Employee Misclassification

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What is Employee Misclassification?

There is no single universal definition that fits the term “employee misclassification.” It is also known as “sham contracting” or “disguised employment,” and it refers to the incorrect labeling of workers as independent contractors.

Here are some key points to remember about worker misclassification:

• The classification of workers is crucial for every company because it defines the legal relationship between the company and its employees through a work contract. This classification also makes it easier to calculate the taxes owed by the company.
• When an employee is incorrectly classified as an independent contractor, they are not entitled to employee compensation, wage laws, or unemployment benefits.
• Independent contractor is a legal term that applies to workers who do not fall under full-time employees under the law.
• Companies that engage in employee misclassification may face a misclassification lawsuit and be required to pay fines or worker settlements.

Why Employee Misclassification Matters to Governments?

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

• Loss of public revenue: In most countries, employers must deduct a certain percentage of each employee’s salary for taxes. These taxes include Social Security, Medicare, and federal tax. With worker misclassification, employers save on these taxes. However, when independent contractors file their taxes, they can claim deductions that employees cannot, such as transportation 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 offer employee benefits such as health insurance, pension contributions, etc. Many multinational companies provide additional benefits, such as student loan payments, wellness programs, and other financial schemes, to their global workforce. Independent contractors do not receive these benefits, which eventually burdens governments to extend benefits to them under public policies.
• No legal protection for workers: Under the government’s labor law, full-time employees are entitled to minimum wage protections, sick leave, 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 interests, but it does not protect their rights as such.
• Balancing the changing market: With more people turning to the gig economy and worker misclassification resulting in financial gains for a company, governments fear a lack of full-time employment opportunities. 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 who misclassify their employees may be held accountable for an attempt to breach these standards.

Navigating the Evolving Legal Landscape of Employee Misclassification

Worker misclassification can lead to a significant loss of public revenue, and hence, both state and federal governments are concerned about the growing number of independent contractors. More than 50% of the US workforce is projected to be part of the independent contractor category 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 a worker 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 the penalty for violation can be as high as $25,000.
• California Assembly Bill 5 (AB5) in California: Under this law, freelance workers receive 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 worker misclassification went into effect recently in New Jersey. Under these laws, companies that intentionally misclassify workers are penalized or shut down. In addition, organizations must post notices informing workers about the issue of misclassification. The notice should also include information on where to file a complaint if they are misclassified.

How to Properly Classify Your Employees

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

Here are some standard tests for worker classification:

• 20-Factor test: The IRS issues a list of 20 factors under three categories – “behavioral,” “financial,” and “kind of relationship” – to determine the extent 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 must meet the following three conditions to be categorized as an independent contractor:
  • 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 determine 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.
• Properly classifying workers is essential to avoid misclassification and comply with labor laws. Companies must assess their worker classification regularly and use the appropriate test to ensure compliance with state and federal laws.

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 beneficial for many organizations. Here are some other reasons why employers engage in independent contractor misclassification:

• Employers are free from the legal responsibilities of their workers. They do not have to pay minimum wage or follow 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 do not need to pay for health and pension plans or other benefits for independent contractors.
• Employers do not need to verify if workers are US citizens or possess the correct work visa if a recruit is misclassified as an independent contractor.
• Business owners can save significantly on labor expenses. As per estimates, independent contractors save 30% of labor costs compared to correctly classified employees.

Employers should note that the misclassification of employees as independent contractors can have legal and financial consequences. It is important to properly classify workers and comply with labor laws to avoid legal complications and penalties.

The Risks of Worker Misclassification

Many employers may engage in worker misclassification to cut costs, but ultimately, they pay a higher penalty for misclassifying employees. State and federal laws enforce penalties for employee misclassification. The penalties for misclassification of employees are categorized as follows:

• Administrative fines for non-compliance.
• Criminal penalties for purposely misclassifying employees, which can also include jail time.
• Payback for employee benefits with interest.
• Payment of 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 the compensation owed to the misclassified employee. Class-action lawsuits can negatively impact the company’s reputation, and bouncing back from negative publicity can be challenging.

Legal Victories for Misclassified Workers

It is not just the governments fighting the issue of employee misclassification, but workers themselves are also taking legal action. Several cases have resulted in victories for the workers, giving them their due compensation.

Here are some legal victories from worker misclassification lawsuits:

• Uber settled a lawsuit for $100 million brought by drivers in California and Massachusetts. However, the class-action lawsuit of 2016 did not go to trial, and the dispute with independent contractors is still unresolved.
• In 2013, the Department of Labor helped 196 employees from a cable installer company in Kentucky recover $1 million in 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 in back wages, penalties, and damages from them.

These victories serve as a reminder that proper worker classification is essential for employers to avoid legal complications and penalties. Employers should assess their worker classification regularly and comply with state and federal laws to ensure that they are not misclassifying their workers.

Staying Compliant: Tips for Employers to Avoid Legal Issues

Many companies, irrespective of their nature or size, have independent contractors on their team. However, 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 solutions company for smoother processing. Here’s a 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 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 doubts 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 for audits and to help you manage an independent workforce. Plus, it comes in handy while calculating taxes.
• Proper employee classification is essential for companies to avoid legal complications and penalties. By following these steps, companies can ensure that they are compliant with state and federal laws and that they are not misclassifying their workers.

How Can Multiplier Help with Employee Misclassification?

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.