A growing business faces numerous risks. These moments of growth offer equal parts opportunity and danger. However, some of the largest of these risks can be avoided by examining how they occur. And one of the most important things to look into is employee misclassification.

Defining Employee Misclassification

Employee misclassification refers to instances where a company incorrectly classifies an employee as an independent contractor. This might seem like a minor distinction at first glance. And this is an especially easy mistake to make for smaller companies that are just starting to grow their workforces. After all, it’s quite common for companies to phase in talent from their pool of recurring contractors. But at the same time, it’s also quite common for companies to intentionally misclassify their workers.

Why Misclassifications Occur

You might wonder why someone would intentionally misclassify a worker. The answer comes down to the protections and benefits an employee receives. The short explanation is that it’s simply more cost-effective to classify your employees as contractors. Cheaper, but also illegal.

Independent contractors are legally self-employed. The contractor is working with you rather than for you. As such, you’re not required to meet the requirements for minimum wage, workers’ compensation, medical, overtime pay, etc. If you were to hire that same person in a permanent position, then you would suddenly find yourself legally responsible for those elements. You’re quite aware of how much of a financial burden that can be if you’re running a small business. However, there’s also the issue of legal complexity to factor in.

Legal Complexity and Confusion

Before looking at the penalties involved with misclassification, it’s important to circle back to instances where people simply make an honest mistake. Someone outside the world of small business might find it impossible to conceive of such a black and white designation being a source of confusion. However, most people running a small company have encountered countless situations where the changing legal landscape makes the seemingly straightforward rather convoluted.

In this case, there’s often some confusion between employment classification on the federal and state levels. For example, California works under a default assumption that all workers are employees until proof is presented that they’re contractors. This involves matching criteria to an ABC test with three separate points. Just because you understand the law on a federal level doesn’t mean that you understand the local variations.

Penalties

The source of the misclassification is a small point compared to the objective reality of the situation. The consequences of misclassification are as significant as you might imagine when dealing with a combined force of the IRS, DOL, and state labor departments. In short, a company faces severe financial penalties from three different directions when misclassifying workers. This isn’t just a combined penalty, but rather three significant governing bodies all requiring some form of compensation at the same time. On top of this, you also need to factor in legal fees, lost productivity, and administrative strain.

Ensuring Proper Compliance with Regulations

The best strategy for misclassification is to put considerable effort into ensuring it doesn’t occur in the first place. Increasing a small business’s workforce is a difficult task with more administrative red tape than most people suspect. However, this is why it’s so important to conduct regular audits of any area where this type of error can occur. Employment classification is one of those areas.

Safeguards can be made more effective by putting additional care into your initial documentation and training for both employees and contractors. Your documentation should be centralized, and onboarding needs to be firmly separated. Supervisors and managers also need to understand the difference between contractors and employees. The administrative records should always account for these employee designations.

Your administrative methodology needs to take different worker classifications into account so that the chances for inadvertent line crossing are minimized. The paper trail needs to continually show a contractor and employee’s different classifications even when they’re working through the same area or role.

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