Employee classification is a crucial component of the staffing industry. It serves as a foundation for determining the compensation, benefits, legal rights, and tax requirements of workers. However, it’s a complex process, with numerous gray areas.
Moreover, the costs of misclassifying your workers are steep. It can result in tax implications and legal challenges, including hefty fines and lawsuits.
A thorough understanding of the types of employees and best practices for classification can help you mitigate these risks.
The Basics of Worker Classification
Employee classification affects both what an employee is entitled to, as well as an employer’s legal responsibilities.
Employee classification is a multi-tiered process, which starts with the definition of an employee. According to US laws, employees are workers who are financially dependent on their employer. They are protected by a number of state and federal labor laws.
The classification depends on whether your workers are exempt or non-exempt. Exempt workers are typically salaried employees, paid at least $684 a week. They’re not entitled to overtime pay, and they’re not subject to labor standards like minimum wage.
Non-exempt employees are usually paid an hourly rate, and are subject to minimum wage. They must also be paid one and a half times their normal rate for overtime.
Types of employees
It’s also important to distinguish between direct and indirect employees. The former are employed directly by a company, whether they work on-site or remotely. The latter are workers who are not paid by their workplace employer but by outside organizations. As such, compliance risks for such staff fall to your agency instead.
- Full-time. Although this term isn’t regulated federally, under the Affordable Care Act (ACA), full-time employees work an average of 30 hours per week for more than 120 days annually. Their work hours and salary are set, and they may have access to benefits like health coverage, a 401(k), and paid time off.
- Part-time. Generally, this includes employees who work fewer than 30 hours a week, for an hourly wage.
- Seasonal. This includes employees who work during a specified period, and not throughout the year.
- Contractors. Here, workers are contracted for a limited timeframe to complete a project.
- Temporary. Often, this refers to short-term employment cover for full-time employees on an extended absence, like maternity leave.
- On-call. These employees work at specified hours during the day or night, so their duties aren’t tied to traditional business hours.
- Leased. Leased workers can be full-, part-time, or temporary workers contracted by a staffing agency, but working for a different employer.
What about independent contractors?
Independent contractors are commonly misclassified, due to the tax and legal definitions of employment. They’re considered self-employed. While not technically employees, they are still on a company’s payroll. Moreover, they’re neither strictly exempt nor non-exempt, as their working hours and duties depend on their contracts.
Independent contractors are responsible for their own taxes, including self-employment taxes. They’re also not entitled to a company’s employee benefits.
Thankfully, the IRS has strict guidelines on who is considered an independent contractor. These cover behavioral and financial control of the role, as well as the type of relationship with the employer.
Importantly, the Department of Labor (DOL) Wage and Hour Division published a final rule on the matter on 10 January 2024. Effective from 11 March 2024, there are strict guidelines governing how to analyze a worker’s status. This rule rescinds the Independent Contractor Status Under the Fair Labor Standards Act of 2021. It states that the term “independent contractor” should be used for workers who are not economically dependent on an employer for work and are in business for themselves.
Legal Criteria for Classification
There are several laws impacting employee classification. The Fair Labor Standards Act (FLSA), for example, governs minimum wage and overtime pay. Its broad definition of employment provides expansive coverage for different types of workers. The Migrant and Seasonal Agricultural Worker Protection Act (MSPA) uses the FLSA employment definition to govern wages, safe housing, and transportation of seasonal workers. The Family and Medical Leave Act (FMLA) also relies on the FLSA definition for employees entitled to job-protected leave. There are also state-level worker’s compensation laws based on employee classification for workplace injuries and unemployment insurance.
So there’s a broad legal framework surrounding employee classification. The DOL takes any violations of these laws very seriously. Misclassification can result in several penalties, such as:
- Fines of up to $1,000 per misclassified employee
- A prison sentence of up to a year
- Class action lawsuits for punitive damages
- Repayment of benefits insurance due to misclassified workers
Some state laws also impose additional penalties for misclassification. For example, California courts charge businesses who knowingly misclassified their staff fines of up to $25,000 per employee!
Tests for employee classification
Because of the strict legal framework surrounding the classification of workers, there are several tests used to ascertain a worker’s status. They include varying numbers of factors to be considered, relating mostly to the level of control an employer has over the worker, where job tasks are performed, the nature of the work, and a worker’s skill level.
- The IRS 20-Factor Test: This was the first published classification test. Essentially, it outlines that businesses may control how, when, and where their staff work, but they may not do so with contractors and freelancers. As the name suggests, there are 20 different factors considered, although it’s not necessary to meet all 20.
- Borello Test: Designed according to the IRS test, this uses 11 different factors to determine whether a worker is freelance or an employee.
- Economic Realities Test: This evaluates the extent of the worker’s financial dependence on a hiring company to define the working relationship, based on five different factors.
- ABC Test. Often seen as the strictest test, three factors must all be met for a worker to be considered an independent contractor. If even one of these is not met, the worker must be classified as an employee.
Tax Implications of Misclassification
Misclassifying your workers can result in tax liabilities for your staffing agency. It results in unpaid employment taxes, and lost tax revenue to the government. The IRS considers this tax evasion, which can lead to severe penalties, as well as audits.
Moreover, if the IRS discovers that your agency misclassified employees, you will owe back wages, unpaid overtime, and benefits to those workers. Tax violation fines are usually structured as follows:
- Up to 3% of the misclassified employee’s wages
- 100% of FICA taxes you didn’t pay for the worker
- Up to 40% of the FICA taxes that your agency failed to withhold
- $50 per W-2 tax form not filed for the worker
The exact penalties depend on the size of your agency, as well as how long a worker is misclassified.
The Voluntary Classification Settlement Program
The VCSP is an IRS initiative that allows staffing agencies to voluntarily reclassify workers for future tax periods. Under the program, you pay 10% of the amount of employment taxes due to the employee being reclassified, to prevent penalties or interest. Once you successfully start the VCSP, you also avoid audits for worker classification in previous tax returns.
It’s important to note that if your agency is currently under audit for employee classification, you don’t qualify for the VCSP.
The impact on workers
When workers are misclassified, they lose the protections and benefits associated with their employment type. This includes health insurance, unemployment insurance, and worker’s compensation. Essentially, they become fully responsible for their social insurance. In the case of independent contractors, who are considered self-employed, incorrectly classified employees can also face tax penalties for failure to pay self-employment taxes.
More importantly, it may affect their wages and livelihood. Misclassified employees are often paid less than employees for the same work, because they are denied minimum wage and overtime pay.
Best Practices for Accurate Employee Classification
To avoid misclassifying workers, your agency should establish a classification strategy, and enforce this consistently. It should include:
- Documentation. Make sure you have all the documents in place that establish a worker as an independent contractor or employee. This means payment information, contract agreements and tax filings for all staff. It’s also important to ensure all contracts match the worker’s job duties.
- Professional advice. Conduct a classification audit, or enlist a labor lawyer to draw up compliance solutions.
- Applicable state and federal laws.
- Employer needs. Depending on the needs of the business you’re contracting or hiring workers for, this may affect the employment types.
Once you have a strategy, you can classify workers according to factors like job roles, responsibilities, and employment status. For this, keep the below factors in mind:
- Employment Category: Define whether workers are full-time, part-time, temporary, seasonal, or contractors. Include specific criteria that distinguish each category.
- Job description and responsibilities: Outline primary responsibilities and requirements.
- Working hours and schedules. Define how working hours and schedules are determined.
- Compensation and pay structure. Explain how and when each worker is paid, according to applicable laws.
Conduct regular assessments and audits of all worker agreements, including the nature of the work, level of employer control, and payment structures.
Handling gray areas
With the rise of remote work and the gig economy, you may face instances where employee classification isn’t clear-cut.
The best way to manage this is to seek expert opinions. Legal and tax CPAs can advise you on best practices for dealing with specific worker cases. Their knowledge of laws and experience can make them a valuable reference if ever you have doubts or concerns.
Staying Informed and Compliant
Because tax and labor laws change frequently, the best way to ensure your agency is compliant with employee classification is by keeping up with these changes.
By partnering with a legal expert and tax accountants, you can ensure that your staffing agency is always compliant.
Moreover, ensure that all staff working with employee classification receive training and refreshers about the laws and practices surrounding classification issues.
The role of technology
Using the right software can go a long way in ensuring compliance. With accounting software that automates payroll and benefits administration, your agency can avoid the tax implications of worker misclassification. For example, tools like QuickBooks time tracking software can accurately monitor the working hours of non-exempt staff to ensure correct overtime payments, and adjust employee categorization should these hours fluctuate.
For advice on the tax implications of employee classification, or the best accounting software to ensure compliance, schedule a Discovery Call with one of our CPAs.
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