Contractor Management

Employee and independent contractor misclassification

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What is employee and worker classification?

Employee and worker classification refers to the status/classification of the worker from the point of view of the local government. It refers to the categorization of individuals working with an organization as employees and independent workers. There are two types of workers - employees (meaning the company holds more responsibility) and self-employed contractors.

A recent study estimates that between 10 and 30 percent of employers in the United States misclassify their employees, resulting in billions in tax losses for US tax authorities. 

In this blog, we'll take a glance at what exactly employee misclassification is, what consequences it can have for your company, and what measures you can take to avoid it. 

Let's dive in!

What exactly is employee misclassification? 

Employee misclassification is a judgment by a government regulatory agency (eg - tax authorities) or the courts that individual workers have not been classified correctly under the law. It often occurs when workers are given the wrong designation, whether by mistake or on purpose. In both situations, businesses face penalties.

In many cases, misclassification of employees occurs when resources are hired under a "service contract" or when there is no explicit contract. These workers may be referred to as "freelancers" or "independent contractors" rather than salaried employees. 

Note that an independent contractor is not the same as a sole proprietorship, although independent contractors often adopt this business structure. In some countries, the deliberate misclassification of employees is called "false hiring." 

It must be kept in mind that there is no uniform and internationally valid definition of “employee misclassification” as it is treated in a different manner in different states and countries. Furthermore, there is no single “proof” of employee misclassification. Several factors must be considered before it can be determined whether or not a person has been classified correctly. Let's discuss these factors in detail, but before that, let's see why misclassification is a risk.

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What are the risks of misclassification?

There are a number of laws, tests, and definitions that help companies determine whether an employee is an independent contractor or an employee. Unfortunately, these guidelines lack uniformity, are often very detailed, and can be interpreted in different ways. This makes it difficult to classify as workers who, after a series of tests or from the point of view of one person, can be considered employees, but others as independent contractors. 

The correct classification is important because employers are not required to provide general benefits such as health care, unemployment insurance, or minimum wage to independent contractors. Worker misclassification stems from the economic and business advantages of using independent contractors and a grey area of ​​competitive legal advice.

What are the risks of misclassification? 

Because labor laws vary from country to country, if you do not understand applicable labor laws, there is a risk that an employee on your distributed equipment will be misclassified. For whatever reason, misclassification of workers can lead to a number of negative (and potentially costly) consequences, including: 

Fines for non-compliance

The tax and labor authorities in the employee's country might impose fines if they find that employees from their country are misclassified during routine audits. The amount of fines and penalties vary from country to country. In some cases, both state and state regulators have the power to fine or take other action in case of worker misclassification. Although the range of possible fines can be wide, they can add up quickly when multiple workers are involved. 

Compensation for lost wages

Another penalty that is often imposed if your business is found guilty of employee misclassification is the re-compensation of wages. These can be refunds, social benefits, taxes, and employer contributions. All must be paid for the misclassification period. 

Civil action 

Possibly the major risk of all—employees who were or are misclassified as independent contractors (or who think they have been misclassified!). A misclassified employee can sue your company for misclassifying them. This often leads to lawsuits and audits by tax authorities to ensure compliance with applicable labor laws.

Damaged reputation

Employee misclassification can damage your company's reputation in public, especially if the employee reports their company to the local Department of Labor (DOL). The damages for misclassification of employees can result in a loss of revenue, as clients may not want to support a company with a dubious reputation. 

Criminal Sanctions

In the United States, the government can sanction the leaders of your company if it determines that the misclassification of workers was intentional. The deliberate employee or independent contractor misclassification can result in incarceration in addition to other penalties and payments.

Read More: Cost of an employee vs. cost of a contractor

Why is employee misclassification a problem?

There are certain issues that can arise as a result of employee misclassification. This type of worker exploitation can lead to public tax revenue losses and unfair competition. Here’s a brief explanation of these issues. 

Worker exploitation

One of the primary issues of misclassifying employees is that misclassification of employees as independent contractors prevent them from accessing employee rights and protection. Typically, employee rights and protections in most countries include;

  • Minimum wage
  • Pension plans
  • Unemployment benefits
  • Sick leave
  • Overtime pay
  • Rest breaks
  • Hour laws

Unfair competition

In case of independent contractors, the labor cost is low as companies need not provide them with mandatory benefits. By misclassifying employees as independent contractors, companies gain a financial advantage unfairly compared to the organizations that hire employees and provide them with all employee benefits like paid leave, insurance, and retirement contributions.

Public tax revenue losses

Classifying workers as contractors do not require employers to withhold their earnings for tax contributions to local tax authorities. Avoiding these taxes can lead to a significant loss of tax revenue. 

What factors dictate worker classification? 

The factor that dictates worker classification is the working relationship between workers and their hiring company. Here are a few aspects that work differently for an employee and an independent contractor. These show how the working relationship between an employee and the company differs from that between a contractor and the company. 

Work relationship - Typically, employees work with one employer, whereas independent contractors, self-employed, work with one or more clients.

Taxes - Employees and employers share taxes as employers withhold a specific amount from their gross pay for tax contributions. On the other hand, independent contractors withhold and pay their self-employment and income taxes.

Payment - Employees receive salaries through the company payroll, whereas contractors receive remuneration through invoicing.

Benefits - Employees receive certain mandatory benefits like health insurance and retirement contributions. However, independent contractors aren’t entitled to any mandatory benefits. 

Supervision- Managers directly supervise employees, whereas independent contractors require minimum supervision as they control their own processes. 

Considering these differences between employees and independent contractors, companies can correctly categorize their workers.

Read More: How to hire independent contractors: The ultimate guide

How to know if there's employee misclassification in your organization? 

The calculation of compensation for employee misclassification is not an exact science. What works well in one country may or may not work in another. However, regardless of your location, you generally need to prepare to reimburse workers for the benefits and social security contributions to which they would be entitled if properly classified. 

If you discover employee misclassification, there are some factors that can help you estimate how much you will owe:

  • For how long was the employee misclassified? 
  • What did you pay the employee? 
  • What would a person earn in a full-time position at your company doing similar jobs? 
  • What benefits of the company would you normally offer to an employee of this length? 
  • How much tax would you have paid on behalf of the employee? 
  • How much tax would the employee have been liable for? 
  • What are the government guidelines for penalties for misclassification? 

In addition to these questions, you should also consider whether you have identified the worker misclassification yourself. Once you've done this, you can avoid the harshest penalties and fines. However, if the government discovers the problem or the employee files a complaint, then the authorities can make you pay a hefty amount. 

How can this risk be reduced?

To mitigate worker misclassification risk, companies should carefully consider the following -

  • The considerations used by the tax authorities of their country to determine whether a person is an independent contractor or an employee; 
  • Seek legal advice on your employment contracts and pay from independent contractors; 
  • Implement internal systems and procedures to ensure that workers are treated according to their classification; 
  • Engage with an EOR to reduce the risk of workers being misclassified as contractors rather than workers.

Are there only two worker classifications?

There is a third worker classification as well. These workers qualifyfor employee treatment, but they act as independent contractors. This classification of workers is called statutory employees in the US. 

Statutory employees are independent contractors engaging with another contracting party. There is no client, hiring company, or employer. These independent contractors receive rights and protections like employees, such as minimum wage, rest breaks, and statutory time off. 

Ways to determine worker status

Depending on the country and jurisdiction, different classification tests classify workers accurately. Here are two common US-based tests for correct worker classification. 

Reasonable basis test

According to this test, you can classify workers as independent contractors on a reasonable basis. This test offers a generic baseline that shows how the IRS considers workers in similar situations rather than the relationship between specific employer and their workers.

Here are a few reasonable bases that justify a worker’s status as an independent contractor.

  • Workers in similar scenarios are considered independent contractors in your industry.
  • IRS audits did not discover any issue of worker misclassification 
  • Former official consultation with an attorney or CPA.

The ABC test

ABC is a common test to determine workers’ status codified by the California Supreme Court. It involves checking three critical elements of a business relationship to determine that independent contractors are not employees.

To qualify as an independent contractor, a worker must:

  • Perform the same type of work for other client organizations
  • Be free to choose their work methods and working hours
  • Work outside of a client’s daily business activities.

How do I avoid employee misclassification as an employer?

You can avoid employee misclassification by learning the local laws of the countries where your workers reside. For instance, the 1099 misclassification rules in the US are different from those of IR35 in the UK. 

Here are a few best practices to follow to avoid worker misclassification. 

  • Review your self-employed contractors’ contracts.
  • Take legal consultation from experts.
  • Correct and convert misclassified contractors to employees as soon as you identify them.
  • Use elf-check services and government resources.
  • Conduct worker misclassification training sessions for managers to ensure they assign contractors the right work.  

How to calculate employee misclassification?

There is no one formula to calculate the misclassification of employees. What works for one country may not work for another. However, regardless of the country, you must prepare to make corrections and adjustments for an employee if you misclassify them as independent contractors.

Here are a few factors that can estimate how much you owe to a misclassified employee.

  • What are the company benefits offered to an employee of that seniority level?
  • How long has the employee been misclassified?
  • How much taxes have been paid on behalf of the employee?
  • What government penalty guidelines are there for employee misclassification?
  • What have you paid the employee?
  • How much would an employee performing the same responsibilities earn in your company?

Additionally, consider whether you have identified the employee misclassification yourself. If yes, the amount of penalty will be less. If the government identifies it, you must pay the maximum amount as a penalty. 

How to correct employee misclassification?

After identifying worker misclassification, organizations must handle it responsibly. They must compensate the employee for all the mandatory benefits, taxes, and other perks. Further, the company must pay back taxes, pension contributions, and fines related to worker misclassification.

If companies attempt to terminate a working relationship with a misclassified employee to avoid the associated problems, the situation may worsen. Government actions can be much harsher upon finding that the company has intentionally broken the misclassification laws.  Hence, correcting worker misclassifications before the government finds out during audits is always better. 

Penalties for employee and independent contractor misclassification

The penalties for contractor and employee misclassification vary by country. However, certain generic penalties are prevalent in most countries. The company responsible for the worker misclassification must pay fines, penalties, back benefits, and back taxes to the employee and government. 

In several employee misclassification cases, even independent contractors may owe money to the government. This significantly impacts the company’s image and could result in further lawsuits filed by employees or contractors. As a result, the company may find it difficult to attract quality employees and contractors. 

Conclusion 

Employee misclassification occurs when a company classifies an individual employee as an independent contractor or self-employed for tax reasons and for employee benefits, although they would be classified more precisely as an employee. 

Employee misclassification carries great risks for companies. Incorrect classification of employees can lead to hefty taxes, penalties, fines, negative impact on company image, or additional damages. Hence, it is better to get the correct legal advice, hire an EOR like Gloroots, comply with local laws, and treat your employees correctly.

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