Employer Liability - Common Mistakes That Can Be Costly

With the economy improving, businesses are hiring again and bringing in independent contractors.  Because mistakes relating to compensation can be costly, now might be good time to review several common mistakes that can be expensive.

The most common mistakes involve:

1. Misclassifying an employee as exempt from overtime;

2. Misclassifying a person as an independent contractor when they should be an employee;

3. Assigning tasks to an unpaid intern that result in them being classified as an employee;

4. Failing to file employee payroll taxes on time.

This article discusses some of those common mistakes and how to avoid them.

1. Misclassifying  an employee as exempt from overtime pay

The federal Fair Labor Standards Act (“FLSA”) requires that employees receive overtime pay equal to 1.5 X their hourly rate if they work either more than 8 hours in one day or more than 40 hours in one week.  There are several job classifications that are exempt.  Employer problems often occur when they mistakenly believe that a particular employee qualifies for the exemption when they don’t.  

The overtime pay exemption categories include a) executives, b) administrative, c) professional, d) computer employee, e) outside sales and f) highly compensated employee.  The most common problems involve the administrative, computer and outside sales exemptions.  Job titles don’t count.  What counts is the type of work that a person performs.

Here is a link to a brief overview of requirements to qualify for those exemptions.

2. Misclassifying a Person as an Independent Contractor

One of the most common mistakes businesses make is to classify someone as an independent contractor when they are actually an employee.  The IRS and state governments aggressively pursue this type of  misclassification because it reduces the amount of taxes that IRS and state governments collect.

The IRS website provides some guidelines to help determine whether a person qualifies as an independent contractor.  You can also ask the IRS to evaluate your specific situation.  The IRS will issue a determination.  This can be done by filing IRS Form SS-8.

Briefly, factors that the IRS considers in determining whether a person is properly classified as an independent contractor include:

• Does the person have the ability to perform similar work for other businesses without your permission;
• Can the person set their own hours for when they will perform the work;
• Can the person hire other people to assist them in performing the work;
• Does the person supply their own tools or equipment to perform the work;
• Is the work done for a fixed fee where the person bears the risk of profit or loss depending upon how quickly they perform the work;

Because businesses do not pay payroll taxes for independent contractors a business can be liable for significant expenses if the IRS later determines that the person should have be classified as an employee.

As discussed below under the payroll tax liability section the business owners can be personally liable for failing to pay payroll taxes.

3. Unpaid Interns Who Should Be Treated as Employees Based Upon Their Work

An internship can be beneficial for both the student and the business.  The student gets experience that can help them find a job when they graduate and the business gets assistance for free.  However the intern’s activities must meet a six factor test for the business to justify not paying the intern.

Briefly those six factors are:

1. The training, even though it includes actual operation of the facilities of the employer, is similar to what would be given in a vocational school or academic educational instruction;
2. The training is for the benefit of the trainees (rather than the employer);
3. The trainees do not displace regular employees, but work under their close observation;
4. The employer that provides the training derives no immediate advantage from the activities of the trainees, and on occasion the employer’s operations may actually be impeded;
5. The trainees are not necessarily entitled to a job at the conclusion of the training period; and
6. The employer and the trainees understand that the trainees are not entitled to wages for the time spent in training.

A business must meet all six factors.  Failing to meet one of the six factors can expose the business to liability under the Fair Labor Standards Act and to liability for failing to pay payroll taxes.

4. Personal Liability for Failing to Make Payroll Tax Payments

A problem that commonly effects businesses that are having cash flow problems is failing to pay their payroll taxes on time.  The IRS and state governments take this issue very seriously.  Their position is that this is money that doesn’t belong to the employer, but is held in trust for the benefit of the employees and the government.  So, it goes beyond failing to pay taxes.  The government views it as taking money that doesn’t belong to you.  For that reason, the officers, directors and shareholders can be personally liable for failing to timely pay payroll taxes.

Further, this is a liability that a business owner cannot discharge by filing a personal bankruptcy.

In Illinois not only is there potential tax liability, but also there is potential liability from the Illinois Department of Labor and the employees themselves in lawsuits under the Illinois Wage Payment and Collection Act.  For more information on a business’ potential exposure under this Illinois statute see my blog post titled Potential Exposure for Employers Under New Illinois Law.

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