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The Big Payback: Companies Owe Millions for Misclassifying Workers

Chris Sutton, Partner – Clover Global Solutions, LP

For generations, the American workforce was comprised primarily of full-time employees who received all of the benefits – overtime pay, health insurance, paid vacations, etc.,– that their statuses conferred. Yet in recent years, a rising tide of independent contractors has saturated businesses from coast to coast.  The financial incentive to employers for hiring contractors is easy to understand:  Independent contractors aren’t covered by federal or state wage and hour laws, for instance, and are ineligible for employee benefits such as health insurance and participation in company retirement plans. In addition, employers aren’t required to pay Social Security, Medicare and unemployment taxes for independent contractors.

In other words, companies can save substantially on wages and other associated costs by hiring contractors instead of full time employees. Some businesses are even trying to capture those savings by misclassifying their workers.

There’s No Outsmarting the FLSA

Despite strict IRS guidelines intended to help employers distinguish between employees and independent contractors for tax purposes, some 20% of businesses have made what are known as 1099 misclassifications – classifying a worker as a contractor when he or she is really an employee  (1099, of course, refers to the IRS form used to report payments to an independent contractor).  Some of these misclassifications are honest mistakes. But in other cases, employers have deliberately misclassified employees as independent contractors in order to dodge taxes and avoid providing benefits mandated by the Fair Labor Standards Act (FLSA).


According to the IRS, misclassifying employees as independent contractors and failing to provide W-2 forms can subject an employer to back taxes of as much as 41.5% of the contractors’ wages (a figure that includes Social Security tax, federal income tax and unemployment insurance), with penalties going back three years.

As a result, companies who’ve been caught by the U.S. Department of Labor (DOL) violating FLSA provisions by misclassifying employees have paid millions of dollars in fines, penalties and remuneration of employees’ lost wages. In the most costly misclassification case in recent years, FedEx in 2007 learned it owed the IRS $319 million in back taxes for misclassifying FedEx Ground drivers as independent contractors. Since then, two California newspapers also paid considerable sums – the San Diego Union Tribune $11 million and the Orange County Register $22 million – when they were found guilty of misclassifying paper carriers as independent contractors.

Rough times for misclassifying roughnecks

Oil and gas companies have also been investigated for FLSA violations, although so far the paybacks have been smaller than those higher profile cases.

In 2012, HongHua, a Houston-based equipment manufacturer and drilling service provider, had to pay more than $687,000 in overtime back wages to 133 roughnecks and crane operators after an investigation by the US Department of Labor’s Wage and Hour Division. The government determined the company had misclassified the workers as contractors then paid them straight time instead of overtime for the hours they worked beyond the regular 40 per week.

In Carlsbad, NM, Morco Geological was also found in violation of various provisions of the FLSA. The company was forced to pay more than $597,000 in back wages to 121 current and former mud logging technicians, many of whom were working more than 100 hours per week but weren’t being paid any overtime. Earlier this year, two oilfield services companies were ordered to pay back lost overtime to misclassified workers. Oklahoma-based Rigid Oil Field Services settled its case for nearly $52,000 while J&A Services LLC agreed in Colorado federal court to pay $2 million to its misclassified workers.

Oil field service personnel – many of whom easily put in 80-hour weeks – are among the most frequently misclassified oil and gas workers among a list that includes:

  • Electricians
  • Mechanics
  • Oilfield delivery specialists
  • Directional Drillers
  • Wireline Operators
  • Roustabouts
  • Toolpushers
  • Well Testers
  • Rig Clerks
  • HSE/Safety Advisors
  • Wellsite Advisors

Misclassification might cost you more than money

In addition to the hefty fines the IRS can assess on a company, the agency can also levy criminal penalties of $1000 and/or one year in prison for failure to properly classify workers. If the IRS obtains a felony conviction against a person or company for tax evasion due to 1099 misclassifications, the fine can be as much as $100,000 for an individual or $500,000 for a corporation. But that’s not all:  felony convictions can also come with a prison sentence of up to five years.

Row of Jail Cells

Furthermore, individuals such as corporate officers or those who have authority over the financial affairs of a business may be personally liable for up to 100 percent of any uncollected taxes relating to misclassification and may also be subject to criminal prosecution.

Cracking down even harder on violators

Worker misclassification is increasingly the subject of state and federal legislation. On the federal level, the DOL and IRS both have misclassification task forces dedicated to investigating use of independent contractors, including conducting random and focused audits of employers.  The agencies hope to raise $7.3 billion for the federal coffers by cracking down on misclassifications.  The DOL has even awarded $10.2 million to 19 states to help them upgrade their worker misclassification detection and enforcement.

Late last year, Sen. Bob Casey (D-PA) introduced the Payroll Fraud Prevention Act of 2013 at a hearing of the Senate Subcommittee on Employment and Workplace Safety. The bill takes aim at curtailing the misclassification of independent contractors, which the sponsors equate with “payroll fraud.”

Moreover, the IRS, which began its crackdown a few years ago, is promising to be even more vigilant. Those in favor of stricter rules on misclassification say they are protecting not only workers, but companies who already play by the rules. However, since the passage of the Patient Protection and Affordable Care Act (also known as the ACA or “Obamacare”), advocates of stricter regulations fear that employers will be further motivated to keep workers off the books as official employees.

ACA red flags:  What the feds are looking for

danger thin ice

The employer mandate portion of the ACA will require employers with 50 or more full-time employees to provide healthcare coverage to those employees starting in 2015. Some employers have already been cutting employee hours as one tactic to reduce their full-time headcount, while others have instituted layoffs, hiring freezes, or simply hiring independent contractors instead of full-time employees.

While it may seem tempting to begin classifying workers as independent contractors, the cases just described show the danger inherent in that move. As the IRS continues its efforts against worker misclassification, the agency is looking for red flags such as a W-2 employee suddenly showing a 1099 classification instead.

One solution is for companies to utilize contractors who are the legal W-2 employees of a staffing firm. In that case, the worker counts toward the staffing firm’s headcount, not the company’s, and the company remains in compliance with FSLA, IRS and ACA. In today’s new generation of American business, that’s a smart and safe way to proceed.

A few questions come to mind for the readers:

  1. Can a clear, concise statement of work minimize the number of  1099 misclassifications?
  2. What other solutions might help companies to meet compliance requirements?
  3. Other than the oil & gas industry, what industries are notorious for worker misclassification, if any?

Chris Sutton has a sound foundation in the energy sector contracting from both Client and Contractor sides with specific expertise in building alliances to facilitate service capabilities. To contact Chris with any questions or comments, please send an email to Chris.S@clovergs.com.