In a previous blog post I wrote about the ways that employees may try to commit payroll fraud against your company. Employers can also commit payroll fraud through wage theft. Wage theft is defined as, “the denial of wages or employee benefits that are rightfully owed to an employee. Wage theft can be conducted through various means such as failure to pay overtime, minimum wage violations, employee misclassification, illegal deductions in pay, working off the clock, or not being paid at all.” One of the most common ways employers commit payroll fraud is through worker misclassification.

Worker misclassification is a type of payroll fraud that a company commits itself either due to misunderstanding the IRS rules or intentionally breaking the law. It is the practice of illegally classifying individuals as independent contractors (who receive a 1099) instead of as employees (who receive a W-2.) Some employers deliberately avoid classifying individuals as W-2 employees to avoid paying Social Security and Medicare taxes, unemployment taxes, workers compensation insurance coverage, health insurance premiums, and other benefits, which is a clear violation of the law and constitutes fraud. The worker is responsible for paying their own income and self-employment taxes, which can result in underpayment of taxes if the employee doesn’t understand how to correctly handle their independent contractor obligations. Additionally, the worker is not covered by most state and federal laws, including the Fair Labor Standards Act. They also do not have workers compensation coverage if they are injured on the job and have no unemployment benefits if they lose the job.

Other companies misclassify employees by accident. Either way, the fine from the IRS for such fraud can be as high as $25,000 per instance. That doesn’t include the back-payroll taxes and penalties. Therefore, it is best to work with a qualified payroll company like the Payroll Source Group or an experienced manager to classify employees appropriately.

With the fines being so steep for misclassifying an employee, why do some businesses risk it? While the legal requirements are complex and may result in inadvertently categorizing the worker incorrectly, a big incentive in misclassifying workers is the savings on labor costs, which typically are a major portion of overhead for businesses. It’s estimated that a business can save 30 percent of their labor costs by using independent contractors rather than employees. That provides a real incentive for businesses to classify their workers as independent contractors, even if the workers are truly employees.

While not always a deliberate attempt to break the law, such savings may allow a business to gain a competitive edge over other businesses.

Worried about misclassifying an employee? Let the Payroll Source Group make the determination for you. 


By Betsy Drellack

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