Avoiding Employee Misclassification: the Difference Between Independent Contractors and Employees
Employee misclassification occurs when a company wrongly classifies a worker as an independent contractor or freelancer and can cause hefty penalties. Read further to know how to avoid it.
What is an employee? Turns out, it is quite a complex issue. It involves laws, rules and court cases. Get it wrong and your business is liable to face substantial penalties, back taxes, and reputational hazards. This is what employee misclassification means, why it matters and how to prevent it.
What is employee misclassification and why does it matter?
Classifying each worker is a legal decision that defines the relationship between the company and the worker. Classification affects everything from what taxes the company owes to how the worker delivers services.
Employee misclassification occurs when a company labels workers as independent contractors or freelancers, rather than employees. Using contractors can cause a significant reduction in labour costs, as well as lower bureaucratic pressure. Often referred to as the "underground economy", employee misclassification can have negative consequences for companies that may be obliged to pay severe fines: just last week, delivery company DoorDash Inc has agreed to pay more than $5 million to settle an investigation by San Francisco into alleged labour law violations because of employee misclassification. For states and federal governments, the practice results in a shortage of millions of dollars in tax revenue, while workers who are misclassified as independent contractors work without the legal protections typically afforded to employees, such as wage and hour laws, workers compensation, and unemployment benefits.
There are multiple definitions of what exactly constitutes an employee. One simple standard is who has control over the final output of someone’s work: if it is the company, then the worker is an employee, not an independent contractor or freelancer. However, additional and more complex definitions exist, and they can vary significantly depending on the country.
Penalties for Misclassifying Employees and Independent Contractors
Misclassification of workers has serious consequences. Employers pay taxes on employees, but not on independent contractors. Improperly classifying workers as independent contractors rather than employees deprives the state of properly due tax revenue, including income, Social Security, and unemployment taxes. In conclusion, employee misclassification may cause tax evasion.
Penalties fall into the following categories:
Substantial Back-Taxes. If a business has misclassified an employee, there is a risk the tax authorities will determine that the business owes income and payroll taxes for the period of misclassification.
Financial Penalties. Besides back-taxes, tax authorities or other government regulators may decide to fine or penalize a business for misclassification. The penalties available vary under each law, as does how a penalty is calculated.
Legal Action from Employees. Misclassified individuals may bring legal action against a company under employment legislation. A court may find that the business is liable for damages to compensate individuals for any lost benefits over that period.
Reputational hazards. In the fierce war for talent, companies risk their reputation and hiring capabilities if they venture into employee misclassification.
For example, the IRS could impose administrative penalties on a company equal to the taxes it should have paid for the misclassified worker. If it’s found that the worker was underpaid under a state wage law, then the company may also owe back pay and benefits to the worker. In both cases, interest and late fees could also be applied.
Because each applicable law sets out its own penalties and legal remedies, the total costs for misclassifying a worker can quickly compound.
Steering clear of employee misclassification
Given the serious consequences of employee misclassification, it is essential that businesses consider carefully the factors that determine whether an individual is, or is not, an employee.
This is what you can do to stay compliant:
Review worker classification practices. Conducting an internal audit is a valuable practice that can provide you with an in-depth understanding of your current classification practices and whether they are compliant. To conduct an audit, gather records of services performed by contractors, check to see if you have contracts on file for your independent engagements;
Seek legal advice. Have an HR specialist review your employment contracts and how they pay independent contractors;
Ensure independent workers are properly classified. Governments apply different laws and tests to determine worker classification. These tests lack uniformity, so just because a worker complies with one test, doesn’t mean they’ll comply with another. Keep records of documents that support a classification decision, such as a business or professional license, business cards, or insurance certificates that can be used as proof of self-employment.
Implement internal systems and procedures for ensuring that workers are treated in line with their classification: your business may have a worker classification policy in place, but do employees consistently follow it? Work with your HR team or hiring managers to develop a centralised program for engaging and managing your independent workers.
Require hiring managers to use a written contract. Using a written contract for all independent contractor engagements not only helps to clearly define your working relationship but also helps to verify classification in the event of an audit. In addition to outlining the scope of work, defining the communication process, and specifying payment terms, you might include additional safeguards such as explicitly stating the person you’re engaging with is an independent worker, that they are free from control, and that they have insurance.
Engage a company that can take on the role of ‘Employer of Record’. Employers of Record or EoR are companies that take on the responsibility of hiring workers in compliance with local laws and that mitigate the risks of having workers misclassified as contractors, rather than employees. This means taxes and social security are taken care of for the customer company.
In short: protect your business and your workforce against employee misclassification
Employee misclassification occurs when a business classifies a worker as an independent contractor or freelancer, for tax and employee benefits, when they would be more accurately classified as an employee.
Employee misclassification carries major risks for businesses such as significant back-taxes, penalties, or damages. Given the risks involved, and the complexity of working out when a worker has been classified correctly, it is essential to seek expert help.
Get in touch with our team of legal and HR specialists, that can help you navigate the cross border hurdles of employee misclassification.
