Employee misclassification occurs where a business classifies a worker as an independent contractor for tax and legal purposes, but they are, in actuality, an employee. A recent study estimates that 10 to 30 percent of employers in the United States may be misclassifying their workers, resulting in billions in lost taxes for US tax authorities. The UK Government recently introduced new IR35 rules to clamp down on the practice.
Here we explain what employee misclassification is, what the consequences can be for your organization, and the steps you can take to avoid it.
What is Employee Misclassification?
Employee misclassification is a judgment made by government regulators (such as tax authorities), or courts, that individual workers have not been categorized correctly under the law. It often occurs where workers have been engaged either under a ‘contract for service’ or where there is no explicit contract in place. These workers might be referred to as ‘freelancers‘ or ‘ independent contractors’, rather than employees (though confusingly, in the US, they are often known colloquially as ‘1099 employees‘). Note, an independent contractor is not the same as a sole proprietor, though often independent contractors adopt that business structure.
Note, there is no single internationally applicable definition of ’employee misclassification’, as it is treated slightly differently across different states and countries.
Furthermore, there is no single ‘test’ of employee misclassification: A whole list of factors must be taken into account before determining whether or not an individual has been correctly classified. We will discuss these factors in considerable detail below.
For a detailed account of how to fix any existing misclassification see How to Convert Contractors to Employees.
Why Do Authorities Care about Employee Misclassification?
Employee misclassification is concerning to authorities for several reasons:
What Are the Risks of Employee Misclassification?
Putting to one side the consequences of employee misclassification for authorities, if a business misclassifies employees, what are the potential negative implications for the business itself?
Possible consequences include
How Do I Know if Employees are Misclassified?
How to Avoid Employee Misclassification?
Given the risks involved, and the complexity of working out when a worker has been classified correctly, what are the best practical steps to take to avoid employee misclassification?
We recommend that businesses consider the steps set out below:
ConclusionEmployee misclassification occurs when a business classifies a individual worker as an independent contractor or freelancer, for the purposes of tax and employee benefits, when they would be more accurately classified as an employee. Employee misclassification carries major risks for businesses. A failure to classify workers correctly could result in significant back-taxes, penalties or damages. To mitigate this risk, businesses need to carefully consider:
- The considerations that are applied by tax authorities in their country for determining whether an individual is an independent contractor or an employee;
- Seeking legal advice on their employment contracts and how they pay independent contractors;
- Implementing internal systems and procedures for ensuring that workers are treated in line with their classification;
- Engaging a Global PEO that can take on the role of ‘Employer of Record’ for workers, mitigating the risk that any workers are misclassified as contractors, rather than employees.