Classifying Employees Correctly

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Misclassifying workers is one of the most common mistakes made by nonprofits that result in IRS penalties, and even more commonly, violations of federal and state wage and hour laws resulting in back wages and associated penalties. In recent years the IRS has been stepping up its enforcement of employee classification, creating a compelling reason for nonprofits to reexamine whether workers are properly classified as employees and independent contractors, and as exempt or non-exempt employees. 

Why does it matter?

Misclassifying a worker can result in the nonprofit owing significant penalties, back taxes, and back pay. Nonprofit employers need to know first whether any worker is an independent contractor or an employee – and if an employee, whether the employee is “exempt” or “non-exempt” from overtime. The correct classification is determined by two layers of definitions: federal and state, so both state and federal Department of Labor (DOL) regulations may apply. Twenty-eight states follow the federal Fair Labor Standards Act (FLSA) definitions but in others, different definitions and wage/hour rules may apply, just as different states have different minimum wage rules.

Independent contractor or employee?

A typical misclassification scenario is that a nonprofit classifies a worker as an independent contractor when in fact the federal DOL, or state wage and hour laws would define that same worker as an employee.

  • If the state or federal DOL finds that the nonprofit has misclassified the worker, the nonprofit can be responsible not only for un-paid wages, including overtime but also state/federal withholding taxes, as well as potential penalties.
  • Not sure of the differences between independent contractor and employees? (IRS Publication 1779)

Practice Pointers

  • Position descriptions should be prepared for employees, but not for independent contractors.
  • Independent contractors should sign a written contract with the nonprofit describing the scope of work instead. The agreement is also a good place to document that the independent contractor/consultant understands that s/he is responsible for his/her own income taxes and insurance coverage.
  • IRS guidance can help distinguish between employees and independent contractors; state law definitions should be checked also.
  • Reporting payments to independent contractors. (IRS)

Exempt or Non-Exempt?

Another common misclassification scenario occurs when a nonprofit considers a worker to be exempt from overtime payments, when in fact federal or state wage and hour laws would classify the worker as non-exempt, which could result in the employer owing the worker compensation for overtime, and potentially also owing the state or IRS penalties.

Practice Pointers

  • Even if a worker is "salaried" s/he could still be entitled to overtime for hours worked over 40 in a single work week under the federal rules. Manage employees' expectations by letting them know whether they are, or are not, entitled to overtime.
  • Each state has its own wage and hour rules that govern which workers are entitled to overtime in that state and what makes an employee exempt from overtime, so be sure to review the applicable wage and hour regulations/guidelines in your state. Quite a few states automatically follow federal wage and hour (and overtime) regulations. See our map to learn whether your state follows the federal rules.
  • Manage your employees’ expectations about their compensation by including a category of “worker classification” on position descriptions, for example: “Regular, full-time, exempt” or “Temporary, part-time, non-exempt.”
  • Most employment lawyers advise employers to have a policy that workers may only work overtime with advance authorization from their supervisor - which limits surprises and budget overruns.
  • When preparing budgets for grant proposals, consider whether to anticipate overtime in the budget.

Resources

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