Employee classification errors are one of the most common issues employers face during payroll audits. These errors can lead to costly penalties, back pay, and legal trouble with agencies like the IRS and the Department of Labor (DOL). Understanding how to properly classify workers is crucial for maintaining compliance with labor laws and avoiding unnecessary risk.
What is Employee Misclassification?
Employees vs. Independent Contractors
At the heart of employee classification errors is the confusion between employees and independent contractors. This distinction affects payroll taxes, benefits, overtime pay, and more. Misclassifying an employee as a contractor can lead to wage theft claims, tax penalties, and lawsuits.
Exempt vs. Non-Exempt Employees
Another common mistake is misclassifying employees under the Fair Labor Standards Act (FLSA). Exempt employees do not qualify for overtime pay, while non-exempt employees must be compensated for overtime hours. Incorrectly labeling someone as exempt can result in significant underpayment issues and contribute to employee classification errors.
Common Causes of Classification Errors
Misunderstanding Labor Laws
Many employers simply aren’t familiar with the complexities of employment law. Misunderstanding the criteria set by the DOL or FLSA can lead to employee classification errors.
Relying on Job Titles
Job titles alone don’t determine classification. The actual duties and level of control the employer has over the worker’s tasks are the deciding factors. Relying on titles can lead to employee classification errors that could be caught in an audit.
Temporary or Part-Time Work
Some assume that part-time or temporary workers automatically fall under the contractor category. This is a dangerous myth that can trigger audits and result in employee classification errors.
Tools for Proper Classification
The IRS Common Law Test
The IRS uses three main categories to determine worker status: behavioral control, financial control, and the type of relationship. If the company controls what, when, and how work is done, the worker is likely an employee. Misapplying this test is one of the major sources of employee classification errors.
The ABC Test
Some states apply the ABC Test, which presumes a worker is an employee unless all three of the following apply:
- The worker is free from control and direction.
- The work performed is outside the usual course of the business.
- The worker is engaged in an independently established trade.
Using this test can help you prevent employee classification errors, especially in states like California where it is legally required.
The Risks of Getting It Wrong
Financial Penalties
If the IRS finds classification errors during a payroll audit, the employer may face back taxes, interest, and penalties. The DOL can also require payment for unpaid wages, including overtime.
Lawsuits and Legal Action
Employees who are misclassified can sue for unpaid wages, lost benefits, and other damages. This often leads to settlements or class-action lawsuits that can damage a business’s reputation and finances.
Tax Withholding Issues
Misclassification may result in failing to withhold the correct amount of taxes, leading to problems with payroll taxes, underpayment, and additional scrutiny from tax authorities.
Best Practices to Avoid Classification Errors
Conduct Regular Internal Audits
Review your workforce regularly to ensure employees are correctly classified. This is especially important when roles or responsibilities change.
Document Everything
Keep thorough records of worker agreements, job descriptions, and payment terms. Clear documentation helps defend your classification decisions during audits and minimizes the risk of employee classification errors.
Consult Legal or HR Professionals
When in doubt, seek advice from labor law attorneys or HR experts. Getting it right the first time can save thousands in the long run.
Train Your HR Team
Invest in training to help your HR team stay up-to-date with labor laws, FLSA guidelines, and IRS regulations.
Employee classification errors can quietly build into major problems if left unaddressed. Between payroll audits, back pay, legal claims, and compliance issues, the costs of getting it wrong are high. By understanding the difference between employees and contractors, staying updated on legal requirements, and applying tools like the ABC Test and IRS guidelines, businesses can avoid unnecessary risk and ensure a more stable and compliant workforce.
Don’t wait for an audit to find out something is wrong—take steps now to ensure your employee classifications are accurate and free of employee classification errors.