Employee and Independent Contractor Misclassification: What You Need to Know

Misclassification of independent contractors is a widespread issue in the US and is becoming a raising concerns as new businesses, like startups and fintechs,  intentionally or unintentionally label workers as independent contractors rather than employees to save on benefits, wages, and taxes. 

In the U.S., about 10% of workers are wrongly labeled as independent contractors. A 2020 study by the National Employment Law Project estimated that 10-30% of employers are guilty of this practice, leading to significant financial losses for workers and tax collection gaps for the government. 

This malpractice not only results in financial repercussions but also creates an unfair labor market where genuine workers lose their rights and lawful employers face undue disadvantages. As the gig economy gains traction, distinguishing between contractors and employees becomes paramount. 

This article emphasizes the importance of understanding the distinctions between these two worker classifications, the risks of getting it wrong, and the significance of adhering to labor laws for a fair and transparent business environment.

What Is Employee and Independent Contractor Misclassification?

Employee and independent contractor misclassification occurs when businesses incorrectly label their workers as independent contractors (self-employed) instead of employees. Misclassification is a form of worker exploitation that can result in the loss of public tax revenue and create unfair business competition. It can also deprive workers of their rights and benefits, such as minimum wage, overtime pay, health insurance, social security, unemployment benefits, and safe workplace protections.

Why does misclassification happen? Sometimes, it is unintentional, due to the lack of clear or consistent definitions of employees and contractors across different laws and jurisdictions. Other times, it is intentional, as some employers try to save costs or evade taxes by avoiding their obligations to their workers. Either way, misclassification can have serious legal and financial repercussions for both parties.

Misclassification can also affect accounting and finance firms that provide services to businesses with misclassified workers. For example, accounting firms may have to deal with ethical dilemmas or legal risks if they knowingly or unknowingly assist their clients in misclassifying their workers. 

How Can You Set apart Employees From Independent Contractors?

There is no single test or rule to determine whether a worker is an employee or an independent contractor. Different countries and agencies have different criteria and methods for worker classification. However, most companies in the US consider:

• The degree of control that the employer has over the worker’s work, such as how, when, where, and by whom the work is performed.
• The degree of independence that the worker has over their own business, such as whether they have their own equipment, tools, insurance, licenses, clients, and expenses.
• The nature and extent of the relationship between the employer and the worker, such as whether there is a written contract, how long the relationship lasts, how often the work is performed, how integral the work is to the employer’s business, and whether the worker receives any benefits.

Generally speaking, an employee is someone who works under the direction and supervision of an employer, who provides them with the necessary tools and resources to perform their job, who pays them a regular salary or wage, and who offers them certain benefits and protections. 

An independent contractor is someone who works independently and autonomously, who provides their own tools and resources to perform their job, who negotiates their own fees and terms with each client, and who bears their own risks and liabilities.

Let’s see some examples

To illustrate the difference between employees and independent contractors, let’s look at some examples:

• An accountant who works for an accounting firm on a full-time basis, using the firm’s software and equipment, following the firm’s instructions and deadlines, and receiving a monthly salary and health insurance from the firm. This person is likely an employee.

• An accountant who works for various clients on a project basis, using their own software and equipment, setting their own rates and schedules, paying their own taxes and insurance. This person is likely an independent contractor.

What Are Some Common Industries Where Misclassification Occurs?

Misclassification can occur in any industry or sector where workers perform services for businesses or customers. However, some industries are more prone to misclassification than others due to various factors such as:

• The nature of the work (whether it requires specialized skills or training)
• The availability of workers (whether there is a shortage or surplus of workers in the market)
• The demand for flexibility (whether there is a need for variable hours or locations)
• The level of regulation (whether there are specific laws or standards governing the industry)

For example, construction workers are often hired as independent contractors by contractors or subcontractors who want to save on labor costs and taxes. However, many construction workers are actually employees who work under the direction and control of their employers, and who depend on them for their income and livelihood. They don’t work for other companies and jump from one project directly to another because the company is constantly building. 

Probably the most widespred industry where misclasifications happens is in technology. Technology workers, such as software developers, web designers, or IT consultants, are often hired as independent contractors by companies that want to access specialized skills or talent without committing to long-term contracts or obligations. Remote work and the strat-up type bussines model has rested on these type of contracts to grow. Ttechnology workers who work exclusively or primarily for one employer, and who receive regular payments and instructions from them and not in agig-economy schedule shouldn’t be considered contractors. 

What Are the Risks and Penalties of Misclassification?

While companies that outsource or offshore their operations are usually nos legally obligated to register workers, misclassifying employees as independent contractors can have some consequences for both workers and employers. For workers, misclassification can mean losing out on important rights and benefits that they are entitled to as employees, like:

• Not receiving minimum wage or overtime pay for their work.
• Not having access to health insurance or other benefits provided by their employer.
• They may not be covered by workers’ compensation or unemployment insurance in case of injury or loss of work.
• They may not be protected by labor laws that regulate working conditions, discrimination, harassment, termination, etc.
• They may have to pay higher taxes or face penalties for not filing or paying taxes correctly.

For employers, misclassifying workers can lead to major legal and financial headaches. They might end up owing back taxes, including those for federal income, social security, Medicare, state income, and state unemployment. On top of that, they could face hefty fines or penalties for breaking tax or labor laws. Damages or compensation may also be due to those workers adversely affected by such misclassification. And if that's not enough, they might find themselves under the microscope, facing audits, government investigations, or even lawsuits from employees or rival businesses.

The amount and severity of the risks and penalties of misclassification depend on various factors, such as the number of workers involved, the duration of the misclassification, the degree of the employer’s negligence or willfulness, and the jurisdiction of the case. 

How to Avoid Employee and Independent Contractor Misclassification?

Review the laws and regulations

It's crucial for employers to familiarize themselves with the specific laws and regulations concerning worker classification that apply to their particular industry and geographical location. Each region may have nuanced laws that differentiate employees from contractors. As laws evolve and change, staying up-to-date ensures that businesses remain compliant. Whenever there's ambiguity, employers should never hesitate to seek guidance from legal or tax experts. These professionals can offer tailored advice to ensure that businesses are classifying workers correctly.

Evaluate workers' nature and characteristics

Understanding the nature of a worker's role and responsibilities often involves examining the degree of control they have over the worker, how integral the worker's role is to the business, and the worker's financial arrangements, among other things. This ensures that workers are appropriately classified based on their actual job functions and relationship to the company.

Document terms and conditions

Transparency is key. Employers need to meticulously document the terms of their relationship with their workers. Using written contracts or agreements is beneficial as they can clearly define the status, rights, and responsibilities of each party. These documents serve as a reference point for both the worker and employer and can be critical if there's ever a dispute about the worker's status.

Treat workers consistently and fairly

Once workers are classified, it's of utmost importance to treat them in a manner consistent with that classification. For example, if someone is an independent contractor, employers should avoid exerting the kind of control or influence typical of an employer-employee relationship. This includes matters like setting specific work hours, providing training, or dictating how the job should be done. Treating workers fairly not only ensures legal compliance but also fosters a positive work environment.

Monitor and update worker classification

The nature of work and business relationships can evolve over time. It's essential for employers to periodically reassess and update their worker classifications. Regular check-ins can help identify if there have been significant changes in a worker's role or in the relationship that might necessitate a change in classification. Adjusting as needed ensures that businesses remain compliant and workers continue to receive the rights and benefits they are entitled to.

Also, follow this best practices to avoid misclassification:

• Use clear and specific language in contracts or agreements with workers, stating whether they are employees or independent contractors, and outlining the scope, duration, payment, and termination of the work.
• Provide workers with written policies and procedures that explain the expectations and standards of their work, such as hours, deadlines, quality, safety, etc.
• Maintain accurate and complete records of workers’ hours, payments, expenses, taxes, benefits, etc.
• Respect workers’ autonomy and independence as independent contractors, allowing them to set their own schedules, choose their own clients, use their own tools and resources, etc.
• Communicate regularly with workers about their work status and any changes or issues that may arise.

How to Legally Hire Nearshore Workers

When it comes to hiring a remote team, in many instances, direct employment isn't feasible unless the company has a presence or legal entity in the worker's home country. However, a popular alternative is to onboard them as contractors.

Such a contractual arrangement can still resemble traditional employment, offering full-time roles and paid time off (PTO). Plus, in this digital age, you can extend additional perks, such as health insurance or even gym memberships, through online platforms, ensuring that your international remote team remains content and productive. Here are your three main hiring options:

Hiring on your own

If you opt for direct hiring in another country, it's imperative to be well-versed with its specific labor laws, which might vary from those in your homeland. Setting up a legal entity there might be both expensive and lengthy. It would entail responsibilities like tax payments, ensuring proper benefits, handling payroll, drafting contracts, and ensuring overall compliance. A critical aspect to note here is the classification of workers. Mislabeling them as independent contractors could lead to substantial fines or even legal disputes.

Using an Employer of Record (EOR)

An EOR acts as a third-party intermediary, essentially becoming the legal employer of your overseas workers. There are many benefits of relying on a Employer of Record like delegating the management all the intricate details - from payroll and tax commitments to compliance and immigration concerns. With them ensuring your team's proper legal classification, you can concentrate solely on your business operations without the added burden of potential misclassification issues.

Partnering with a Staffing Agency

Staffing agencies specialize in recruiting for short-term or temporary roles. They handle the administrative side of employment, from taxes to benefits. It's an excellent option when you require additional manpower for specific projects without long-term commitment. However, it's essential to partner with a trustworthy agency that adheres to local laws, especially concerning worker classification, to prevent potential legal complications.

Final Thoughts

Worker classification is not only a matter of legal compliance, but also a matter of ethical and social responsibility. By classifying workers correctly, employers can show respect and appreciation for their workers, and provide them with fair and adequate compensation and benefits. This can improve the morale and productivity of the workers, as well as their loyalty and satisfaction. Workers who are treated well by their employers are more likely to perform better, stay longer, and recommend their employers to others.

Conversely, by misclassifying workers, employers can harm their workers’ well-being and dignity, and expose them to risks and hardships. This can lower the quality and efficiency of the work, as well as the retention and engagement of the workers. Workers who are mistreated by their employers are more likely to quit, complain, or sue their employers.

Therefore, worker classification is not only a legal obligation, but also a moral duty. By classifying workers correctly, employers can foster a positive and healthy work environment, where workers feel valued and respected, and where they can thrive and grow. This can benefit both the workers and the employers in the long run, as well as the society at large.