The are several reasons why the legal classification of an employee is important: 1) it governs the respective liabilities of the employee and the employer for injury to third parties; 2) it determines the ability of an employee to legally bind the employer in transactions with third parties; 3) employees in certain categories are limited by workers' compensation laws for compensation for their employment-related injuries; 4) it governs the employer's treatment of the employee in connection with the U.S. Internal Revenue Service; and 5) it affects employer's right to unilaterally terminate the employment relationship, and the effect of unemployment compensation laws on such termination.
An employee's classification may even differ, depending upon the reason the classification is made. For example, a licensed engineer may have one classification for tax purposes, but another for liability for professional malpractice.
Thus, disputes over the legal status of employees arise for a number of reasons. An injured third party would seek to establish an employment status that would require joint liability of the employee and employer, whereas the employer or employee would seek to establish a status wherein only the other was liable. A third party seller who dealt with an employee would seek to establish an employment status that would bind the employer to the terms of the sale, whereas the employer would seek to establish a status wherein it was not bound. An employee seriously injured on the job would seek to establish an employment status in which his compensation would not be limited by workers' compensation laws, whereas the employer would seek to establish a status wherein its liability is limited by the workers' compensation laws. A fired employee may seek to establish an employment status covered by unemployment compensation, whereas the employer may seek an unprotected status.
A large number of disputes over the legal status of employees are with the Internal Revenue Service. Certain employment classifications require the employer to pay social security tax, withhold federal income tax from the employee's salary, and comply with certain laws governing pensions and other employee benefits. As a policy matter the IRS prefers to have employees classified for withholding. This reduces tax fraud and facilitates tax collections. It also funds benefit systems such as unemployment insurance. The IRS has recently tightened its rules on employee classification, with the specific intention of forcing the reclassification of employees into withholding categories. Substantial monetary penalties exist for employers who misclassify employees into nonwithholding categories.
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