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Published: November 9, 2022

Employee or Contractor? Guide to Employee Misclassification for US Companies

What’s in a name? When it comes to classifying workers, everything. Accurate categorisation of workers in line with IRS guidelines is a critical priority for all companies. Misclassifying employees as independent contractors deprives workers of employee protections such as leave, insurance and social security. It also robs federal and state coffers of tax revenue.

This blog provides a comprehensive overview of the issue of employee misclassification in the United States. Employee misclassification occurs when a worker is improperly classified as an independent contractor rather than an employee, or vice versa. This misclassification can result in significant legal, financial, and reputational consequences for both employers and workers.

The blog post begins by discussing the legal differences between employees and independent contractors, including the factors that federal and state governments use to determine worker classification. It then delves into the potential risks and consequences of misclassification, such as unpaid wages, penalties, and legal liability for employers.

Employee misclassification: Understanding the risks and consequences for US companies

As businesses in the United States continue to expand and evolve, so do the methods by which they engage workers. One area that has been the subject of significant scrutiny in recent years is the classification of workers as either employees or independent contractors.

While both types of workers can provide valuable services to companies, there are important legal and financial implications associated with misclassifying employees as contractors, or vice versa. In this article, we will explore the risks and consequences of employee misclassification, including the importance of correctly classifying workers, labor laws and regulations, and the benefits and entitlements associated with employee status.

Department of labor and labor laws

The Department of Labor (DOL) is responsible for enforcing labor laws that regulate worker classification, overtime pay, and employee benefits, among other issues. The Fair Labor Standards Act (FLSA) is a federal law that establishes minimum wage, overtime pay, recordkeeping, and child labor standards for employees in the private and public sectors.

According to the FLSA, an employee is defined as “any individual employed by an employer,” while an independent contractor is defined as “any individual who is in business for himself or herself (including a partnership or corporation) and who is not subject to control or direction from the employer.”

It is important to note that employers who misclassify workers may be subject to legal and financial penalties, including back wages, fines, and legal fees. In addition, employees who are misclassified may be denied certain benefits and entitlements, such as health insurance, unemployment insurance, workers’ compensation, and overtime pay. Therefore, it is crucial for businesses to be aware of the guidelines set forth by the DOL and to properly classify their workers to avoid potential legal and financial issues.

Employee benefits when being classified as an employee

One of the primary benefits of being classified as an employee is access to employee benefits, such as health insurance, sick leave, and workers’ compensation. Employers are generally required to provide certain benefits to their employees, including unemployment insurance and minimum wage. Employees may also be entitled to other benefits, such as retirement plans, disability insurance, and vacation time.

Independent contractors are not entitled to employee benefits, and may need to purchase their own health insurance or other benefits. They are also responsible for their own tax obligations, including paying self-employment tax, which includes social security and Medicare taxes.

Tax implications

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 paying their own taxes and are not subject to tax withholding. Employers should be aware of the tax implications, such income taxes of employee misclassification and ensure that they are correctly classifying their workers.

If an employer misclassifies an employee as an independent contractor, 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 tax authorities. In addition, employees who are misclassified as independent contractors may be denied access to certain tax benefits, such as the earned income tax credit.

Employee misclassification in other countries

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.

Overtime pay and sick leave

In addition to minimum wage requirements, the FLSA also establishes overtime pay requirements for employees who work more than

40 hours in a workweek. Employers are required to pay eligible employees 1.5 times their regular rate of pay for each hour worked over 40 hours in a workweek. Independent contractors are not entitled to overtime pay, as they are not considered employees.

Sick leave is another benefit that is typically provided to employees, but not to independent contractors. Some states and cities have sick leave laws that require employers to provide a certain amount of paid or unpaid sick leave to their employees. These laws may also have specific requirements related to employee classification, such as the number of hours worked or the length of employment.

Remote workers and employee misclassification

Remote hiring carries a heightened risk of misclassification, for a number of reasons. Companies don’t pay tax on a contractor’s behalf, so there is a clear incentive for companies to categorise their remote or foreign workers as contractors.

In addition to this, the nature of remote work leads to some ambiguity. People who work from home, using their own tools (hardware or software), appear to enjoy a level of independence that suits contractors more than employees. 

In this guide we will cover the following topics to help companies and employees to navigate employee misclassification risk.

  • Misclassification myths: busted
  • What happens when employees are misclassified
  • For workers: what to do if you’re misclassified as a 1099
  • For employers: how to guard against misclassification risk

Myths and misconceptions about misclassification

Let’s begin by dispelling some common misconceptions about the differences between employees and independent contractors. 

Myth 1: all remote or teleworkers are independent contractors

Who controls how the work gets done? This is one of the questions that distinguish independent contracting from employment. Typically, contractors control how they work, while employees work in a way that is specified by the organization.

When workers work from home, it may seem as if they are exerting control over the where and the how, and are therefore independent contractors.

But it’s fully possible for an employer to control the way in which an employee performs their work, even if they work remotely.

Being off-site is not, in itself, adequate grounds for deciding independent contractor status. If a company controls how the work is done or reserves the right to be able to do so, the relationship usually qualifies as employment. 

Myth 2: An independent contractor agreement was signed, on the dotted line. Case closed.

Any agreement that exists between the worker and the organization is a relevant factor in the process of evaluating the relationship. But it’s not the only factor. In fact, it’s not even the most important one.

In terms of both the Fair Labor Standards Act and the Family and Medical Leave Act, a worker is an employee if they are economically dependent on the employer.

Only if they truly work for themselves, can they be safely classified as contractors. It is possible for an IRS employee misclassification audit to void an independent contractor agreement, even one that the worker has signed. 

Myth 3: Anyone who receives a 1099 is an independent contractor.

Form 1099-NEC (non-employee compensation) is used for reporting payments to independent contractors. Independent contractors receive 1099 forms from the organizations they perform services for.

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

The IRS lists more myths about employee misclassification on its website. 

What happens when companies misclassify workers? 

As federal and state legislatures move to tighten loopholes around the gig economy, it’s more important than ever for companies to understand what’s at stake. 

Penalties: domestic and international

US companies who misclassify remote workers within the United States face heavy penalties:

  • $50 fine for each W-2 that should have been filed in the past
  • Up to 3% penalty on wages
  • Up to 40% of FICA taxes that should have been withheld
  • Up to 100% of matching FICA taxes the employer did not pay

In cases where an employer knowingly flouted the law, penalties can be even more severe. And penalties aren’t limited to fines: in New Jersey, employers can face stop work orders for failing to comply with laws around tax, benefits and wages.

Complexity multiplies for companies that work with international teams. Each country has its own rules and enforcement mechanisms to protect workers from misclassification.

In some countries, this can include hefty fines along with additional retrospective payments for benefits. The reputational damage that accompanies misclassification is a further factor to consider.

While it may be harder to quantify, its effects are equally significant, if not more so.

Voluntary Classification Settlement Program

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. The eligibility requirements for this program are strict, but it does offer some relief for employers who have blundered in worker classification and express a desire to make redress.

What to do if you’re misclassified as a 1099 freelancer

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.

Then, they should use Form 8919: Uncollected Social Security and Medicare Tax on Wages to determine how much is owed on Social Security and Medicare taxes.

How to avoid misclassifying your team

Staying on the right side of classification rules requires ongoing attention to detail and complete transparency in defining job roles. The IRS uses a three-part test that companies should be familiar with:

Behavioural Control: This part of the test answers the question: does the company control how the worker completes the work?

Financial Control: For this part, the IRS considers the financial dependence of the worker on the business of the company. For example, is the worker able to make his or her services available in the relevant market? Does the company reimburse expenses and cover the costs of necessary tools and supplies?

Relationship of the Parties: The final part of the test examines the way the parties interact. 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?

For a more detailed examination of compliant classification for payroll officers and HR personnel by region, check out our global guide.

Understanding employee misclassification: Ensuring compliance and fair treatment for workers

Employee misclassification is a complex issue with significant legal and financial consequences for US companies. It is crucial for employers to understand the guidelines set forth by the Department of Labor and properly classify their workers to avoid potential legal and financial issues. Correctly classifying workers also ensures that employees receive the benefits and entitlements they are entitled to, such as health insurance, unemployment benefits, and overtime pay.

Employers should also be aware of the labor laws in other countries where they operate to ensure compliance with local regulations related to worker classification and tax obligations. By understanding the risks and consequences of employee misclassification, US companies can protect themselves from potential legal and financial problems and ensure fair treatment for their workers.

Classification hole-in-one with Playroll

Navigating all of this is hard enough within one country. When companies expand across borders, the complexities – and risks – mount.

The best way to secure a global business against the risks of unintentional misclassification is to partner with an Employer of Record. EORs streamline and derisk remote hiring, allowing companies to focus on growth.

With a network of international subsidiaries spanning over 170 countries, Playroll enables companies to expand their teams globally and retain talent, easily and with full compliance.

Schedule your demo to see our technology-enabled global platform up close, and find out how Playroll could become your strategic partner in expanding your global reach and accurately classifying your workforce.

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