What is Employee Misclassification?

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. 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. Note, an independent contractor is not the same as a sole proprietor, though often independent contractors adopt that business structure. 

In some countries, deliberate employee misclassification is known as ‘sham contracting‘. 

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:

  • No Tax Withholding
  • The misclassification of employees usually deprives governments of the tax intake they are entitled to under law. This is because, in most countries, employee income tax must be withheld by employers, before distributing salary and wages to the employee. By contrast, independent contractors are expected to submit their own taxes. This results in a lower total tax take as it is more difficult to monitor income tax compliance with individual contractors than it is with employers.
  • Incorrect Expense Deduction
  • Independent contractors are often entitled to deduct a range of expenses from their gross income, that are not permissible deductions for employees. This may include deductions for transport, office equipment, private health insurance and pension contributions. This means that the tax authorities may receive a lower amount of income tax from a misclassified individual (who is illegitimately claiming expenses), than they are entitled to.
  • Benefit Deprivation 
  • In most countries, employers must make a range of compulsory payments towards employee benefits. This may include compulsory health insurance, pension contributions and workplace compensation levies. Employee misclassification means that, in many cases, workers are deprived of these benefits. As well as hurting individual workers, this may also increase the ultimate burden on the state who may need to ‘pick up the slack’, and provide essential services to misclassified workers.
  • Find out more about how to correctly administer employee benefits at 8 Useful Tips for Employee Benefits Administration
  • Lack of Employee Protections 
  • In most countries, there are a range of protections in place which apply only to employees, and not to independent contractors. For example, employees often have minimum wage protections, eligibility for sick leave, annual leave and maternity leave, and a right to be treated fairly under the law. By contrast, contractors are dealt with under the more permissive rules of general contract law.
  • Breach of Industry Agreements/’Awards’
  • In many countries (such as Australia), there are standards that apply across industries which provide higher levels of protection for employees than under general employment law. Employee misclassification may be interpreted as an attempt to breach these standards. 

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

  • Substantial Back-Taxes
  • If as business has misclassified an employee, there is a risk that the tax authorities will determine that the business owes income and payroll taxes for the period of misclassification. This could be a sizable sum.
  • Financial Penalties
  • In addition to back-taxes, tax authorities or other government regulators may decide to fine or penalize a business for misclassification. This is especially true if the authorities suspect that the business has intentionally misclassified employees. 
  • Legal Action from Employees

    Misclassified individuals may bring legal action against a company under employment legislation. A court may find that the business is liable for damages to compensate individuals for any lost benefits over that period. In addition, the court may award additional punitive/exemplary damages for flagrant misconduct. 

  • Legal Action from Clients or Insurers
  • The risk of an employee being misclassified is usually interpreted as the risk that an organization will be held to the standards of an employer. However, there is a related risk where the worker has been legitimately (within the law) classified as a contractor, but their work should, nevertheless, have been performed by an employee. For example, negligent conduct of employees, but not the negligent conduct of contractors, may be covered by the professional liability insurance of a firm, this means that a failure to properly clarify the legal situation of an independent contractor carries an additional risk for the business in question. 

How Do I Know if Employees are Misclassified? 

Given the serious consequences of employee misclassification, it is essential that businesses consider carefully the factors that determine whether a given individual is, or is not, an employee. We discuss this issue in further depth in What’s the Difference Between Employees and Independent Contractors?
 
Here we consider the factors that are considered by the Internal Revenue Service (IRS) in the United States  for determining whether or not an employee is being misclassified. The IRS focuses on three general areas: behavioral control, financial control and the relationship between the parties. Each of these general areas is then divided into further specific factors. We consider them sequentially below: 
 
  • Behavioral Control
  • Employers have the right to direct and control their employees. Some of the following factors may indicate that the worker is being controlled in this way:
    • Work style
    • If the business instructs the worker where and when to work, and which tools they need to use, this may indicate that they are the employer.
    • Detailed instructions
    • The less detailed the instructions given, the more likely it is that the individual is an independent contractor.
    • Evaluation systems
    • If workers are evaluated on how they arrived at an outcome (rather than just the output or outcome itself), this points to employment, rather than a genuine contracting relationship.
    • Training
    • Independent contractors tend to already approach the job fully trained, rather than needing to be trained ‘on the job’.
  • Financial Control
  • Under this heading, the business must look at the financial arrangements in place for the worker’s role. Relevant factors include:
    • Investment
    • Where the business has invested significantly in the resources used by the worker, this may indicate employment.
    • Treatment of expenses

      It is more likely that an independent contractor will incur expenses which are not reimbursed by the business (though note, conversely, it is more likely that a contractor will be able to deduct work-related expenses from their net income).

    • Opportunity for profit or loss

      The fact that a worker could either win or lose money (such as in roles that are heavily commission-based), may indicate an individual is a independent contractor.

    • Freedom

      Independent contractors are generally able to seek out other business opportunities (i.e. their contracts tend not to have enforceable ‘anti-competition’ clauses).

    • Payment Method

      Employees are more likely to be paid a regular amount on a regular basis. Independent contractors, by contrast, are often paid variable amounts or via a flat-fee arrangement. 

  • Relationship Between Business and Worker
  • Other factors which may be relevant for determining that an individual is or is not an employee include:
    • Contracts/Agreements
    • A contract stating that an individual worker is either an employee or an independent contractor is indicative, though it won’t be sufficient, to determine that an individual is either an employee or an independent contractor.
    • Employee Benefits
    • Benefits such as health insurance and pension contributions are not usually provided to independent contractors.
    • Permanency
    • If it is expected that the relationship will continue indefinitely, this may indicate an employment rather than a contracting relationship.
    • Core business
    • The closer the services performed by the worker are to the core business of the enterprise, the more likely it is that the worker will be seen as an employee, rather than a contractor. 

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: 

  • Engage a Professional Employer Organization (PEO)
  • A PEO employs workers who then work exclusively for a client business. As the worker is an employee of the PEO, employee income and payroll taxes are withheld and all employee benefits provided, ensuring there is no misclassification. At the same time, it means that a client business has outsourced the risk of non-compliance with tax and employment laws as they are not the employer (note, under a co-employment model, there can still be some residual liability for the client company).
  • A contract staffing company offers a similar service to a PEO, but with a focus on temporary and project-based HR solutions. 
  • A Global PEO offers these solutions across international borders. For example, a Global PEO can mitigate employee misclassification risk for European Union firms operating in the UK after Brexit
  • Ensure Employment Contracts are Professionally Drafted

     

  • Contracts between a business and an individual can be drafted to clearly set out the nature of the engagement, and whether it is in the nature of employment or independent contracting. Note, that the mere statement in the contract that an individual is an employee or an independent contractor, will not be determinative.
  • Develop a Company-Wide Contracting Policy 
  • An organization should have a policy that applies across the organization clarifying how individual workers are to be treated. This will help ensure that the hiring of independent contractors is treated distinctly from the hiring of employees, creating ongoing liability. It also documents compliance in the event of an audit by tax authorities or other regulators.

Conclusion 

Employee 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. 

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