2024 Guide to Employee Misclassification For Global Employers

Learn how to avoid employee misclassification and correctly classify independent contractors. Ensure compliance with this comprehensive guide for global employers.

Contractor Management

Marcelle van Niekerk

October 4, 2024

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Key Takeaways

Employee Misclassification can result in fines, penalties and reputational harm to your business.

Your business can be found guilty of employee misclassification regardless of the label used in the contract an independent contractor entered into.

Staying up-to-date on local labor laws, converting contractors to employees, and seeking expert help are some ways to avoid employee misclassification.

Considering hiring independent contractors to get projects completed, quickly? You have a vast talent pool to choose from: Since the global pandemic and rising popularity of remote work, the gig economy has seen a significant uplift. In 2022, a McKinsey’s report found that 36% of employed Americans were independent workers – with this number only expected to increase.

Hiring freelancers holds many benefits for businesses, including flexibility and cost savings. However, it’s crucial to hire independent contractors compliantly – and for the correct reasons. Many businesses fall into the trap of misclassifying employees as independent contractors to avoid employer liabilities such as paying benefits and employer taxes, or to skirt their obligations surrounding the termination of the relationship.

This can expose businesses to hefty penalties, legal consequences and reputational harm. Given the publicity of high-profile misclassification cases involving large corporations, coupled with workers becoming more knowledgeable on their rights, many governmental authorities are clamping down on the issue of misclassification.

In this guide, we’ll break down how to distinguish between employees and independent contractors. Remaining compliant while hiring remote workers is easier when partnering with experts in global employment, such as Playroll. We’ll give you our top compliance tips and what to watch out for when hiring freelance workers, straight from our legal experts.

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What Is Employee Misclassification and Why Does It Matter?

Employee misclassification is the incorrect categorization of a worker as an independent contractor when they should be classified as an employee due to the true nature of the relationship, regardless of the type of contract they had entered into. This misclassification occurs when companies fail to meet legal criteria that distinguish employees from contractors.

Why is this problematic?

A loss of employee benefits: Employment laws and labor standards, such as tax obligations, health insurance, and workers' compensation, termination requirements, obligations, rights and procedures, differ between employees and contractors. If they’re misclassified, employees miss out on key benefits and protections.
Lost revenue: When misclassifying workers, employers may not withhold the requisite amount of employment taxes required by law. Government agencies take this particularly seriously, as it means a loss of income for them. By some estimates, $3-4 billion is lost annually due to misclassification.
Fines and penalties: Misclassification can result in violations of labor law and costly penalties for businesses. This could even include court orders for retrospective reinstatement (with back-pay) of the individual as an employee of the company.

Employee misclassification is particularly challenging because the criteria for determining employment status vary between countries and states.

For example, a worker classified as a contractor in the US may be seen as an employee in the UK based on local labor standards. Because these rules can be complex, many businesses rely on expert assistance to ensure compliance across different jurisdictions.

Important To Know

As a business, you shouldn't focus solely on how the contract with the individual is defined – i.e. simply whether the individual is labeled as an employee or independent contractor. In many countries, a “substance over form” principle is followed. This means that the objective reality of the relationship is considered and the relationship type is not merely determined by how it's labeled in a contract.

For example, a contract with an individual may be called an “independent contractor agreement”. However, a court or the government authority may find that the true nature of the relationship between the parties is actually one of employment.

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What Are The Differences Between Independent Contractors and Employees?

To avoid misclassifying employees as independent contractors, you first need to know how to distinguish between them. Here are the key differences:

Tax Obligations

Employees have income tax automatically deducted from their wages, while contractors are responsible for their own tax filings.

Degree of Control

Employees follow strict guidelines from their employer on how and when to perform their tasks, while contractors have more flexibility and autonomy.

Intellectual Property (IP) Protection

IP created by employees typically belongs to the employer, while IP created by contractors remains their own unless specified in contracts.

Employee Benefits and Protections

Employees are entitled to mandatory benefits such as health insurance, unemployment insurance, and workers' compensation, while contractors usually do not receive these same benefits.

Employees are also generally entitled to protection from discrimination and harassment, whilst contractors may not be afforded the same level of protection.

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Employee vs. Contractor Compliance Checklist

Correctly distinguishing between employees and contractors can get surprisingly complex: several tests exist for this reason, for example the Economic Reality Test test in the U.S.

There are, however, some common hallmarks of misclassification. Here’s your checklist of the most common questions that government authorities use to determine misclassification. If you’ve hired a contractor and find your answers aligning with the characteristics of an employee, it’s a red flag that they may be misclassified:

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Question	Employee	Contractor
Who decides when the work is performed?	The employer sets the schedule	The individual decides
Who provides the equipment?	The employer provides equipment such as a laptop	The individual provides their own equipment
Who is required to perform the work?	Personally performed by employee	The work can be outsourced or subcontracted
How is the worker paid?	Fixed salary or hourly	Paid per project or on the presentation of an invoice
Is there economic dependence?	The employee is economically dependent on the employer	No economic dependence
How important is the work to the business?	Integral to business operations	Not central to operations
Is training provided?	Training is usually provided	Generally, no training is offered
What is the length of the relationship?	Ongoing	Generally defined by project duration

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The Risks of Employee Misclassification

There are several risks to employee misclassification, whether unintentional or not – though the repercussions tend to be most severe if government authorities find that a business has intentionally misclassified workers or committed fraud.

Some of the repercussions can include:

Fines: Governments impose financial penalties for failing to classify workers correctly.
Reputational Damage: Misclassification cases can cause significant harm to your business reputation, especially if employees publicly sue for backpay or benefits.
Potential Legal Battles: Misclassified workers may take legal action, leading to costly lawsuits.
Back-pay to Employees: Employers may need to compensate misclassified employees for lost benefits, overtime, or wages, with the additional risk of reinstatement.
Operational Disruption: Legal battles and regulatory investigations can distract from day-to-day business operations, affecting your business’ productivity.

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Which Industries Are Most Susceptible To Misclassification?

Whilst any industry is susceptible to employee misclassification, some industries have longer standing practices of misclassification than others or it’s generally more common.

For example, businesses in sales, IT, high-tech, hospitality, entertainment, logistics and construction industries should be especially aware of misclassification risks.

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Penalties for Misclassifying Employees as Independent Contractors

Penalties for employee misclassification differ between countries but can include financial fines, tax penalties, and reputational damage. For example:

United States

The IRS imposes heavy fines for unpaid payroll taxes, along with penalties for failure to provide benefits like health insurance or workers' compensation. The Wage and Hour Division of the U.S. The Department of Labor also actively pursues claims. For example, you can be subject to a $50 fine for each unfiled Form W-2, or charged a percentage of wages.

Check out our full guide to U.S. misclassification penalties.

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United Kingdom

Companies may face penalties under the UK’s Employment Rights Act, including paying back-pay for lost wages, holiday pay, and missed pension contributions.

European Union

Penalties vary but may include large fines, repayment of lost unemployment insurance benefits, and damage to the company’s standing with labor unions.

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What Are Examples of Employee Misclassification Penalties?

Several notable legal cases highlight the consequences of misclassifying employees:

FedEx was ordered to pay millions in fines and back-pay after it was found to have misclassified drivers as independent contractors.
The UK Supreme Court ruled that Uber drivers were employees, entitling them to minimum wage, holiday pay, and other benefits.
Nike faces potential tax fines of more than $530m, as they may have misclassified thousands of temporary office workers.
Microsoft paid $97 million to settle a lengthy lawsuit involving thousands of workers claiming they were entitled to employee benefits.

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How to Avoid Employee Misclassification as an Employer

There are several measures you can take as a business to avoid the pitfalls of misclassification. These include:

Create airtight independent contractor agreements (and abide by them)

Ensuring compliance and the correct classification starts at the recruitment and onboarding stages. When hiring contractors, make sure your contractor agreement is set up correctly in line with local labor laws. It should cover, amongst others (see checklist above):

The terms of engagement and type of work they’ll perform
The hours they’ll work or the length of the project
IP Protection and confidentiality

In a worst-case scenario, a robust contractor agreement can be used in your defense in legal cases – assuming you truly haven’t misclassified the worker.

Whilst the content of the contractor agreement is important, employers should still be aware of the “substance over form” principle, discussed above, and determine if it is applicable in the countries in which they hire individuals.

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How We Tick The Box On Compliance

At Playroll, you can rely on up-to-date expertise – layered on top of intuitive technology that features built-in compliance. Here’s how we shield you from misclassification in practice:

On-the-ground legal and tax experts in 180 regions, to inform you of shifting regulations in any market.
Clear contractor agreements that protect your IP rights.
Track working hours, expenses and more in real-time so you’re never out of the loop.

Book a chat with our experts here to find out how we can ensure your team is correctly classified.

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Stay updated on local regulations

Employment laws are constantly evolving, especially in the context of remote work.

Spend time researching local regulations for the regions you’re interested in, before taking the next step and hiring an independent contractor or employee.

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Run internal audits

Regularly review the status of all your workers to ensure they are correctly classified. Make sure this forms part of your standard policies or procedures, and assign ownership of the audit to a specific person or department so these checks don’t fall through the cracks of your business.

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Convert contractors to employees

If a contractor's role has evolved to more closely resemble that of an employee, consider offering them a formal employment contract. This can also hold the following benefits:

It provides the worker with the benefits and protections they’re entitled to, which can boost employee satisfaction and retention.
They will become an integrated member of your team and wider company culture.
You can better safeguard your company data and IP.
You’ll be able to assign them work that is more critical to your business.
You can ensure that your business remains compliant.

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Seek expert help

It can take significant time and resources to stay compliant as a global business when hiring remote workers. That’s why many businesses choose to use global employment services like Playroll, that have experts on-hand to help you make sense of local labor laws and stay fully compliant when hiring across borders.

I always feel completely calm and safe with Playroll, which is very important to me and the people we employ. I have complete trust that everything is done by the law.

Violeta Cirkovic, HR Generalist, Two Desperados

Read Case Study

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Ensure Global Compliance When Hiring Independent Contractors with Playroll

Employee misclassification can get complicated, but it doesn’t have to be a bottleneck to scale your global team.

Playroll can help businesses sidestep employee misclassification risk by ensuring compliance with employment laws in over 180 countries. No matter what type of worker you want to hire, Playroll’s team of experts will do the heavy-lifting to ensure your workforce is correctly classified and compliant – freeing you up to focus on your business growth.

Book a free chat with our team and get a compliance consultation, to ensure your business is not at risk of misclassification.

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Employee Misclassification FAQs

How can misclassification impact a company’s taxes?

When a business misclassifies an employee as an independent contractor, it may fail to withhold the necessary payroll taxes, such as income tax, Social Security, and Medicare. This can result in the company being liable for unpaid taxes, including penalties and interest. The business may also face additional scrutiny from tax authorities, potentially leading to audits.

What should a company do if it realizes it has misclassified an employee?

If a company discovers that it has misclassified an employee, it should take immediate action to correct the classification. This includes reclassifying the worker as an employee, issuing corrected tax forms, and paying any outstanding taxes or benefits. An EOR service such as Playroll can assist with the process of converting independent contractors to full-time employees.

What is the role of government agencies in addressing misclassification?

Various government agencies, such as the IRS in the U.S. or HMRC in the UK, monitor employee classification to ensure businesses are complying with tax and labor laws. These agencies can conduct audits, impose fines, and require companies to provide back pay and benefits to misclassified employees. In some cases, workers themselves can report suspected misclassification to these agencies.

What are the penalties for employee misclassification?

Penalties for employee misclassification can vary depending on the jurisdiction but may include fines, back taxes, retroactive benefits payments, and legal fees. In severe cases, companies can also face lawsuits, including class-action suits, and damage to their reputation.

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What is the difference between an employee and an independent contractor?

Employees typically work under the direct control and supervision of their employer, receiving set wages and benefits such as health insurance, and they are subject to company policies and procedures. Independent contractors, on the other hand, offer services on a more flexible basis, manage their own working hours, and are often paid per project rather than receiving a regular salary.