How To Avoid Penalties For Misclassifying Employees In The United States

Why should businesses care about the risks of misclassifying employees as contractors?

In recent years, the gig economy has seen a sharp increase as employers enjoy the flexibility of hiring skilled workers on a project-by-project basis.  However, between 10-30% of US employers are misclassifying their workers, according to the National Employment Law Project. 

There are a few reasons the authorities take this especially seriously:

• A loss of revenue on income taxes: When misclassifying workers, employers may not withhold the correct amount of employment taxes required by law. By some estimates, $3-4 billion is lost annually due to misclassification.  
• A loss of employee benefits and protections: Misclassification deprives employees of their statutory benefits and employee protections, such as leave, insurance and social security, leading to potential reputational harm and legal fallout for you as an employer. 
• Employers who misclassify their employees could gain an unfair advantage over compliant businesses by avoiding certain required employer costs and legal obligations.

While this guide focuses on U.S. regulations, businesses operating internationally should be aware that employee misclassification carries similar risks across many countries, with varying legal frameworks.

What are the differences between employees and independent contractors in the U.S.?

There  are several distinct differences between full-time employees and independent contractors. Here’s a summary of the key differences:

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The penalties of misclassifying employees as independent contractors in the U.S.

If an employer misclassified workers as independent contractors, they may be required to pay back taxes, penalties, and interest on unpaid taxes. Employers may also be subject to legal action by the Internal Revenue Service (IRS) or other US tax authorities. Misclassified employees may not get tax benefits like the earned income tax credit if they are labeled as independent contractors. 

Here are all the potential consequences of employee misclassification:

Civil Penalties

Misclassifying employees as independent contractors can trigger IRS audits. If the misclassification is deemed unintentional, civil penalties include:

• A $50 fine for each unfiled Form W-2.
• 1.5% of wages, along with 40% of unpaid FICA taxes (Social Security and Medicare), plus the employer’s full share of FICA taxes.
• Interest penalties on these amounts, accruing from the due date.
• A failure-to-pay penalty of 0.5% per month, up to 25% of the total tax liability​.

Additional penalties for fraud or intentional misconduct

If the IRS identifies fraudulent intent, additional penalties may include:

• 20% of wages.
• 100% of FICA taxes (both employer and employee portions).
• Criminal fines up to $1,000 per misclassified worker and possible imprisonment​.

Class-action lawsuits and back pay

Employees can sue for back wages, including unpaid overtime and benefits, if misclassified. This may involve costly retroactive compensation for benefits like health insurance and retirement plans that the employee was entitled to​

Damage to your reputation

Besides pure financial cost, the long-term effects of being found guilty of employee misclassification can be devastating. Bad press, drawn out legal battles and the impression that you are treating workers unfairly will impact your ability to attract new talent and retain your existing staff. 

Examples of misclassification penalties

How have cases of misclassification played out in practice? These prominent legal cases highlight how hefty the consequences of misclassification can get:

• In 2022, Uber and its subsidiary, Rasier LLC, paid $100 million in unpaid state payroll taxes and penalties in New Jersey, after being convicted of misclassifying nearly 300,000 drivers.
• Nike faces potential tax fines of more than $530m,  as they may have misclassified thousands of temporary office workers.
• FedEx paid a $228 million settlement in a lawsuit alleging that they had incorrectly classified more than 2000 drivers in California. 

How to determine if your worker is an independent contractor or an employee in the U.S.

So, how can you be certain that you’re classifying your workers correctly? It can get surprisingly complicated to distinguish correctly between employees and independent contractors. 

There are a number of tests in the US that can guide employers to distinguish correctly between the two. Two of the most relevant tests that businesses can use include:

Common-law test

The IRS distinguishes between workers under common-law rules according to the categories of behavioral control, financial control and the relationship between parties. Some questions the IRS asks as part of this test includes:

• Does the company control how the worker completes the work?
• Does the company reimburse expenses and cover the costs of necessary tools and supplies?
• What is the nature of the written agreements between the worker and the company? 
• How permanent is the working relationship? 
• Is the work integral to the business of the organization?

Get more details on the questions the IRS asks for each of these categories here. 

Companies and individuals can also file IRS Form SS-8, requesting that the IRS conduct an official audit to determine a worker’s status.

The Economic Reality Test

In January 2024, the Department of Labor (DOL) published a final rule revising how employees and independent contractors are classified under the Fair Labor Standards Act (FLSA). The final rule looks at these six factors when distinguishing between contractors and employees:

• Opportunity for profit or loss depending on managerial skill
• Investments by the worker and the potential employer
• Degree of permanence of the work relationship
• The nature and degree of control
• The extent to which the work performed is an integral part of the employer's business

Get more details on the economic reality test here.

The reasonable basis test

This test looks at how the courts and the IRS have classified similar workers in your company or your industry in the past, rather than examining the nature of the working relationship. There are several conditions in this test, that could mean you have a reasonable basis for classifying a worker as a contractor. 

These include, for example:

• A court ruling exists that treats workers in similar circumstances as non-employees.
• There is a past IRS payroll audit that didn't find workers in similar positions at your company to be employees.

Get more details on the reasonable basis test here.

How Other Countries Handle Employee Misclassification

Employee misclassification is not unique to the United States and is an issue in many countries around the world. Employers should be aware of the labor laws in the countries where they operate and ensure that they are correctly classifying their workers. 

Many countries have laws and regulations that are similar to those in the United States, such as tax obligations for employers. In addition, some countries have specific laws and regulations related to worker classification that employers must follow.

Avoid The Risks Of Employee Misclassification With Playroll

Employee misclassification is a complex issue with significant legal and financial repercussions for US companies. One way to avoid the penalties of misclassification, is to partner with a team of experts that know the rulebook when it comes to compliance.

An Employer Of Record like Playroll removes the risk of hiring full-time employees and contractors alike, in the United States and beyond. Dedicated legal and HR experts will help you correctly classify your workers, and convert contractors to employees if needed.

Playroll helps companies expand their teams worldwide and keep talented employees, with a robust infrastructure of established entities in over 180 countries, ensuring ongoing compliance.

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