Contractor to Employee: Correcting Classification Errors

As a provider of payroll and benefits administration services, Dallas-based BenefitMall occasionally encounters situations in which new clients are discovered to have unintentionally misclassified workers. More often than not, this means classifying workers as contractors when they are actually employees under the law. Such errors are not reason to panic as long as the employer takes corrective measures as soon as the mistake is discovered.

This article describes what to do if your company discovers it has incorrectly classified contractors. It should be noted that misclassification is one of the most common payroll errors discovered by companies like BenefitMall. Why? Because IRS guidelines are fairly ambiguous despite the existence of what is known as the ‘IRS three-prong test’.

The test may only include three prongs, but there are 13 individual conditions under those three prongs. Determining the right classification is not always as easy as the IRS makes it sound.

Step #1 – Check with the IRS

The first step in correcting a classification error is to check with the IRS to make sure an error has actually been made. Assuming you have already looked at the three-prong test and still do not have an answer, you can go directly to the IRS by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. It is a four-page form that asks dozens of questions the IRS will use to determine whether the worker in question is a contractor or an employee.

Step #2 – Notify the Employee

Assuming step #1 does verify that the worker is an employee rather than a contractor, the next step is to notify the worker of his or her change of status. It is best to do so in writing so as to protect the employer against future litigation. The notice should be dated and, if mailed, sent either certified mail or with signature confirmation requested.

Step #3 – Get the Worker on the Books

Once notice has been given, it is time to put the employee on the books. That means having him or her fill out a W-4 for withholding purposes. The HR department will also have to gather any other information necessary to complete its records. The employee will have to be entered into payroll software under the new classification as well.

In order to make all this work as it should, the HR department will also have to figure out a normal rate of pay. You may have paid the worker piecemeal during the period you had him or her classified as a contractor, but that will not do for an employee on the books. A definite pay rate has to be determined in order to comply with federal law. That pay rate can be hourly or salary based.

Step #4 – Determine Exemption Status

Lastly, the HR department has to determine whether the employee is classified as being exempt from overtime pay. All hourly workers are considered non-exempt. That is to say they receive one-and-a-half times their regular rate for hours worked in excess of 40 per week. If the newly classified worker is a salaried worker, he or she may be exempt according to federal law. It is up to the HR department to make that determination.

BenefitMall points out that each of the steps listed here are things that payroll services normally provide. That’s one of the big benefits of taking payroll out of the office and turning it over to a qualified service provider. Payroll providers can help resolve classification errors quickly, efficiently, and in full compliance with the law.

News Reporter