Insights into global expansion & employee retention

Published: November 9, 2022

How to Can US Companies Avoid Employee Misclassification Penalties?

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. Employers misclassify workers when they improperly classify them as independent contractors instead of employees, or vice versa. This misclassification can result in significant legal, financial, and reputational consequences for both employers and workers.

The blog post discusses the differences in legal status between employees and independent contractors. It also explains how governments determine whether someone should be classified as a worker. 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.

The distinction between workers as employees or independent contractors has been thoroughly scrutinized. The classification of workers as either employees or independent contractors has been deeply analyzed. Both categories of workers are vital to businesses. However, there are legal and financial consequences if employees are incorrectly identified as contractors, or the other way around.

This piece will delve into the hazards and repercussions of incorrect employee categorization, encompassing the significance of proper worker classification, employment laws and rules, along with the advantages and rights linked to being an employee.

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. Misclassified employees may not receive benefits like 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 related to employee misclassification.

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 implication

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 need to understand the tax consequences, such as income taxes, of incorrectly categorizing their employees and make sure they are properly classifying their workforce.This article will discuss the dangers and consequences of wrongly categorizing employees.

This article will discuss the dangers and consequences of wrongly categorizing employees. This article will talk about the risks and outcomes of misclassifying employees. It will emphasize the significance of properly categorizing workers, abiding by employment laws, and the advantages and entitlements that employees enjoy.

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. Misclassified employees may not get tax benefits like the earned income tax credit if they are labeled as independent contractors.

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. Businesses must follow the DOL guidelines. They should correctly classify their workers. This is to avoid legal and financial problems. These problems may arise from employee misclassification.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.

Two Men Looking at Employee Misclassfication Details

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 determines how the work is done? This is one of the questions that distinguish independent contracting from employment. Typically, contractors dictate their work, while the organization specifies how employees work.

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. This distinction is vital in avoiding problems associated with employee misclassification.

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.

They can be safely classified as contractors only if they truly work for themselves. An IRS audit can cancel a contractor agreement, even if the worker has already signed it. 

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

Form 1099-NEC is for freelancers and contractors who aren’t employees. Independent contractors get 1099 forms from the organizations they work 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 laws change for gig workers, companies need to know what’s at risk. 

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 for employee misclassification can be even more severe. In New Jersey, employers can get stop work orders if they don’t follow tax, benefits, and wage laws. Penalties can include fines.

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. Ensuring compliance is essential in mitigating risks associated with employee misclassification.

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. Employers who made mistakes in worker classification and want to fix them can qualify for this program. However, the rules for this program are strict. Employers can receive some help in fixing their mistakes.

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.

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

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. Remaining compliant is key to averting risks linked to employee misclassification.

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. Employers must follow Department of Labor rules and correctly categorize workers to prevent legal and financial problems. Properly categorizing workers guarantees they get the benefits they deserve, like health insurance, unemployment benefits, and overtime pay.

Employers must know labor laws in other countries where they work to follow local rules on worker classification and taxes. US companies can avoid legal and financial issues by understanding the risks and consequences of misclassifying employees. Additionally, they can ensure fair treatment of 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.

To protect a global business from accidental employee misclassification risks, work with an Employer of Record. EORs streamline and derisk remote hiring, allowing companies to focus on growth.

Playroll helps companies expand their teams worldwide and keep talented employees, with subsidiaries in over 170 countries, ensuring compliance.

You can book a demo to see our global platform in action. During the demo, you will discover how Playroll can help you expand globally. Additionally, you will learn how Playroll can accurately classify your workforce.

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