Understanding Employee Misclassification: Navigating the Fine Line between Independent Contractors and Employees

Employee misclassification is a common yet complex issue that can affect both employees and businesses. In a time where workforces are scattered across the world, it can be more challenging than ever to differentiate between contractors and employees. 

The risk of misclassification is particularly pertinent in the tech world, with talent working on tech jobs across territories. 

What is employee misclassification?

The classification of each employee involves legally defining the relationship that a company has with their worker. The classification that you assign to each employee will impact on a range of facts, from employee benefits to the taxes that the company owes, and how the worker provides their service on a day-to-day basis. 

Why does it matter?

Misclassification of employees arises when a business gives someone who is, by law, a worker, the classification of independent contractor or freelancer, instead of that of permanent employee. For businesses, the lure of using contractors and freelancers is significant; contractors tend to cost less in the long term as they do not receive benefits such as holiday and sick pay or pension packages, and they are easier to manage, hire and fire. By misclassifying employees, companies can save huge amounts in taxes, depriving the states and federal governments of millions – potentially billions – of dollars in revenue. It’s not just the state that misses out; employees that are misclassified are not protected by employment laws including workers’ compensation, wage and hour laws, and unemployment benefits. 

The penalties of misclassification

The problem of misclassification is not unique to the United States. Governments across the world are constantly adjusting their guidelines to accommodate increasingly flexible working patterns, with many governments focusing on the intentional or unintentional misclassification of employees and the impact on the workforce and state income. 

As such, most countries have implemented stringent penalties for organizations that fall foul of employee classification. The penalties vary depending on the location and nature of the violation, but in the US the most serious penalties of misclassification are:

• Wage, tax, and employment eligibility violations
• Tax and payroll fines
• Legal and punitive damages

Wage, tax, and employment eligibility violations

There are a number of ways to assess whether a worker is an employee or a freelancer or contractor. Depending on whether the investigation is being led by the federal or state government, or a particular government agency, different classification parameters will be applied. This of course makes it more complicated for organizations to make sure that they classify correctly, and it makes it easier for employers to intentionally – or unintentionally – misclassify employees and find themselves in violation of tax, wage and eligibility requirements. Organizations found to misclassify can be penalized for failure to pay minimum wage and overtime under state laws as well as the FLSA (Federal Fair Labor Standards Act). If an employer is found to have deliberately misclassified, payments can go back for up to three years. 

Tax and payroll fines

Perhaps the most obvious impact of misclassification is tax and payroll penalties. By misclassifying, employers avoid paying Social Security and Medicare, as well as state and federal payroll taxes. Another requirement is that employers keep I-9s for every employee to prove eligibility for employment. If found in violation of this, fines can run into the millions, as DoorDash discovered in 2021. There are additional fines for incorrect filing of I-9s, or for failing to have I-9s for misclassified employees. 

The risk doesn’t stop there; if the IRS can prove that an organization has intentionally misclassified, those responsible could be at risk of criminal or civil action. 

Legal and punitive damages

Organizations may save a large sum of money by misclassifying their employees, but class action lawsuits that are likely to arise when organizations are exposed can make the risks far outweigh the financial gains. 

How to avoid misclassification and protect your business

Aside from the drain on resources and time, the huge risk to reputation is often one that companies can’t afford not to take. It is, therefore, important that organizations do their best to identify existing potential misclassifications and avoid subsequent employee misclassifications in the future. In order to do this, companies need to:

• Continually review classification processes. With HR environments constantly changing and confusing, often conflicting, guidelines, it is vital that an organization can demonstrate up to date, reviewed processes so that if they do unintentionally misclassify, they can mitigate the error. 
• Invest in specialist advice. In order to avoid doubt about employee classification, it can pay to have an HR specialist that is responsible for reviewing employment contracts and assessing and auditing how contractors are paid. 
• Keep records of classifications. Amid confusing and conflicting guidelines, it is important that you hold appropriate records of each employee and the reasons for your decisions, so that if enquiries are made, you have a strong case for support. 
• Have clear organization-wide definitions for employees and contractors and ensure that there are distinct parameters on how different classifications of staff are treated. Ensuring clarity not just in how you classify your employees, but how you subsequently treat them in line with that classification can help to provide uniformity and transparency throughout the organization. 

The question of classification is one that can impact organizations of all sizes. Whilst it may be tempting to apply sweeping classifications, or to lean towards contractors in order to save a few dollars here or there, the risks if found guilty of misclassification are enough to make most employers think twice. If you are uncertain about the classification of an employee, or if you are an employee and feel that you may have been misclassified, seek professional help; an HR specialist or recruitment agency should be able to provide you with guidelines to ensure that employees are treated fairly, and employers avoid the considerable risks of being found guilty of misclassification.