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What Are the Penalties for Misclassifying Employees?

As a small business owner, you've probably weighed the pros and cons of hiring independent contractors or full-time employees. And you've also hopefully considered the possible penalties for misclassifying workers as independent contractors when they're really employees.

The IRS has been consistently cracking down on independent contractor use, but they're not the only organization you need to be wary of. Here's what can happen to employers that misclassify employees as independent contractors.

Back Wages

Many employers will classify employees as independent contractors to skirt the federal Fair Labor Standards Act's overtime provisions. Because independent contractors aren't protected under the FLSA, employers won't pay overtime wages for hours worked beyond 40 in a week. Wal-Mart tried this gambit and got nailed by the Department of Labor back in 2012.

The DOL began a Misclassification Initiative in 2011, and judging from their press releases, they've been busy. The DOL can secure unpaid wages for misclassified employees, so you may think you're saving money now, but you'll pay the piper later.

Back Taxes

Employers will also misclassify employees to save on their tax liability. And if there's something the federal government dislikes more than employees not getting what they're owed, it's the government itself not getting what it's owed. And the Internal Revenue Code includes some hefty penalties for failing to deduct and withhold taxes of misclassified employees, doubling the penalties for employers who disregard reporting requirements.

So not only will you have to pay the amount of taxes you should've been paying all along, but you'll have a sizable penalty included as well.

Forward Penalties

Speaking of sizable penalties, suits for unpaid wages or unpaid taxes due to misclassification might also yield some hefty punitive damages. Punitive damages are monetary awards above and beyond what it takes to compensate an individual (or government entity) for losses and instead are intended to punish the guilty party. And if the IRS is willing to hit Wal-Mart with half a million dollars in penalties, they'll be happy to go after your small business as well.

The best way to avoid these penalties is to properly classify all of your employees and independent contractors. And if you need help sorting that out, and experienced labor law attorney can help.

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