Employee Misclassification

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Table of Contents

What is Employee Misclassification?

There is not one single definition that universally fits the term employee misclassification. It is also called ‘sham contracting’ or ‘disguised employment’ and refers to wrongly labeling workers as independent contractors.

Here are some key points to know about worker misclassification:

  • Workers’ classification is vital for every company as it defines the relationship between the company and its employees with a legal agreement (a work contract). Such classification smoothens the process of calculating the taxes owed by the company.
  • When an employee is incorrectly classified as an independent contractor, it does not entitle them to employee compensation, wage laws, and unemployment benefits.
  • An independent contractor is a legal term for workers who do not fall under full-time employees under the law.
  • Companies engaging in employee misclassification may have to face a misclassification lawsuit and pay fines or worker settlements.

Why do the Governments Care About the Employee Misclassification?

Over the past few years, more people have chosen to become freelancers and contract workers. Almost 36% of the US workforce has been classified under this category, and the number is projected to rise by 2025. Tax authorities are concerned because workers’ misclassification directly affects tax revenue. Both state and federal labor laws regulate employee-employer relationships in organizations. In addition, there are a few laws such as the Dair Labor Standards Act and Employee Misclassification Prevention Act (EMPA) that regulate employee misclassification. And here’s why governments care about this issue:

  • Loss of public revenue: In most countries, employers have to deduct a certain percentage of every employee’s salary as tax. These include Social Security, Medicare, and federal tax. With employee misclassification, employers save on these taxes. However, when independent contractors file their taxes, they claim deductions that employees cannot, such as transport expenses, health insurance, retirement plans, etc. This results in a loss of tax revenue for the governments.
  • Lack of benefits for independent contractors: Most companies have dedicated plans for employee benefits like health insurance, pension contributions, etc. Many multi-national companies provide additional benefits like student loan payments, wellness programs, and other financial schemes with a global workforce. Independent contractors get none of these benefits, which eventually burdens the governments to extend benefits to them under public policies.
  • No legal protection to workers: Under the government’s labor law, full-time employees are liable for minimum wage protections, sick leaves, annual leave, maternity benefits, etc. When classified as independent contractors, they are not eligible for these perks. Instead, freelancers or independent contractors are defined by a contract that negotiates their interest, but it does not protect their rights as such.
  • Level the changing market: With more people turning to the gig economy, and employee misclassification resulting in financial gains for a company, governments fear no full-time employment opportunities. So, if companies stop hiring full-time employees, it may cause an extreme imbalance in the employment market.
  • Breach of industry standards: Some countries have a higher level of protection for their employees under employment law. Thus, employers misclassifying their employees might be held accountable for an attempt to breach these standards.

Evolving Legal Landscape of Employee Misclassification

Employee misclassification can lead to a severe loss of public revenue, and hence, both state and federal governments are concerned with the growing number of independent contractors. More than 50% of the total US workforce is projected to be a part of the independent contractors in the next five years. With such rapid growth, essential legislation becomes crucial for these workers.

Here are a few laws and state-level legislation for an employee misclassification lawsuit:

  • Freelance Workers Protection Act in New York: This law introduces several protections for independent contractors, such as timely payments, hazard pay, and night shift differential. It makes written contracts mandatory, and if violated, the penalty can be as high as $25,000.
  • California Assembly Bill 5 (AB5) in California: Under this law, freelance workers get an extension as employees. Companies must use the ABC test to determine the classification between employees and contractors. Under the employee classification, gig workers are entitled to unemployment insurance, paid leaves, health insurance, and other relevant benefits.
  • New laws in New Jersey: Four new laws concerning employee misclassification went into effect recently in New Jersey. Under these laws, companies that purposely misclassify are penalized or shut down. In addition, organizations must compulsorily post notices informing about the issue of misclassification. The notice should also include information on where to file a complaint if they’re misclassified.

How to Classify Employees?

Owing to the lack of a rigid employee classification system, many workers fall prey to misclassification. However, specific tests help determine if an individual is an employee or an independent contractor. Different states use different tests of employee classification.

Some of the standard tests for worker classification are:

  • 20-Factor test: The IRS issues a list of 20 factors under a bigger umbrella of ‘behavioral’, ‘financial’ and ‘kind of relationship’ that helps determine the scope of control over the worker. If workers have more independence in several categories, they are classified as independent contractors.
  • ABC test: This is a three-pronged test widely used by several states for classifying employees. An individual has to meet these three conditions to be categorized as an independent contractor:
  • If they are free from control and direction concerning their duties and tasks under the service performance contract.
  • The individual’s service is performed beyond the usual course of the hiring employer’s business.
  • The individual is customarily engaged in an independently established trade, occupation, profession, or business similar to the service performed.
  • Economic reality test: This test seeks to find whether an individual is economically dependent on an organization or is conducting their own business. The Department of Labor provides several factors to determine the extent of an employer’s ability to control, hire, fire, train, and pay workers.

Reasons for Misclassifying an Employee as an Independent Contractor

The primary reason employers engage in employee misclassification is to save on taxes. This misclassification proves financially conducive for many organizations. Some of the other reasons why employers engage in independent contractor misclassification are:

  • Employers are free from the legal responsibilities of their workers. They do not have to pay minimum wage or follow the hourly wages.
  • There is no law enforcement by the Equal Employment Opportunity Commission that protects employees’ civil rights.
  • Independent contractors cannot form a union or bargain for their wages as they are not covered under the National Labor Relations Act.
  • Employers need not pay for health and pension plans or other benefits to independent contractors.
  • Employers don’t need to verify if the workers are US citizens or possess the correct work visa if a recruit is misclassified as an independent contractor.
  • Business owners save significantly on labor expenses. As per estimates, independent contractors save 30% of labor costs compared to correctly classified employees.

The Risks of Worker Misclassification

Many employers may engage in worker misclassification to cut costs, but ultimately, they pay a higher penalty for misclassification of employees. There are state and federal laws enforcing penalties. The employee misclassification penalties are categorized under:

  • Administrative fines for non-compliance.
  • Criminal penalties for purposely misclassifying employees also include jail time.
  • Payback for employee benefits with interest.
  • Pay damages for civil lawsuits and punitive damages.
  • Severe penalties for not publicly posting laws related to independent contractors.
  • If a terminated worker retroactively claims their rights as an employee, the company must pay severance and other due payments.

The laws are different, and the penalty is imposed according to the employee’s statement. These penalties are usually calculated as a percentage of compensation owed to the misclassified employee. Class-action lawsuits affect the company’s reputation, and bouncing back from negative publicity is challenging.

Legal Victories for Misclassified Workers

It is not just the governments fighting the issue of employee misclassification but workers themselves. Several cases resulted in a victory of the workers, giving them their due compensation.

Listed below are some legal victories from worker misclassification lawsuits:

  • Uber had to settle a lawsuit for $100 million brought by drivers in California and Massachusetts. However, the class-action lawsuit of 2016 did not go to trial. Thus, the dispute with the independent contractor is still unresolved.
  • In 2013, the Department of Labor helped 196 employees from a cable installer company in Kentucky to recover $1 million through overtime pay and other employee benefits.
  • A construction company in Utah and Arizona had misclassified over 1,000 employees. The Department of Labor recovered $700,000 from them in back wages, penalties and damages.

How to Stay Compliant?

Many companies, irrespective of their nature or size, do have a presence of independent contractors in the functioning. But the problem lies in being unaware of proper employee classification.

To stay compliant and avoid employee misclassification, companies should undertake the following steps:

  • Maintain records: If you have independent contractors in your team, document their details. It will help distinguish between full-time employees regarding recruitment, payment, and compliance. You could team up with a professional employment solution company for smoother processing. Here’s the list of things you must document:
  • List of all independent contractors (non-payroll workers) and their location.
  • Legal documentation such as a signed contract detailing the work hours, deliverables, nature of the relationship between the company and independent contractor.
  • Record the data of the tasks done by the worker, duration of their work, hourly wage rate, and additional benefits (if provided by the company).
  • Manual audit: As per the law, a company must conduct an audit of its independent contractors every six months. It primarily concerns the flexible working terms and conditions that may change according to state and federal laws.
  • Regularly undertake employee classification tests: Some defined employee classification tests help determine the employer-employee relationship. To avoid employee misclassification, it’s recommended to take these tests if you have genuine doubt about classifying an individual.
  • Develop key policies: To keep things in favor of both, you must draft a well-laid out policy for independent contractors.
  • Prepare professional employment contracts: A single statement declaring an individual as an employee or independent contractor will not be definitive proof of the employment terms. So, create a professional agreement that states other relevant details like working conditions, worker rights, and the management system of independent workers.
  • Prepare reports: It is an excellent practice to have detailed reports delivering essential information about your independent talent. This is instrumental both for audits and also to help you handle an independent workforce. Plus, it comes in handy while tax calculation.

How Can Multiplier Help?

Employee misclassification is a serious issue, and sometimes, companies may unknowingly do it. Thus, if you want to stay compliant and avoid lawsuits, get a global employment solutions company like Multiplier. With a strong presence in 150+ countries, we can help you onboard and manage employees from around the world.

If you are looking to hire full-time workers, independent contractors, or freelancers from across the border, our experts can take care of documentation, payroll, and much more. Do get in touch with us to know more about our services.

Frequently Asked Questions

Q. Is employee misclassification illegal?

Although labor laws differ for several countries, deliberate misclassification of employees violates tax and employment laws. The consequences and penalties vary, but it is illegal to misclassify workers as independent contractors in the US, Canada, Australia, Belgium, and India.

Q. How to fix misclassified employees?

The IRS gives three options to deal with the problem of employee misclassification:

  • If the employer is not being audited, they must fill the Form SS-8.
  • If the employer is being audited, they must choose the Classification Settlement Program. The employer must prove that they’ve always consistently treated the independent contractor’s position. They should also provide reasons on why they classified the position.
  • Employers who have not been audited for the past three years must choose the Voluntary Classification Settlement Program. This provides an opportunity of reclassifying the workers for employment tax for future tax periods.
Q. How much is the penalty for employee misclassification?

A company is subject to pay several penalties like – 

  • $50 fine for each incorrectly filled W-2 form for the employees. 
  • There is an additional 1.5% penalty on employees’ wages.
  • 40% of the FICA (Federal Insurance Contributions Act) taxes not withheld from the employee. In case of deliberate misclassification, companies must pay 100% FICA and income taxes.
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