What Are The Penalties For Misclassifying Freelancers?

If you’ve started working with more freelancers this year, your company and your HR department may have come up against something they’ve never had to cover before – freelancer classification. While classifying full-time employees is straightforward, they are W2 employees who need taxes withheld and are entitled to certain benefits, classifying freelancers can be messy. Misclassifying freelancers, whether intentional or not, can cause huge problems for businesses.

You have to be very careful when classifying freelancers. Individual states and even cities have started to crack down on who is considered a 1099 freelancer vs who is considered a W2 employee. Misclassification can trigger penalties and fees for your business and the IRS takes this classification very seriously. Failing to properly classify a worker as either an independent contractor or an employee can have devastating consequences for the employer.

Who is Considered a 1099 Freelancer?

Why is this classification process such a big deal to the IRS? When freelancers are classified as independent contractors, organizations don’t pay the benefits that W2 employees are entitled to such as health insurance, paid time off, and payroll taxes. Misclassifying a freelancer as 1099 instead of W2 means that you aren’t providing them with the benefits they’re owed and you aren’t paying the government the correct payroll taxes.

According to the Internal Revenue Service, there are three ways to determine how a worker will be classified:

Behavioral Control: The designation is indicated by the behavior of the company toward the worker. The worker is an employee if the business has the right to dictate how they perform their job and gives specific instructions. This can include the types of instruction, the detail of instruction, evaluation methods, and training. An independent contractor often uses their own tools and utilizes their own knowledge and experience to perform the work with little instruction by the business.

Financial Control: The designation is indicated by how the worker receives their compensation. The worker is an employee if the business owns the equipment they use to work, if their work expenses are not reimbursed, and if they are paid a set wage with taxes, Social Security, and Medicare deducted. Independent contractors often require reimbursement for expenses, can take a financial loss on the project, and are usually paid a flat fee.

Relationship: The designation is dictated by how the company and worker perceive their relationship with one another. A worker is an employee if there is an expectation that the job will continue indefinitely and if the business pays benefits like overtime, insurance, or healthcare. Independent contractors usually have limited-term employment or provide their services based on contracts rather than employment agreements.

Misclassifying Your Freelancers = Penalties and Fees

If the IRS determines that someone has been misclassified, your penalties could include:

• A $50 fine for each Form W-2 the employer failed to file on such employee
• A penalty of up to 3% of the wages, plus up to 40% of the FICA taxes that were not withheld
• Up to 100% of the matching FICA taxes the employer should have paid.

And these are just the penalties for accidentally misclassifying your employees. If the IRS determines that a company was knowingly trying to skirt the law, the penalties could be even steeper. Fines from the U.S. Department of Labor, IRS, and state agencies can total millions of dollars. Companies can be held responsible for paying back taxes and interest on employees’ wages as well as taxes that weren’t withheld.

On top of the very expensive government penalities for misclassifying freelancers, your company could also face lawsuits from the freelancers themselves. Notable lawsuits have been in the news lately including an $8.5 million settlement against Lime Scooters. A California court ruled that Lime misclassified their “juicers”, who pick up and recharge their scooters, as independent contractors. By misclassifying their workers, Lime violated labor code regarding the payment of minimum wage, reimbursement for necessary business expenditures, and the provision of accurate wage statements. 

Protect Your Company From Misclassification

As we’ve seen, misclassification carries serious penalties, risks, and consequences, so it is essential that you protect your company and leverage an outside company that specializes in this type of work and can provide you with an objective view of your individual situation.

This is what AllWork does every day. We help start-ups and established companies of all sizes navigate the complex and ever-changing world of compliance for the Gig Economy. We’re here to ensure that businesses are always in compliance with all state, federal, and even individual city laws when it comes to classifying their freelancers.

Ready to learn more about how AllWork can help you classify, onboard, manage, and pay your freelancers? Schedule a demo of our platform here.