California Imposes New Penalties for Misclassifying Workers

An employer must classify each of its workers as either a company employee or an independent contractor. Classification as an employee brings certain federal and state protections for the worker, such as minimum wage, overtime compensation, and minimum standards for working conditions. There are also tax considerations for the employer; generally, employers are liable for payroll taxes on wages paid to an employee, but not on fees paid to independent contractors. A company can benefit from classifying workers as independent contractors rather than employees, as long as the classification complies with the legal rules and definitions.

Concerned that some employers may deliberately misclassify employees as independent contractors for the resulting tax benefits, the California Legislature has taken action. As of January 1, 2012, the California Labor Code will include significant fines for companies that misclassify employees as contract workers, along with other changes.

A company can be fined $5,000 to $10,000 for its first misclassification offense, with larger fines for subsequent offenses. Under the new California employee classification law, companies will have to keep more detailed records and provide specific notice to workers who are classified as independent contractors. The law also penalizes third parties, such as background check providers, for advising companies to intentionally misclassify employees as contractors.

Additionally, California employers may be liable for federal penalties for worker misclassification, and the Internal Revenue Service recently became more watchful in scrutinizing companies for classification compliance. The IRS recently initiated a Voluntary Classification Settlement Program that provides incentives for companies to correct classification errors voluntarily in order to defer or avoid an IRS audit and reduce their possible penalties. Companies now can get into compliance with federal law by reclassifying workers and making minimum payments on past payroll taxes.

Taken together, the enhanced state-level penalties and the new IRS program may motivate California companies to examine worker classifications carefully and make corrections where they are warranted. An experienced tax attorney can help companies review their worker classifications and adjust them if necessary. A tax lawyer also can help companies decide whether participating in the Voluntary Classification Settlement Program is appropriate for them.