How To Avoid Penalties For Misclassifying Employees In The United States

The penalties for misclassifying employees as independent contractors can be steep, including fines, back pay, increased scrutiny by government authorities, potential lawsuits – and a ruined reputation. Here’s your full guide on the penalties of employee misclassification in the United States, and how to avoid it.

Legal and Compliance

Marcelle van Niekerk

September 5, 2024

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Key Takeaways

Hiring independent contractors has boomed in recent years due to the flexibility and cost savings it offers employers. However, misclassifying them can result in hefty penalties and reputational damage for your business.

This guide will focus primarily on employee misclassification penalties in the U.S., with specific references to IRS regulations. However, since this is a global issue, we will also explore how other countries address misclassification – and how you can stay compliant with the help of experts in global employment such as Playroll.

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 differences between independent contractors and employees
	Employees	Independent Contractors
The nature of work	Employees are appointed with the intention of performing work in the long-term for a single employer, often with no fixed end date to the employment contract.	Contractors are hired for short-term work on a project-by-project basis, often with a fixed end date attached to a contract. They can work for multiple employers.
Control	Employers have more oversight when it comes to the work performed by employees.	Contractors have more freedom to conduct the work as they see fit, since they are in business for themselves.
Employee benefits	Full-time employees have access to mandatory employee benefits and protections. In the United States, this includes Medicare, Social Security, unemployment insurance, and workers' compensation, as well as overtime pay, a set minimum wage and paid or unpaid sick leave.	Independent contractors are not entitled to employee benefits or protections, and may need to purchase their own health insurance or other benefits.
Income tax	Employers are responsible for withholding and paying certain taxes for their employees, including income tax, social security taxes, and payroll taxes.	Independent contractors are responsible for their own tax obligations, including paying self-employment tax, which includes social security and Medicare tax.

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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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Employee Misclassification FAQs

How can companies remedy worker misclassification?

Within the US, the IRS offers a way for companies to manage the costs of misclassification. Companies who successfully enter the Voluntary Classification Settlement Program agree to treat misclassified workers correctly for future tax periods.

These companies pay less of the employment tax liability than they would ordinarily have incurred. Employers who made mistakes in worker classification and want to fix them can qualify for this program.

What to do If you’re misclassified as a 1099 freelancer instead of a W2 employee?

The IRS offers remedies for people who have worked as employees but under an incorrect classification. They can begin by requesting a determination of worker status using Form SS-8.

To determine the amount owed for Social Security and Medicare taxes that were not collected from wages, use Form 8919.

Is a worker classified as an independent contractor if they receive a 1099-NEC Form?

Form 1099-NEC is a tax form that reports income payments made to non-employees, and is used by contractors and freelancers to report their income and file taxes.

But a worker receiving a 1099 is not, in itself, the defining factor. All the usual considerations come into play during an IRS audit, especially the question of who controls the work.