Independent Contractor vs Employee: 6 Misclassification Consequences

contractor vs employee misclassification consequences

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Independent Contractor vs Employee

Understanding the legal differences between an independent contractor vs employee is important. It isn’t always clear, and there are enticing benefits for employers to try to fit their team members into the contractor definition. However, there are significant consequences to the misclassification of employees, including fines and legal issues.   

Determining if your team member should be an independent contractor vs employee depends on how much control you have over that worker. Usually, independent contractors have multiple sources of income, provide their own working environment and tools, and are not always required to operate within a certain space or time frame. 

However, it can be confusing to identify your worker’s appropriate status, as state and federal classifications can contradict each other. A worker may be an independent contractor under state and federal tax laws, but an employee under FSLA. These three criteria are used by the IRS as a contractor test to determine how you should classify workers: behavior, financial, and type of relationship.

  • Behavior: How much control do you have over the worker? Are you directing them through work tasks, or are they relatively independent? 
  • Financial: Here you will consider how the worker is paid, whether they are reimbursed for expenses, and if they are provided tools by your organization.
  • Type of Relationship: Consider how essential the worker’s services are to the business, and if it is a long-term relationship. Consider any written contracts involved and if you are providing employee-type benefits.

No single indicator points to whether a team member is an independent contractor or employee. Using the contractor test, the entirety of the relationship must be examined to make the proper classification. And you must have justification for classifying a worker as an independent contractor. It isn’t a business choice; there are legal repercussions to misclassifying. If it remains unclear which category your worker falls under, after the contractor test above, file Form SS-8.  The IRS will determine the worker’s status.

This effort may take some time but is worth it in the long run to protect you from the consequences of misclassification. Also, if you regularly have similar roles in your business, one act of filing can help determine the status of future workers.

The Consequences of Misclassification of Employees 

With independent contractors, employers don’t have to pay health insurance or overtime, offer paid time off, and can avoid paying taxes associated with employment. But misclassification can have major economic costs that are detrimental to your business, so be sure to analyze the relationship closely to avoid these. Ensuring your worker has the right status helps you adhere to the legal obligations surrounding that person’s employment.

The following are some consequences of misclassifying workers. Employers may:

  1. have to pay back taxes
  2. incur fines and penalties
  3. face the possibility of lawsuits
  4. be responsible for reimbursement of benefits to misclassified workers
  5. be charged with 1-9 violations
  6. experience compounding violations from discrimination considerations

Back Taxes

If it is found that you have misclassified an employee, you will be responsible for paying any state and federal taxes owed. These taxes include payroll, social security, state, federal, and Medicare taxes, and may be subject to penalties. 

Fines and Penalties

These are highest when there is willful (known) misclassification. The US Department of Labor and state Departments of Labor can collect interest on back taxes that employers failed to pay, which can cost a company heavily, depending on the infraction. Fines may be levied if these payments are not made. 

A business will be liable for paying those taxes at a rate of 1.5% of the worker’s wages, plus interest, and 100% of employer-due FICA taxes, and up to 20% of social security taxes owed by the employee.  They will also be charged a $50.00 fine for any missing W-2.  

However, if it is found that an employee has been misclassified through willful neglect, and without reasonable cause, penalties increase. You may be subject to 3% taxes, and 40% social security owed by both the employer and employee.

A company may also incur penalties for not having reported and paid on the accurate number of employees for state unemployment insurance. 


Employers may be subject to lawsuits from the misclassification of employees. If the plaintiff is found to have been misclassified, they may be entitled to lost wages, overtime, liquidated damages, vacation pay, compensation of benefits and cost of legal fees.

Not only are lawsuits a financial risk, but they are damaging for a business’s reputation as well. You may lose valuable employees, partnerships, and potential clients. Talent acquisition becomes difficult, and the efficacy of your team slows down when handling damage control.  It also shines a spotlight on you, making you more susceptible to future audits and scrutiny. 

Reimbursing Benefits to a Misclassified Worker

An employer that is found to have wrongly classified a worker may have to provide benefits to the worker that were not provided as an independent contractor. These may include 401k options, severance, health coverage, stock plans, overtime, PTO, or even break time hours.

I-9 Violations

You are not required to have I-9s on file for independent contractors. However, if you have misclassified a worker as an independent contractor, you may be in violation of the I-9 requirements. I-9s are all about work eligibility and need to be filed within a certain time upon the commencement of employment for employees. 

Violations of a Discriminatory Nature

Be aware of potential compounding issues if the misclassification occurred to a member of protected groups. Anti-discrimination, military personnel, and age discrimination laws may take effect if a misclassified worker falls into one or more of these groups.

Employee versus Independent Contractor: Get it Right, Right Away

When in doubt of a worker’s status, file Form SS-8 to work directly with the IRS in making a determination. It will save you penalties, time, resources, and possibly your reputation in the long run, giving you peace of mind and clarity.

Want to avoid the status question entirely? Consider working with a Timpl that takes on the burden of a worker’s status, so you don’t have to.