Penalties for Misclassifying Employees as Independent Contractors

Employers who misclassify their employees as independent contractors, whether intentionally or unintentionally, may be liable for significant penalties and costly liabilities. Over the years, federal regulations and evolving interpretations by the Department of Labor (DOL) have raised the stakes, making it critical for businesses to understand and follow the guidelines for proper worker classification. 

Civil lawsuits are just one potential outcome, often resulting in significant financial burdens for employers. Both employees and attorneys who pursue these cases should be aware of the wide-ranging consequences and liabilities misclassification can impose on businesses, from back wages and benefits to extensive legal fees and fines.

A brief history on federal legislation regarding employee misclassification

According to the Fair Labor Standards Act (FLSA), all employers are required to pay employees minimum wage and overtime–but this requirement excludes independent contractors. Employees, especially those working full-time, are also entitled to additional benefits under various laws, such as paid sick leave required by state law, workers' compensation, unemployment benefits, and access to employer-sponsored ERISA plans like health insurance and 401(k) options. 

However, employee misclassification, even if unintentional, comes with significant penalties.

Historically, the Department of Labor (DOL) and courts have used the Economic Reality test to distinguish employees from independent contractors under the FLSA. In 2015, the Obama Administration’s Wage and Hour Division expanded this test, emphasizing that a worker's economic dependence on an employer is the most important factor for determining employee status under the FLSA. 

However, in 2021 under the Trump Administration, the DOL introduced the 2021 Rule, which defined independent contractor status in a way widely seen as more favorable to businesses. This rule prioritized two main factors: the employer’s level of control over the work and the worker’s opportunity for profit or loss, making it easier to classify workers as independent contractors.

Then, on January 10, 2024, the Biden Administration’s DOL amended the 2021 Rule, reverting back to the Economic Reality test as the base for determining if a worker is an employee or contractor. This revision is what’s known as The Final Rule.‍

The Final Rule and the Economic Reality test

This new rule establishes the Economic Reality test as the standard for worker classification under the FLSA. It considers the entire context, focusing on six factors to assess a worker's economic reliance on an employer or client (however, California, Illinois, Pennsylvania, Washington, and Nebraska apply a separate “ABC Test”).

The rule clarifies that economic dependence does not depend on income amount or other income sources. The primary question is whether a worker relies economically on an employer for work—indicating employee status—or is self-reliant and, therefore, an independent contractor.

The rule specifies that no single factor determines a worker's status. Instead, all six factors must be considered. These include:

• The extent to which the work performed is an integral part of the employer's business.
• The worker's opportunity for profit or loss depending on their managerial skill.
• The extent of the relative investments of the employer and the worker.
• Whether the work performed requires special skills and initiative.
• The permanency of the relationship.
• The degree of control exercised or retained by the employer.

Federal penalties for misclassifying employees as independent contractors

Employers who misclassify employees as 1099 contractors can face financial penalties and reputational damage. 

The following are some of the federal penalties:

1. FLSA back wages and overtime: Under the FLSA, misclassified employees are entitled to back wages, including overtime pay for any hours worked over 40 per week. This can go back up to three years if the misclassification is deemed intentional, and the DOL may also impose additional fines per employee for FLSA violations.
   Additionally, if an investigation reveals intentional violations, the DOJ may become involved, potentially leading to further scrutiny and penalties.
2. Unpaid payroll taxes with double penalties: The IRS requires employers to pay payroll taxes, including Social Security and Medicare contributions. Misclassification results in unpaid payroll taxes, and if deemed intentional, the IRS can apply double or even triple penalties on top of the back taxes owed. Employers may also face penalties from state tax agencies. Failure to comply with federal tax laws can lead to DOJ intervention in cases of fraud or intentional misclassification, resulting in greater financial and legal consequences.‍
3. Retroactive employee benefits: Misclassified workers are often owed benefits they should have received, such as health insurance, retirement contributions, and paid time off. This can create a costly, complex retroactive obligation, particularly if the employee was working for a company for a long time. Companies might also have to revise their benefits reporting to comply with ERISA.‍
4. Class-action lawsuits and legal battles: Misclassified employees may file lawsuits against employers, seeking compensation for unpaid wages, overtime, and denied benefits. These lawsuits can escalate into class-action cases, multiplying the legal costs and damages awarded if the employer loses. For instance, in the high-profile case Dynamex Operations West, Inc. v. Superior Court of Los Angeles (2018), delivery drivers filed a class-action lawsuit against Dynamex, arguing they had been misclassified as independent contractors to avoid paying benefits and overtime. ‍
5. Penalties for I-9 violations: Independent contractors are not required to complete Form I-9, which verifies their eligibility to work in the US. However, if a misclassified worker should have been classified as an employee, failing to complete an I-9 form can lead to employer penalties for non-compliance with federal immigration requirements. Penalties can range from fines to potential civil and criminal liabilities for severe cases.‍
6. Loss of reputation and talent: Misclassification under FLSA, I-9, or tax violations can damage a company's reputation. It signals poor compliance and disregard for labor laws, potentially making it harder to attract top talent. Competitors may also leverage the company’s damaged reputation to their advantage, potentially attracting dissatisfied clients or business partners who prefer to work with organizations known for strong compliance practices, leading to lost business for the accused employer.‍
7. Ongoing government scrutiny and audits: Employers flagged for misclassification may be scrutinized more closely by the IRS, DOL, and state agencies. Future audits can be disruptive, especially if they extend beyond FLSA compliance to check for I-9 violations, payroll tax issues, or other compliance risks, creating a long-term administrative burden for the company.
   Once identified, serious infractions may lead to DOJ oversight, especially if other compliance issues emerge, significantly heightening regulatory and legal risks.

State-specific penalties

Several states have implemented stringent penalties for the misclassification of employees as independent contractors. Additionally, states may alert federal agencies of any cases it discovers, potentially resulting in multi-level investigations by the DOL, IRS, and DOJ, increasing the severity of consequences for the employer.

A few notable examples of state-specific penalties include:

• California: Employers determined to have willfully misclassified workers can face civil penalties ranging from $5,000 to $15,000 per violation. If the government or court determines a pattern of behavior, fines can increase to between $10,000 and $25,000 per violation.
• New York: The state imposes penalties of up to $2,500 for the first misclassification offense and up to $5,000 for subsequent offenses. Employers may also be required to pay back taxes and contributions to the state's unemployment insurance and workers' compensation funds.
• Massachusetts: Employers can face fines of up to $25,000 and up to one year of imprisonment for willful misclassification. Civil penalties can also include treble damages for unpaid wages and benefits.
• New Jersey: The state enforces penalties of up to $1,000 per misclassified employee and up to 90 days of imprisonment. Employers may also be liable for back taxes and contributions to state benefit programs.
• Illinois: Penalties include fines of up to $1,500 per day for each misclassified worker, with additional fines for repeat offenses. Employers are also responsible for unpaid wages, taxes, and contributions to state funds.

Partner with Darrow to prosecute your next employee misclassification case

Attorneys pursuing employee misclassification cases need to stay attuned to the shifting framework of federal and state regulations. With the establishment of The Final Rule, lawyers face new opportunities to advocate for clients' rights to fair wages and benefits.

The stakes are high: building solid cases that highlight the substantial financial and legal risks of misclassification means that attorneys can deliver meaningful outcomes for workers and set strong precedents for compliance. In today’s environment, those who fully grasp the depth of potential penalties and liabilities are best positioned to make a powerful impact.

At Darrow, we're committed to creating partnerships with class action attorneys by providing solid cases, quality plaintiffs, and litigation support.

We’ve developed our own in-house intelligence infrastructure, driven by generative AI, to evaluate potential employee misclassification cases beyond traditional legal analysis.

For example, using our own anomaly detection algorithms, we investigated and sold an employee misclassification case to a leading law firm against a large US-based package delivery company. The case has an estimated 6,000 plaintiffs and a value of $13.5 million in damages. 

We work hand-in-hand with our partners throughout the entire litigation process, ensuring attorneys have all of the resources they need to win their cases. Our team of in-house counsel guide, advise, and support  partners as they navigate the complexities of employee misclassification cases. From initial case assessment to final resolution, we ensure they have everything they need to effectively pursue justice.

Interested in finding your next employee misclassification case? Talk to one of our legal experts. 

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