Employee Misclassification: Definition And How To Avoid It
Employee misclassification is the term that describes an incorrect classification of a worker as an independent contractor instead of an employee, leading to potential legal and financial consequences for both the employer and worker.
This article will explain the difference between employees and independent contractors, the risks and costs of misclassification, and how to avoid and correct employee misclassifications. I’ll also explain how companies can leverage an Employer of Record (EOR) partnership to proactively avoid future misclassification errors and manage workforce compliance requirements on a global scale.
What is Employee Misclassification?
Employee misclassification occurs when an employer incorrectly categorizes a worker, usually as an independent contractor when legally they should be considered a full employee.
Most of the time, this occurs accidentally when an employer is unaware of the rules and regulations in place that define employees and contractors. However, there may be cases where an employer has intentionally misclassified a worker to avoid additional costs, such as offering employee benefits, paid vacation, and other employment perks.
While working with independent contractors can potentially save companies a considerable amount of money, the act of employee misclassification can also lead to serious legal issues.
Misclassifying workers as independent contractors impacts the rights of workers by denying them access to critical benefits and protections they are entitled to, creates unfair competition in the labor market, and can lead to significant loss in tax revenue.
When in doubt, employers should refer to the standardized tests laid out by the Internal Revenue Service (IRS) or the Department of Labor (DOL) to ascertain the proper classification.
Fair Labor Standards Act
Established in 1938, the Fair Labor Standards Act (FLSA) is a US federal law that sets standards for minimum wage, overtime pay, recordkeeping, and child labor. It is widely recognized as the main legislation that safeguards employee compensation practices. The FLSA encompasses full-time and part-time workers in the private sector and in federal, state, and local governments.
In terms of employee misclassification, the FLSA plays a critical role. Under the act, employers are obligated to classify workers as either employees or independent contractors. If a worker is incorrectly classified as an independent contractor, the employer may bypass specific obligations such as overtime pay and benefits.
The FLSA stipulates that employees must receive at least the federal minimum wage and must be paid for overtime hours, which helps counteract misclassification. The Department of Labor actively enforces these standards to ensure employees are receiving their lawful employment rights and benefits.
Misclassification in Canada
In Canada, the Canada Revenue Agency (CRA) uses a multifactor classification test to decide if a worker is an employee or a contractor. Key factors include:
- The degree of control an employer has over the worker's schedule and tasks
- Whether the worker provides their own tools and equipment, and
- If the worker has the chance of profit and risk of loss.
Employers who intentionally misclassify workers may face penalties or be held liable for their misclassification. In addition, there can also be significant tax implications resulting from employee misclassification.
Using Canadian payroll software or a specialized Canadian Employer of Record (EOR) service are two ways you can ensure proper worker classification and ongoing compliance with Canadian regulations.
Misclassification Abroad
Employee misclassification is a global issue and different nations have their own labor regulation laws and classification guidelines that must be followed if you plan to do business there. Countries like the UK, France, and Germany have distinct legal systems and definitions in place for temporary, part-time, or freelance workers. Different legal proceedings are associated with each worker category, and misclassification can lead to fined penalties or legal proceedings.
For multinational companies, understanding each country's specific labor laws and keeping up-to-date is crucial to reducing misclassification risk. However, to get those hassles off of your desk, there are also specialized EOR services for hiring within designated countries, including UK-specific EOR services, or global payroll services that can monitor compliance for all the countries you’re interested in engaging workers in.
Employee or Independent Contractor?
To help you avoid possible worker misclassifications, you need to understand the definition of an employee and an independent contractor first.
An employee works under their employer’s direct supervision. This means the employer controls how, when, where, and with who the worker performs their tasks. They are paid regularly, and are eligible for typical employment benefits.
Independent contractors, on the other hand, have more control over how they execute their work, often using their own methods and materials. They may provide their services to multiple clients at a time, unlike employees. They are paid irregularly, according to the terms of their written contract, and are not eligible for any benefits.
Key Comparison Table for Independent Contractors vs Employees
| Worker’s Status | Employee | Independent Contractor |
| Working Relationship | Works for one client or company. | May work for multiple clients or companies simultaneously. |
| Length of Relationship | Ongoing employment relationship with no specified end date. | Contractual for a specific task or short-term period. Often project-based. |
| Degree of Control | Work is completed according to the employer’s requirements. | Client has limited control over how and when the individual completes their work. |
| Payments & Taxes | Paid a regular hourly wage or salary via payroll, including typical employment taxes and payroll deductions. | Paid irregularly according to their contractor agreement. Contractors submit invoices for payment and pay self-employment taxes. |
| Job Security | Job security is protected by labour laws. | No job security, not protected by labour laws. |
If you’d like to drill into the finer details, my detailed comparison of independent contractors vs employees is a natural next step.
Why Does Misclassification Happen?
Employee misclassification can arise from a variety of factors. Understanding the most common root causes of misclassification is an important way to proactively avoid this issue:
- Lack of awareness: Employers with limited internal resources (especially small businesses or startups) may not be aware of the legal distinctions between employees and contractors, leading to accidental misclassification. A lack of awareness is also compounded by how complex employment laws are, making it a challenge for employers to stay informed.
- Convenience: For some employers, classifying workers as independent contractors rather than employees is often seen as a simpler way to manage workforce costs and flexibility without delving into the complexities of employment classifications. However, this convenience can come at the cost of violating labor laws and undermining worker rights.
- Ignorance of consequences: Some employers may underestimate the legal and financial repercussions of misclassification. Ignorance of the consequences, such as potential penalties, back taxes, and damages for violating labor laws, can make misclassification seem like a low-risk decision. Unfortunately, this misunderstanding does not protect companies from the significant liabilities that can arise from misclassification, including costly lawsuits and damage to the company's reputation.
- Industry-specific practices: In some industries, it's a common practice to engage workers as independent contractors rather than employees. This norm can be so ingrained that employers follow suit without considering the specific legal requirements or implications. This is particularly common in the gig economy, construction, and consulting sectors, where flexibility and project-based work are valued.
- Complex regulatory environments: The criteria for determining employee status can vary significantly between jurisdictions and are subject to change. Employers operating in multiple regions or countries may find it challenging to keep up with the differing and evolving regulations, leading to unintentional misclassifications. This complexity makes it difficult for businesses to consistently apply the correct classification standards across their operations.
- Rapid business growth or downsizing: Companies experiencing rapid growth or significant downsizing may misclassify employees as they try to scale their workforce quickly or cut costs. In the rush to adapt to changing business needs, proper classification may be overlooked, leading to legal and financial complications down the road.
- Use of third-party staffing agencies: Businesses that hire workers through third-party staffing agencies might assume that the agency has correctly classified the workers, inadvertently leading to misclassification. This delegation can lead to a lack of direct oversight and misunderstandings about who bears the responsibility for proper classification. (This is why it’s better to use an EOR service rather than a staffing agency.)
- Intentional cost savings: In some cases, the decision to misclassify employees is a deliberate strategy to reduce operational costs. By labeling employees as independent contractors, businesses can avoid paying for employee benefits, overtime, workers' compensation, and part of the Social Security and Medicare taxes. While this might offer short-term financial savings, it is a risky maneuver that can lead to legal challenges and penalties, reflecting a clear intent to circumvent labor laws for financial gain.
The Risks and Costs of Employee Misclassification
The risks and costs of employee misclassification can be significant. When detected by legal authorities, it can result in severe legal and financial penalties, back payments, and damage to the company's reputation.
In addition to the legal implications, misclassification can also lead to other indirect costs. Dissatisfied misclassified employees may be resentful or bear grudges against the company, potentially affecting team productivity, morale, and cohesion. Additionally, misclassified workers may lack the commitment and loyalty of regular employees, which can lead to higher turnover rates, increased recruitment costs, and a potential decrease in service or product quality.
Below, I’ve broken down the typical risks and costs of employee misclassification for employers and employees.
Costs for the Employer
The financial impact on employers who misclassify their employees can be substantial.
- Penalties and fines: Employers who misclassify workers will need to pay retroactive taxes, Social Security costs, Medicare contributions, and late filing penalties. Interest may also be charged retroactively on payments that should have been submitted previously, compounding the financial impact of misclassification further.
- Retroactive compensation: Misclassified employees are often entitled to retroactive compensation, including back wages for overtime and benefits they would have received as employees. This not only involves a direct financial cost but also the administrative burden of recalculating compensation over potentially long periods.
- Labor law violations: Misclassification can lead to non-compliance with a broad spectrum of labor laws, including Occupational Safety and Health Administration (OSHA) regulations, Unemployment Insurance (UI), or Employment Insurance (EI), depending on your jurisdiction. These violations can carry additional legal actions and penalties, plus the costs of instituting future corrective measures.
- Legal issues: Employers risk facing lawsuits from misclassified employees seeking compensation for benefits, wages, and protections they were denied. Legal battles not only incur direct costs like legal fees and settlements but also distract from business operations and can take years to resolve.
- Damage to corporate reultation: The negative publicity from misclassifying employees can tarnish a company's reputation, affecting its relationship with customers, investors, and potential future talent. Rebuilding trust and brand image after such incidents can be challenging and expensive, impacting long-term profitability and growth.
Costs for the Worker
Misclassification of employees can have significant monetary implications for the affected worker, in addition to impacting their career trajectory and mental health.
- Lack of compensation and benefits: Workers misclassified as independent contractors miss out on essential benefits and protections, such as health insurance, retirement plans, paid leave, and unemployment insurance. Additionally, they may not receive overtime pay or compensation for work-related expenses, leading to financial strain.
- Unexpected tax obligations: Misclassified workers may be hit with unexpected tax obligations, as they are responsible for paying both the employee and employer portions of Social Security and Medicare taxes. This situation can lead to a significant financial burden come tax season, especially if they were not aware of or did not plan for these additional expenses.
- Limited opportunities for career growth and advancement: Misclassification can stifle workers' career trajectories, limiting access to training, development programs, and opportunities for advancement typically available to employees. This barrier can hinder their professional growth and long-term earning potential, affecting their career satisfaction and future prospects.
- Mental health impacts: Misclassified workers often face unnecessary stress due to job insecurity, unclear job expectations, and the absence of employment protections. This stress can affect their mental health and overall well-being, complicating both their professional and personal lives.
Famous Misclassification Lawsuits
Many well-known companies have faced misclassification lawsuits in the past, which underscore the importance of properly classifying your workers. Heed these examples and learn from their mistakes so you can avoid similar situations in your own business.
- Microsoft Independent Contractor Case: In the 1990s, Microsoft was required to pay $97 million in a settlement after a court ruled that hundreds of workers classified as "freelancers" were eligible for the same benefits as full-time employees. This case is often cited as a landmark in misclassification litigation and led to significant changes in how companies classify workers.
- Dynamex Operations West, Inc. Case: The California Supreme Court's decision in Dynamex Operations West, Inc. v. Superior Court (2018) established the "ABC" test for determining whether workers in California are employees or independent contractors. This case significantly impacted labor law in California, making it harder for businesses to classify workers as independent contractors.
- FedEx Ground Package Systems Settlements: In 2016, FedEx faced lawsuits alleging misclassification of 12,000 drivers as independent contractors, leading to a $240 million settlement with drivers in 20 states. The settlement resolved claims for benefits, wages, and operating expenses that were not provided due to the misclassification. This was followed by a second lawsuit in 2021 where 192 drivers in New Jersey sued for misclassification as independent contractors, forcing FedEx to agree to another $2.4 million settlement.
- Uber Settlements: Uber has been involved in multiple lawsuits over the misclassification of drivers as independent contractors, with another lawsuit active as of early 2024. Notably, in 2016, Uber agreed to settle two class-action lawsuits in California and Massachusetts for up to $100 million, which allowed it to continue classifying drivers as independent contractors while providing some concessions. Uber also faced a lawsuit in California for a similar misclassification suit, costing them another $8.4 million settlement.
How to Avoid Employee Misclassification
Avoiding employee misclassification starts with a comprehensive understanding of the differences between independent contractors and employees. Employers need to consider:
- the degree of control they have over the worker's tasks,
- the financial and operational aspects of the worker's job, and
- the type of relationship that exists.
One way to stay clear of misclassification is through accurate job descriptions that clearly delineate responsibilities, the extent of control, and the tenure of engagement.
Another option is leveraging HR software and other management tools to generate documents and records reflecting the actual nature of the work relationship, discouraging any possibilities of misclassification.
Other worthwhile options to consider include consulting a legal expert, using an EOR service, or establishing a foreign entity abroad.
Consult a Legal Expert
Engaging a legal expert can be an invaluable resource when navigating complex employee classification requirements. Legal professionals specializing in labor law can provide advice, clarity, and direction regarding the interpretation and execution of classification standards. This level of legal guidance can serve as the cornerstone for organizations, and ensure compliance with federal, state, and local employment laws.
Furthermore, when disputes regarding employee classification do arise, a legal expert can guide an organization through potential litigation or regulatory investigations. This, in turn, can mitigate the risks of fines and penalties, or possibly damaging lawsuits. Legal experts can also help review contracts and agreements to ensure they are legally sound and adequately stipulate employment classifications.
The investment in legal expertise, while sometimes costly, will provide peace of mind and ensure a company is on solid legal ground, acting as a protective shield against potential employment-related liabilities.
Establish a Foreign Entity Abroad
To legally employ a foreign worker, a business must typically establish a foreign entity in that individual's country. This permits ethically sound employment, considering the home country’s labor laws, tax regulations, and employment rights, promoting a respectful global business practice.
Establishing a foreign entity also helps businesses establish a local presence, creating an improved brand reputation and lending easier access to the local market. However, the process can be complex, costly, and time-consuming. As such, businesses may consider partnering with a global Employer of Record (EOR) instead—a way to employ global staff legally, without needing to set up foreign entities.
Use an Employer of Record Service
Using an EOR service is another robust solution to the potential issue of employee misclassification. EORs are external organizations that take on significant portions of the employer's responsibilities and liabilities, including tax compliance, payroll, and employment-related insurance.
With years of HR and legal expertise at their disposal, EORs ensure all employees are classified correctly according to state and federal labor laws, thus reducing the employer's risk exposure to misclassification lawsuits.
EOR services do not only ensure the correct classification of employees, but they also manage other labor-intensive HR tasks, which allows employers to concentrate on their core business functions.
By collaborating with an EOR, employers can navigate the complexities of employee classification and avoid expensive fines and penalties related to misclassification errors. An EOR relationship provides an extra layer of security and compliance for a business, while also streamlining HR procedures.
However, it’s essential to choose an EOR that is competent, trustworthy, and familiar with the laws and regulations of your jurisdiction and industry to minimize any potential risks of using an EOR service.
How to Correct Employee Misclassification
Correcting employee misclassification often hinges on the advice of a labor law attorney to guide you on the best course of action forward. In most cases, it also involves hiring the misclassified worker as a formal employee, making them whole in the eyes of the IRS.
Contact a Labor Law Attorney
When grappling with employee misclassification, it's crucial to reach out to a labor law attorney for professional advice. These legal experts specialize in issues related to workers' rights and federal or state labor laws, including a thorough understanding of issues such as misclassifications. Given their expertise, they can provide comprehensive advice on steps to rectify misclassification and prevent penalties.
Furthermore, in the event of a lawsuit for misclassification, seeking the assistance of a labor law attorney becomes truly vital. They can skillfully guide the employer through the legal proceedings, stand in their defense, and negotiate settlements.
Lastly, their counsel can be invaluable in setting up processes, policies, and HR software configurations that prevent future misclassifications. To stay within legal boundaries and maintain efficient workplace management, consistent legal guidance is needed, especially in a complex field like employee classification.
Hire Your Contractor as an Employee
When a contractor is hired as an employee, there are key changes in benefits, tax withholding, and employment status that your HR department must be prepared to manage. This involves handling the employee's social security and medicare taxes, unemployment taxes, and workers' compensation insurance.
Correcting employee misclassification starts in your HR or payroll software and involves updating job titles, responsibilities, and pay scales to more accurately reflect the employee's true function.
Of course, you must also communicate with the affected worker about these changes promptly, informing them of their new classification as an employee and what that means, especially in regard to their wage and overtime eligibility.
Lastly, if the misclassification resulted in any wage errors such as unpaid overtime, those need to be rectified immediately.
IRS Reclassification
The IRS provides opportunities for employers to correct employee misclassification through programs such as the Voluntary Classification Settlement Program (VCSP). This program allows employers to voluntarily reclassify their workers as employees for future tax periods, with partial relief from federal employment taxes. While engaging in this program requires an employer's accountability for past oversights, it significantly reduces potential liabilities that may be incurred in an IRS audit.
However, in cases where the IRS identifies misclassification during an audit, the consequences can be severe. Not only can the employer be held liable for back taxes and penalties, but they will also be required to reclassify the worker for future tax periods.
In order to prevent potential issues, it's crucial that HR professionals familiarize themselves with the guidelines issued by the IRS to correctly classify employees and independent contractors, and seek expert legal advice when needed. By doing so, they can avoid any negative implications that could arise from misclassification.
Penalties and Fines
Companies found guilty of employee misclassification can be subject to severe penalties and fines levied by federal and state agencies. These fines may vary but often include the following costs:
- unpaid overtime,
- wage and hour violations,
- Social Security and Medicare taxes (including interest),
- workers' compensation benefits, and
- unemployment insurance premiums.
In many cases, employers are also responsible for providing wrongfully classified employees with benefits they would have received as legitimate employees, including healthcare insurance coverage, and retirement plan contributions.
Furthermore, the U.S. Department of Labor (DOL) has increased its focus on employee misclassification, leading to steeper penalties for non-compliance. While the penalties heavily depend on whether the misclassification was intentional or unintentional, the fines per misclassified worker can range from $1,000 to $25,000 USD. For repeat violators, criminal charges are also possible.
The potential legal costs, reputational damage, and resources needed to remedy such situations also pose a significant risk. To avoid these unnecessary costs, it is crucial for companies to classify their employees correctly.
Calculating Misclassification Costs
Calculating the correct compensation for an employee who was misclassified is a bit tricky, and the exact costs will depend on the country where you're employing them. However, there are several factors you can use to estimate how much you will end up paying:
- The length of the misclassification (e.g., weeks, months, years, etc.)
- The amount you’ve already paid the worker
- The existing compensation levels for your existing full-time employees in a similar role
- The range of benefits an employee at the same seniority level would have received had the worker not been misclassified
- The amount of taxes your company would have paid on behalf of the employee
- Whether you discovered the misclassification error yourself, or if it was identified by a government body
As expected, a short-term misclassification that was noticed and rectified quickly will cost far less than a misclassification that went on for a long period of time.
How to Manage Future Global Compliance
To effectively manage future global compliance, businesses should consider partnering with an Employer of Record (EOR) service or using a Global Payroll service. These strategies offer streamlined solutions for navigating the complex landscape of international labor laws and regulations.
Ensure Compliance via an EOR Service
An Employer of Record (EOR) service simplifies global compliance by legally employing workers on behalf of your business, ensuring adherence to local labor laws and regulations. This arrangement offloads the complexities of global employment law, tax obligations, and HR tasks from your team, allowing you to focus on core business operations without the compliance headache.
Ensure Compliance via a Global Payroll Service
A global payroll service provides a unified solution for managing payroll across different countries, adhering to each region's unique tax laws and employment regulations. By centralizing payroll operations, businesses can ensure accurate payments to employees worldwide while minimizing the risk of compliance errors and penalties. This approach streamlines international payroll management, reducing the administrative burden on HR professionals.
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