Employee Misclassification: A Caution to All Employers

Milton Kerstein Milton L. Kerstein

For those businesses that utilize independent contractors as part of their business model, employee misclassification has become a major issue.  It is one that is taking on increasing importance within the United States, as well as here in Massachusetts.

In Massachusetts, employers who are found to have misclassified their W-2 employees as independent contractors face both civil and criminal penalties.  This issue originally appears to have arisen due to the exploitation of recently arrived immigrants and low-income workers by the construction and agriculture industries.  The issue has blossomed into one that has the potential to effect every business in the United States.

In general, significant tax consequences result from the classification of a worker as an employee or independent contractor.   These consequences relate to withholding and employment tax requirements, in addition to certain income exclusions and tax deductions for certain expenses. There are also significant consequences for the employee if the employee is misclassified and then re-classified.  They include potential liability for withholding taxes, interest and penalties and disallowance of previously allowed business related deductions.

Over time, it seems the federal government and many states have concluded that they are losing significant tax revenue due to employee misclassification.  As a result, enforcement of perceived employee misclassification is becoming a priority revenue enhancement opportunity for the federal and state governments.   Studies show that W-2 employees generate more tax revenue to the federal and state governments than those categorized as independent contractors.

Two recent examples demonstrate the attention that the government is now giving this issue.  Federally, the Department of Labor has increased its staff with the intent to more aggressively identify and prosecute employee misclassification within the United States.

Here in Massachusetts  in 2008,  the Legislature amended the Massachusetts Wage Act to provide for mandatory treble damages when an employee prevailed with a Wage Act claim.  Consistent with the Legislature’s emphasis on the Wage Act, the Attorney General indicated that she is committing significant resources within her office to prosecute suspected instances of employee misclassification under the Wage Act.  At the same time, the Supreme Judicial Court here in Massachusetts recently found that an agreement between an employer and employee providing for the employee to pay for workers’ compensation and other insurance coverage was a violation of the Wage Act.

As a result of this trend, all employers that utilize independent contractors of any type should familiarize themselves with these changes.  There is no doubt that this trend is being embraced by other states throughout the U.S.  In my next article, I will offer an analysis of this trend by sampling similar developments in other states.