they are classifying their drivers as either employees or independent contractors. Over 30% of companies misclassify employees as independent contractors; whether accidental or intentional. In July of 2015, the Department of Labor (DOL) issued an Administrator’s Interpretation on employee and independent contractor classification. In addition to the DOL, the Internal Revenue Service (IRS) has also agreed to work together with the DOL to coordinate and enforce the Fair Labor Standards Act (FLSA). Several states have also followed suit and responded with misclassification task forces.
Correctly classifying a driver as an independent contractor or an employee is crucial. When employers improperly classify employees as independent contractors, the individuals may not receive important workplace protections governed by the FLSA. These workplace protections include: minimum wage, overtime compensation, unemployment insurance, and workers’ compensation. If a driver believes he or she has been misclassified, the driver can file a complaint with the DOL. In turn, employers can be audited by the DOL, IRS, the state and/or their workers’ compensation insurance carrier; thus resulting in hefty payment penalties and back premiums.
The ramifications for an employer can vary depending on if the DOL and the IRS determine the misclassification as unintentional, intentional, or even fraudulent. Fees and penalties can range depending on whether the misclassification was inadvertent or not, and can include any of the following: $50 per W-2 form not filed, 1.5% of wages the employer should have paid, 40 percent of FICA taxes, unpaid premiums, overtime, work-related expenses, and unpaid sick/vacation pay. In addition to these penalties, there is additional liability for intentional misclassification including criminal fines up to $1,000 per misclassified worker and prosecution with prison sentences up to one year.
When looking through the insurance lens, the employer can be audited by their workers’ compensation carrier when they have company drivers, as well as, independent contractors. This may be the case if an employer doesn’t require their independent contractors to provide proof of work accident coverage (either Workers’ Compensation or Occupational Accident). The employer could be putting themselves at risk if an independent contractor files a workers’ compensation claim against the employer. If the insurance carrier pays the claim, in turn, they will likely want to audit for 1099 payroll for any uncollected premiums. For example, TRAVELERS INDEMNITY COMPANY, v. D.J. FRANZEN, INC. (IA-2010): Travelers won $550,661 audit (on top of $1,775 original premium) because Franzen failed to appeal audit to NCCI. Court determined Franzen couldn’t contest either Travelers determination that the drivers were employees or the premium charged. It is in the employer’s best interest to require their independent contractors to purchase occupational accident or workers’ compensation coverage.
How can all of this be prevented? As an employer, you can protect yourself with proper documentation and understanding how the IRS and DOL will determine, or “test”, the difference between whether an employer and worker have an employer-employee relationship or the worker is an independent contractor. It is always a good precaution to obtain documentation that states the IC’s self-employed status, require the IC to sign an Independent Contractor Agreement, as well as, request a certificate of work comp or occupational accident insurance.
According to the IRS, “The general rule is that an individual is an independent contractor if the payer 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.” The IRS considers three factors categorized into behavioral, financial, and the type of relationship.
- Behavioral: Does the company control or have the right to control how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how a worker is paid, whether expenses are reimbursed, who provides tools, supplies, etc.).
- Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)?
DOL’s Economic Reality Test
According to the DOL, “An employee, as distinguished from a person who is engaged in a business of his or her own, is one who, as a matter of economic reality, follows the usual path of an employee and is dependent on the business which he or she serves.” There are six factors the DOL relies on:
- “The extent to which the work performed is an integral part of the employer’s business.”
- “Whether the worker’s managerial skills affect his or her opportunity for profit and loss.”
- “The relative investments in facilities and equipment by the worker and the employer.”
- “The worker’s skill and initiative.”
- “The permanency of the worker’s relationship with the employer.”
- “The nature and degree of the employer’s control.”
Independent Contractors can be a low-cost alternative to regularly employed employees; however, it is important to understand the risks associated with the monetary benefits. Employers should make sure they are communicating with their legal counsel, tax advisor, and insurance agent to help them properly classify their workers, always keep documentation on file, and understand the IRS and DOL tests. It is crucial to perform due diligence and make certain the contractors are truly independent of the employer.