Why Are Employees Misclassified As Independent Contractors?
Some employers unintentionally misclassify workers due to a lack of understanding of local labor laws in a particular region, or don’t know the differences between employees and independent contractors.
Sometimes, employees are classifying workers as independent contractors because employers seek to reduce their labor costs. Independent contractors do not have the same rights as employees, meaning businesses can avoid paying for benefits like health insurance, unemployment insurance, and overtime wages.
Misclassification can also reduce the employer's obligation to pay employment taxes, for example Social Security and Medicare taxes in the U.S.
For employers, these apparent cost savings are not worth the risk: they can face significant repercussions if found guilty of misclassifying workers, especially if they do so knowingly.
What Are Employee Misclassification Penalties?
Misclassifying employees can lead to significant financial penalties for employers – it differs from country to country what these penalties consist of.
For example, in the U.S., the penalties include back wages for overtime and minimum wage violations, unpaid Social Security and Medicare taxes, as well as federal tax penalties for failing to withhold income taxes. The Department of Labor can impose fines for violating wage and hour laws, and in severe cases, employers may face criminal charges or class action lawsuits. Additionally, companies could be required to pay workers for missed benefits, such as health insurance and retirement contributions.
How Do You Differentiate Between An Employee Or Independent Contractor?
Correctly distinguishing between employees and independent contractors depends on local employment law in a specific country. That said, check out our table below on some common ways to differentiate between employees and contractors:
In the U.S., the Department of Labor and the IRS use several criteria to correctly classify different types of workers. Some common tests used to distinguish between workers in the U.S. include the common-law test, the Economic Reality test and the reasonable basis test. Read our full guide on the subject here.
How Can You Avoid Employee Misclassification?
These guiding principles can help employers to avoid employee misclassification:
- Employers must have a good understanding of local labor laws in any country where they are operating, to ensure they are correctly classifying workers. In the U.S., this means having a thorough understanding of federal and state employment laws. This requires analyzing the degree of control over the worker, the nature of the work, and how integral the worker's role is to the business.
- Regularly review job roles, contracts and contractor agreements to ensure compliance with labor standards and, when in doubt, consult legal experts.
- Provide training for HR and payroll staff to recognize misclassification risks.
- Make use of EOR services such as Playroll, who are experts in global employment, contractor management and making sure your workers are correctly classified. They can provide guidance on compliantly hiring employees or contractors in 180+ regions, removing the need for the employer to stay up-to-date with ever-changing compliance regulations.
What Are Examples of Employee Misclassification?
An example of employee misclassification is when a delivery driver works full-time for one company, follows a set schedule, uses company equipment, and is subject to detailed oversight, but is classified as an independent contractor.
Another example could be a web developer who works on-site for a company, adheres to the company’s work hours, and receives direct instructions on how tasks should be completed but is wrongly classified as a contractor.
In both cases, these workers should likely be classified as employees due to the level of control and dependence on the company.
As a real-world example: In 2015, FedEx reached a $228 million settlement in a legal case around the misclassification of 2,300 Californian drivers as independent contractors.
Employee Misclassification FAQs
How do you correct employee misclassification?
To correct misclassification, the employer must reclassify the worker as an employee and provide any back pay for unpaid wages, overtime, and benefits. For example, in the U.S., employers should file the necessary payroll and tax adjustments and might need to retroactively pay Social Security and Medicare taxes.
Is employee misclassification illegal?
Yes, misclassifying workers can be illegal, especially if done intentionally to avoid tax and labor law obligations. Violations can lead to fines, back pay, and other penalties.
What protections are employees denied when misclassified as contractors?
Misclassified employees lose access to essential benefits. For example, in the U.S., this includes health insurance, unemployment benefits, overtime pay, and protections under labor laws like the Fair Labor Standards Act (FLSA).
Can employers face criminal charges for misclassification?
In extreme cases, where employee misclassification is part of a willful scheme to evade taxes and labor laws, employers may face criminal charges, particularly for large-scale violations.
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