Learn everything about independent contractor misclassification—definitions, risks, penalties, legal tests, and tips to avoid costly compliance mistakes.
Introduction
In the fast-changing world of work today, independent contractor misclassification presents a serious problem for employers. It refers to a situation in which the employer wrongly categorizes the employee as an independent contractor, which has costly implications. The shift to remote work has again made the subject of contractor status even more important because of the rising gig economy and changing work models.
Basically, such misclassification means that, afterwards, employers will be subject to lawsuits, penalties, and reputational damage. Be it a startup or a small business owner or an HR team member, classifying workers incorrectly can lead to devastating expenses due to lawsuits, tax problems, or non-compliance fines.
This guide will take you through everything you want to know about misclassification: how to identify it, its risks, and how to avoid it. You will also be guided through the legal tests that are used to determine worker classification, and you are going to have practical tips on how to shield your business from these expensive mistakes.
Table of Contents
What is Independent Contractor Misclassification?
Independent contractor misclassification means an employee is hired and classified as an independent contractor but, by law, should actually be considered an employee. Such misclassifications may occur in intent or inadvertently but have far-reaching effects on the business.
An employer could misclassify a worker intentionally by denying the employee benefits attached to healthcare or paid time off or withholding tax. This is particularly true when an employee has little knowledge of the legal definitions of a contractor and an employee. In such a case, the reality is also shaping up, which invariably blurs the differences in the workforces.
It may also be remembered that different nations and jurisdictions have very different laws and criteria with respect to worker categorization. For instance, in the U.S., the IRS and the Department of Labor have their own specific tests by which an individual comes to be defined as an independent contractor rather than an employee. By contrast, countries such as the U.K. and Australia have their own guidelines, which can affect how workers will be classified under local labor law.
Independent Contractor vs Employee: Key Differences
Here are the key differences between an independent contractor and an employee.
| Factor | Independent Contractor | Employee |
| Control over work | Works independently with minimal direction. | Works under the control and direction of the employer. |
| Tools/Equipment | Provides own tools and equipment. | Uses tools and equipment provided by the employer. |
| Work Supervision | Works autonomously, often for multiple clients. | Works under direct supervision and follows company policies. |
| Eligibility for benefits | Not eligible for employee benefits (e.g., insurance, PTO). | Eligible for company benefits like health insurance, paid time off, etc. |
| Tax responsibility | Responsible for their own taxes. | Employer handles tax withholdings. |
Why Misclassification Happens
- Cost-Cutting Measures
Employers often classify a worker incorrectly so as to avoid paying taxes, providing benefits, and fulfilling the obligations of labor laws. By designating workers as independent contractors, businesses can diminish their own liability and increase their profits.
- Lack of Knowledge
Misclassification may also occur when employers are simply not aware of the legal criteria that differentiate independent contractors and employees from one another. An area is now increasingly complicated under labor law, especially with the growth of the gig economy, and it is rather easy for businesses to err by ignorance.
- Surge in Engagement of Gig/Freelance Workers
With the increase in the number of the gig and freelance workforce, grey areas with regards to employment classification have been created. With workers working between multiple clients or employers, businesses can sometimes find it hard to clearly delineate between independent contractors and employees.
- Startups Hiring For-Full-Time Opportunities on Freelance Basis
Startups hire freelancers or contractors to fill jobs that would otherwise be filled by full-time employees,creating ambiguities wherein the overlap exists in the expectations on the side of the employer and on the side of the worker. In some cases, a startup might even hire a freelancer who feels like a full-timer and works full-time hours without supervision; that can put the misclassification risk at a higher level.
Legal Tests for Worker Classification
Unraveling the entangled question of whether a worker is an independent contractor or an employee has not been fab.
Other statutes lay down different tests with different focuses concerning their tests under which such allegations may arise. The foremost tests that are commonly wrought by Relief by Commissions are:
- IRS Common Law Test
The IRS Common Law Test is one of the most useful procedures in classifying workers according to the law in the United States. This test contains the main three areas:
- Behavioral Control: Does the employer control or direct how the worker performs the task? Suppose a worker is told precisely how, when, and where to do the job. In that case, the individual is probably an employee.
- Financial Control: Here is where this test talks about who assumes complete control over the financial aspects of the job. Independent contractors typically have more control over their own finances, including how they are paid and what they charge for particular services, and if any business expenses are incurred. Employees, on the other hand, are usually paid by the employer, and the employees do not have financial independence.
- Type of Relationship: Denotes how the worker and employer Interact. If the contract stipulates terms such that it creates some form of continuing long relationship between the parties and confers certain benefits on the employee, i.e., health insurance, this might weigh in favor of an employee characterization.
For instance, a graphic designer working freelance for several clients while keeping their own schedule really would very likely be classified as an independent contractor under the IRS Common Law Test.
- ABC Test
The ABC Test is used to measure worker classification in several U.S. states, mainly California. This stricter test looks at three simple criteria:
- The worker is free from the control and direction of the hiring entity in performing the work.
- The worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is customarily engaged in an independently established trade, occupation, or business.
For example, if a company hires a delivery driver and cannot tell the driver how to work, but main control of delivery services, which is their core business, and does not operate any delivery business of their own. The ABC Test is stricter than the IRS Common Law Test and results in more workers being classified as employees rather than contractors.
- Economic Reality Test
The Economic Reality Test is implemented by the U.S. Department of Labor (DOL) to identify if a worker is economically dependent on their employee. This test poses criteria such as:
- Does the worker reply for an income to the employer?
- Can the worker negotiate their rate, or does the worker rely upon the employer to determine how much they may be paid?
- Is the individual an integral department of the business or an independent trade on his own?
An example of an Uber driver would be who would probably pass the Economic Reality Test due to substantial dependence on the Uber App to earn money with Uber.
Real-World Examples of Misclassification
Misclassification of workers is more than a dry legal proposition; it has consequences in the real world. Several high-profile cases point to the risks and teachable moments for businesses regarding misclassification.
Uber and Lyft
There have been major legal fights over whether drivers for Uber and Lyft would be classified as independent contractors or employees. In California, a court decided Uber drivers were employees under the ABC Test since Uber controlled many aspects of their work (including pay, the timing of work, and ride requests). The case gave rise to Assembly Bill 5 (AB5), California’s attempt to restrict independent contractor usage in the gig economy.
Lesson learned: Gig economy businesses should ensure that their business models do not unduly create economic dependence on them by workers, especially in the states with stricter tests like the ABC Test.
FedEx
FedEx was sued over the classification of its delivery drivers, labeled as independent contractors but assigned strict directives by the company and were economically dependent on FedEx for their livelihood. A judge in California ruled in 2015 that many FedEx drivers were employees under the ABC Test.
Lesson learned: Businesses should not create independent contractor arrangements where the worker is highly controlled and the person is dependent upon the contractor for livelihood.
Industry Examples
- Tech/Startups: Most of the startups consider freelancers for full-time positions, creating further confusion about whether they should be contractors or employees. These companies give freelancers the same type of work as full-time employees but deny them benefits, resulting in a potential risk of misclassification.
- Media and Content Freelancers such as journalists or content creators hired on a regular basis might be misclassified if they are required to work normal hours and are under the editorial guidelines of the company, implying an employee relationship.
- Construction: Construction workers are often misclassified as independent contractors while having almost no control over their work schedule and having to adhere to company policies. In this scenario, misclassification will attract tax and insurance liabilities.
- Logistics: Delivery drivers or warehouse workers may be misclassified in logistics companies if they rely on one company for all of their income and do not get employee benefits, which puts them in a gray area legally.
Risks and Penalties for Misclassification
Employers may be faced with huge financial, legal, and operational renegotiations when they misclassify independent contractors and have, in fact, employees. The following is a composite of the risks involved:
Financial Risks
Major financial penalties accrue with misclassification consisting of the following:
- Back Taxes: Employers could face back taxes regarding Social Security, Medicare, unemployment insurance, and taxes they should have withheld on behalf of the affected employee.
- Unpaid Benefits: Employers could face claims for unpaid benefits, such as health insurance, paid time off (PTO), and retirement contributions.
- Double Damages: Employers may be subject to double damages for certain violations, such as wage and hour claims under the Fair Labor Standards Act (FLSA). Under this form of penalty, the employee is paid both for unpaid wages and an extra amount.
In the situation where the tax was not properly withheld from the misclassified employee, the IRS may impose penalties associated with the misclassification. These penalties vary from $50 to $500 per each alleged misclassified employee, depending on the extent of culpability. In case of willful misclassification, however, the amount in penalties can run into several thousands.
Legal Risks
The legal implications of misclassification include:
- Lawsuits: Misclassified workers may also undertake lawsuits for the recovery of unpaid wages, overtime, or other benefits. There may also be lawsuits for damages from being treated harshly or for the violation of labor laws.
- Fines and penalties: Govern-ment departments like the DOL and IRS can impose exorbitant fines for improper classification. For instance, the FLSA overtime violations would need to be settled by employers for the misclassification.
- Audits: On the other hand, the claims of employee misclassification might give rise to an audit by the IRS or competent state authority. Such audits could prove lengthy and costly for the employers with substantial fines perhaps awaiting exposure for violations.
An example is California, where under AB5, penalties of $25,000 may apply per violation for the misclassification of workers.
Operational Risks
- Disruptions: Instead, the misclassification of an employee could cause turmoil in the company’s internal environment (lawsuits against the company, turnovers of employees, etc.). The sudden ruling of a worker being an employee may force adjustments onto the employer’s part within the system of compensation and other adjustments regarding classifications of workers.
- Reputational Damage: Companies misclassifying workers may get bad publicity affecting its viability and branding. This, in turn, can cascade into customer loyalty, employee morale, and investor confidence.
How to Correct a Misclassification
If you suspect you’ve incorrectly classified an employee as an independent contractor, it’s very important to rectify this quickly in order to minimize all risks. Here are the steps you should take:
Steps to Take if You Suspect Misclassification
Step 1. Review the Relationship: Carefully watch the pattern of relationship of work. Use legal common tests such as IRS Common Law Test or ABC Test or Economic Reality Test to check if this worker can qualify as an independent contractor or employee.
Step 2. Consult Legal Counsel: Get legal advice from a labor attorney or HR specialist to ensure that you are following the correct procedure in understanding your obligations as the employer.
Voluntary Classification Settlement Program (VCSP) [U.S.]: Misclassification discovered by an employer in the United States can voluntarily remove the employees involved from the list of misclassified workers through VCSP; and this, with lesser penalties. The program involves the employer in filing certain documents with the IRS and agreeing to effect payment of 1% of the wages paid to the misclassified employees in the previous year.
How to Rectify Tax Filings
Where there is misclassification of the worker, the tax filings will have to be rectified:
- Amended Past Returns: Submit amended Forms 941 (Employer’s Quarterly Federal Tax Return) and Forms 940 (Federal Unemployment Tax Return) to reflect the employee status.
- File New W-2 Forms: If the worker should have been classified as an employee, you must issue them a W-2 form for all the previous years they were misclassified.
- Pay Back Taxes: The appropriate taxes for Social Security, Medicare, and any other payroll taxes that the misclassified worker owed will need to be paid
How to Communicate the Change to the Contractor
It’s important to communicate openly with the contractor about the reclassification. Here’s how to handle it professionally:
- Explain the Situation: Inform the worker about the reason for the shift, clarifying legal requirements, and providing understanding of how this will affect pay and benefits.
- Required Documentation Provision: Let forth with the W-2 form the necessary tax forms so that the worker could clearly understand the implications of the change in status and taxation.
- Prepare for Questions: Get ready to respond to curious minds wondering what will happen to benefits, back pay, or any change in the work relationship.
Risks of Late Correction
- Increasing Fines and Penalties: The longer he manages to procrastinate misclassification correction, the higher would end up the fines and penalties. Not correcting the issues for more years, for example, increases back taxes owed and adds in more fines.
- Legal Exposure: The longer delay before misclassifying, the more likely it is for the worker to file a suit for unpaid wages, overtime or other benefits, thus incurring more legal expenses and complications.
- Tax and Audit Hurdles: So long does this situation go on, the tougher your tax filings and audits will present themselves. Delay fixing the issue, and scrutiny from tax investigators toward you may sharpen.
Best Practices to Avoid Misclassification
To avoid threats of operating under worker misclassification, it is essential for companies to take a proactive approach. Below are best practices to avert misclassification related hassles:
- Conduct Internal Classification Audits Regularly
Maintaining regular internal audits of worker classifications is one of the best ways for businesses to assure compliance. The HR team should periodically review the employment status of contractors and employees to ensure correct classification.
- Work with a Labor Attorney or HR Compliance Expert
It’s an arduous task to keep track of the ever-changing nature of labor laws. For this reason, an attorney specializing in labor law or human resources compliance, knowledgeable about regulations applicable in your jurisdiction, should be consulted to obtain certification on classification of the workers.
- Utilize Clear Contracts Defining Scope and Independence
A well-written contract is necessary for shielding your business and clarifying the relationship. The contract should lay out the scope of work, project schedules, and the independent nature of the contractor’s role.
- Limit Control Over Contractor’s Work Processes
To secure a valid contractor status, keep control of contractor work to a minimum. The contractor is to have control over their schedule, tools, and equipment, and how they get the job done. Trying to control the details of day-to-day work processes or supplying the necessary tools may show that an employee relationship rather than a contractor-client relationship was created.
- Train HR/Recruiters on Classification Laws
Ensure that your HR team and recruiters are very well conversant with the classification laws and grounds to differentiate between contractors and employees. This training should include information on determinative tests (such as the IRS Common Law Test or the ABC Test), the associated risks of misclassification, and how that information may affect the judgment of HR teams in deciding who to hire or how to classify workers.
Tools & Services to Help You Stay Compliant
It is essential to comply with the record-keeping requirements of worker classification, contracts, and tax obligations. Fortunately, there are several tools and services available for this purpose. Below are some of the top tools that can help:
Asanify
- Helps with: Asanify is a fully-featured HR and payroll platform for businesses to manage employee and contractor classification, payroll processing, and compliance. Businesses can automate tax filings, streamline onboarding, and ensure that the classification of workers is appropriate under their roles.
- Common use case: It can be used primarily by small businesses or startups that are looking to accelerate their growth but still want to ensure that workers are being classified correctly.
Gusto.
- What it helps with: Gusto provides a complete end-to-end payroll and HR software platform that includes everything-billing, and tax filing, to worker classification and benefits administration. Gusto also enables simple employee and contractor tracking through its easy-to-use tools.
- Common use case: Best for U.S.-based businesses need to manage employees and independent contractors right along and ensure proper tax filing and legal compliance.
Deel
- What it helps with: Deel is an international payroll and compliance platform enabling businesses to engage contractors and employees internationally while keeping their compliance with employment laws of the respective countries. Deel automates the creation of contracts, classifications, payments, and tax filings that concern the global team.
- Common use-case: Best for remote-first organizations or companies having a global workforce with various employments across countries, and they need to comply with local labor laws of different countries.
Remote
- What it helps with: Remote is on creating global payroll, compliance, and contractor management systems. It hires workers in more than 170 countries without having to set up local entities and meet the requirements of proper classification and tax compliance in different jurisdictions.
- Common use case: This is for global teams or growing companies that hire remote workers from different countries and need a seamless process for contract creation, classification, and payroll.
Oyster
- What it helps with: Oyster is a great alternative to all budding and existing organizations with operations on a global scale and with employees who work remotely. It takes into account hiring, payroll, and compliance and classifies workers as employees or contractors. It provides them with tools to manage their contracts, payments, and taxes to address their distributed workforce.
- Common use case: For all remote-first businesses that are looking to hire international talent while ensuring compliance in multiple countries without complex administrative overhead.
Final Thoughts
Proper classification of workers must be done without regard for the size of the company. An employer who misclassifies a worker as an independent contractor when in fact that person should be classified as an employee is courting potential disastrous legal, financial, and operational consequences. Worker classification should not only be about avoiding penalties; it is part and parcel of building a sustainable, compliant business for the years to come.
Short-term gains such as avoiding taxes and benefits for any benefit might be tempting; however, in the long term, the benefits of being compliant outweigh any immediate cost savings. A wrongful classification makes lawsuits, fines, and audits more likely, as they will always outweigh the cost of affording the benefits to employees. Besides, fair and just treatment of the workers lifts employee morale and boosts your company’s image.
Not to be considered as tax, legal, financial or HR advice. Regulations change over time so please consult a lawyer, accountant or Labour Law expert for specific guidance.
