A growing small business reached out to us not long ago for ongoing general counsel support. Like many small businesses expanding quickly, they hadn’t realized that several of their “independent contractors” were, in fact, legally considered employees.
During a routine compliance review, we identified the issue early—before regulators or the IRS did. Left unaddressed, the company faced potential back taxes, unpaid benefits, and penalties totaling nearly $300,000.
As their outsourced general counsel, we stepped in to:
- Reclassify workers properly and update their contracts to align with state and federal employment laws.
- Implement a compliant payroll process and recordkeeping system to prevent future issues.
- Train the leadership team on how to safely engage both employees and contractors moving forward and implement systems and processes to limit the potential for risk and liability they could avoid.
Because of these proactive steps, the business avoided hundreds of thousands in potential liability—and built a stronger, compliant foundation for growth.
Now, instead of worrying about surprise legal risks, they have ongoing access to our general counsel team for day-to-day advice on hiring, contracts, and compliance.
“They didn’t just fix a problem—they helped us prevent future ones. That peace of mind is worth every penny.” — Client
As a business owner, you’re constantly looking for ways to streamline operations and manage costs effectively. It’s completely understandable! However, there is one common cost-cutting practice that poses a greater risk than almost any other compliance issue: employee misclassification.
Misclassification occurs when a company incorrectly designates a worker as an independent contractor rather than an employee. While this can happen due to a genuine misunderstanding of the definitions, it can also be intentional. The unfortunate reality is that this misalignment can subject your company to substantial financial penalties.
If you operate a business the distinction between a contractor and an employee can feel blurred. But correctly classifying workers is absolutely essential for ensuring compliance with labor regulations and safeguarding worker rights. Here’s why misclassification is risky and, more importantly, how you can adopt a proactive approach to keep your business safe and compliant.
I. The Misclassification Trap: Incentives vs. Penalties
The Tempting Cost Savings That Lead to Violation
It’s easy to see why misclassification is tempting for employers. The largest incentive is avoiding legal obligations, including paying eligible benefits, minimum wages, and Social Security and Medicare taxes.
- Significant Savings: By classifying workers as contractors, employers like to think they can save between 20 to 40 percent on total labor costs (this is not necessarily true).
- Tax and Insurance Avoidance: Employers are not required to pay Social Security, Medicare, or unemployment insurance (UI) taxes for independent contractors.
- Benefit Avoidance: Independent contractors are usually not permitted to enroll in employer-based health and pension plans, allowing employers to save money on company-provided benefits.
- Administrative Ease: It can be easier to terminate contractors, and payroll is simplified since there’s no need to account for benefits or contributions. Independent contractors are also not entitled to overtime pay or other protections afforded to employees under the Fair Labor Standards Act (FLSA).
The Catastrophic Financial Risks for Employers
While the cost savings are compelling, the potential penalties far outweigh the benefits. Misclassification carries significant risks for your business.
- Severe Financial Penalties: You face hefty fines, back wages, interest, and penalties that can severely impact your bottom line. The cost of misclassification per worker can range from $5,000 to $15,000.
- Back Wages and Benefits: If misclassification is found, your company may face legal consequences for not providing required benefits (like retirement contributions and health insurance) and will be liable for unpaid payroll taxes.
- Reputational Damage: Employee misclassification lawsuits can be very costly and often make headlines, eroding trust and damaging your company’s brand.
- Increased Regulatory Scrutiny: A history of misclassification can lead to heightened scrutiny from labor authorities, including audits and investigations.
II. The Legal Blueprint: How Is Worker Status Determined?
The distinction between employees and contractors can be nuanced, so it’s crucial to understand the legal standards used by federal agencies like the IRS and the Department of Labor (DOL), and state standard as well. It can be complicated, contradictory and difficult to keep up with the standards applied by the individual agencies. Here’s a look at the standards used by the IRS and DOL as an example:
The IRS Three-Category Test
The IRS has a significant stake in identifying misclassification because it typically results in lost tax revenue. To determine status, the IRS looks at a number of factors that help assess whether an employer has the right to control the details of how the worker performs the services. No single factor is definitive; the overall relationship must be considered holistically.
The evidence falls into three main categories:
- Behavioral Control: Does the company control how the worker does their job? If a company provides training for the worker or dictates the when and where they should work, this signals the control typically exerted over an employee. Independent contractors, conversely, use their own methods.
- Financial Control: Are the business aspects of the worker’s job controlled by the payer? This includes whether expenses are reimbursed, who provides tools and supplies, and how the worker is paid (workers paid per job/assignment are often contractors). Only an independent contractor can realize a profit or incur a financial loss from their work.
- Type of Relationship: This looks at the permanence and intent of the relationship. If there are written contracts or employee-type benefits (like a pension plan or vacation pay), or if the work is a key aspect of the business, the worker is likely an employee.
The DOL Economic Reality Test (FLSA Protection)
The DOL is primarily concerned with ensuring workers receive FLSA benefits, such as minimum wage and overtime pay. The DOL uses the "economic reality test" to determine if a worker is, as a matter of economic reality, dependent on the business they serve.
Key factors in this test include:
- The extent to which the services rendered are an integral part of the principal’s business.
- The permanency of the relationship.
- The worker’s opportunities for profit and loss.
- The amount of the alleged contractor’s investment in facilities and equipment.
III. Deep Dive: Heightened Enforcement and State-Specific Risks
Misclassification isn’t just a federal issue, state governments are aggressively cracking down on violations, empowering workers with enhanced legal tools.
The Worker’s Perspective and Recourse
For workers, misclassification means the potential loss of essential benefits such as unemployment insurance, sick leave, healthcare, and overtime pay.
In states like Virginia, the legal landscape has become particularly risky for employers:
- Presumptive Employee Status: Virginia law now presumes that all workers are employees unless the employer can prove otherwise using the IRS guidelines. This dramatically shifts the burden of proof to the employer. It’s going to be difficult to convince the state that a worker in an independent contractor, the deck is stacked against businesses in these cases.
- Private Right to Sue: Virginia law creates a private right of action for misclassified workers to bring a civil action against their employers. Crucially, an employee need not even show they were owed back overtime; they can sue simply based on the misclassification alone, recovering damages for lost wages, the value of benefits not received, and reasonable attorneys’ fees.
Stiff Penalties and Legal Examples
The consequences are substantial, extending far beyond simple back pay:
- Treble Damages: Courts may award up to three times the amount of unpaid wages for willful violations.
- Civil Fines: Virginia misclassification fines can escalate, reaching $5,000 per misclassified worker for repeat offenses.
- Operational Bans: Repeat offenders may be barred from public contracts for up to three years.
- Criminal Exposure: In Virginia, some companies have faced felony charges and were criminally prosecuted for intentionally misclassifying employees to avoid payroll taxes, resulting in guilty pleas and fines.
For context, this is a real and present danger: in 2015, FedEx settled a lawsuit for $228 million after misclassifying drivers, and Uber settled a similar class action for $100 million in 2016. While these are large companies, a significant amount of federal and state resources are allocated to policing small businesses in regards to worker classification. In Virginia, a construction firm was ordered to pay over $1.1 million in back wages and liquidated damages for misclassification.
IV. Proactive Compliance: How to Safeguard Your Business
The good news is that you don’t have to let uncertainty hinder your growth. The path to managing risk involves a proactive, informed approach.
Essential Best Practices and Auditing
To mitigate the risks, businesses should adopt these strategies, all of which we help clients with:
- Stay Informed: Familiarize yourself with federal laws (like the FLSA) and local labor laws, particularly the legal definitions of employees and independent contractors.
- Develop Clear Contracts: Provide every worker with a written agreement that clearly states their classification and documents the terms of the relationship.
- Conduct Regular Audits: Assess the true nature of the working relationships in your organization using the IRS factors (Behavioral, Financial, Relationship). When in doubt, it makes sense to classify conservatively. You aren’t going to misclassify someone as an employee.
- Seek IRS Guidance: If you are unsure about a worker's status, you can file IRS Form SS-8 for an official determination.
- Train Managers: Ensure supervisors and managers understand rules regarding minimum wage, overtime, and accurate timekeeping.
The Path to Correction and Mitigation
If you discover worker misclassification, swift and correct action is vital:
- Do Not Terminate: If you discover misclassification, do not simply terminate the relationship and hope the issue disappears. That can lead to more severe penalties if viewed as a deliberate violation.
- Resolve Financial Obligations: You are still responsible for compensating the employee and the government for back taxes, benefits, pension contributions, and fines.
- Calculate Compensation: Estimate the owed compensation by considering the duration of misclassification, current compensation, what comparable full-time employees typically earn, the value of missed company benefits, and the amount of employer-paid taxes that were never remitted. Self-correction before government intervention may, and often does, help you avoid the most severe penalties.
V. Conclusion: Compliance as a Business Imperative
In the current heightened regulatory environment, taking proactive steps to ensure full compliance is not just the right thing to do—it is essential to staying in business. The consequences of ignoring these obligations—lost contracts, large dollar settlements, and even criminal charges—can be devastating.
By reviewing your classification practices, tightening your payroll systems, and seeking expert guidance where appropriate, you can protect your business operations, reputation, and bottom line. Don't let uncertainty hinder your growth.
Want to ensure your business is compliant? Contact us to help manage contractors and streamline employee onboarding today.