What Is Employee Misclassification? What Employers Need to Know

Misclassification of employees as independent contractors can have serious consequences for your business. Learn what employee misclassification is and how to avoid it.

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Employee misclassification happens when an employer incorrectly classifies an employee as an independent contractor. While this may be an honest mistake, employee misclassification can have significant consequences for workers and businesses alike.

To better understand what worker misclassification is and avoid it entirely, let’s take a closer look at what distinguishes an employee from an independent contractor. We’ll also outline some criteria you can use to help make that distinction and mitigate legal risk.

What Is an Independent Contractor?

The definition of “independent contractor” varies between countries. But for the most part, what distinguishes them from employees is that contractors invoice a company for their services, so they’re not on the company’s payroll. As a result, contractors tend to have more control over their working relationship with the company than employees do. For example, contractors determine when they work, where they work, and the rate they’ll be paid.

What’s more, independent contractors typically work on specific, time-bound projects, usually outside the business’s area of expertise. For example, a company might hire a contractor to build its new website over a period of six months or design a new feature for customers.

When comparing contractors vs. employees, employees are permanent team members who go on the company’s payroll and are entitled to benefits, such as paid time off and sick leave.

How to Know if a Worker Should Be Classified as an Employee or a Contractor

It’s vital to ensure that your business complies with the relevant local regulations when it comes to worker classification. While the definition of “independent contractor” is different in each jurisdiction, below are some of the common criteria to look out for.

Independent contractors:

• Are paid upon submitting invoices.
• Are responsible for paying their own income tax and social security taxes.
• Work when and where they want to.
• Provide their own equipment.
• Aren’t under direct supervision when working.
• Can assign the work to someone else (an assistant, their own employee, etc.).
• Don’t receive statutory employee benefits such as paid time off or sick pay.

That said, each country and jurisdiction has its own criteria. The following criteria were established by a famous case of independent contractor misclassification, Dynamex Operations W. v Superior Court, in California:

• Independent contractors perform their work independently from the hiring entity’s control.
• Independent contractors' work being done is outside the usual scope of the hiring business.
• The contracted business exists (prior to being contracted for a specific job).

As a result of these differing criteria, it’s essential that you understand worker classification laws before hiring any contractors.

How Can Employee Misclassification Affect Your Business?

Worker misclassification can be a mistake or a malicious scheme, but either way, it could result in serious consequences for your company. If your business misclassified employees, you could face the following:

Lawsuits from Workers & Third Parties

A misclassified worker who is classified as a contractor typically doesn’t receive the social safety net protections that employees do. While misclassification can sometimes give “contractors” a tax advantage by reducing their taxable income, that benefit may be overshadowed by what they lose (workers’ rights). Compared to employees, contractors receive far fewer legal protections and benefits. For example, in the event of a layoff, independent contractors often aren’t eligible for things like unemployment insurance or a notice period.

Additionally, many countries have labor laws regulating employee working hours, overtime pay, sick leave, and more. However, contractors are frequently ineligible for these same legal protections. Similarly, employees are often entitled to employee benefits like health insurance, retirement savings, and annual leave. Misclassified workers can be deprived of these benefits because they lack the legal status of being an employee.

As a result, misclassified workers might sue a business if it prevents them from receiving benefits that directly impact their livelihood. This can cost your business significantly - both in terms of finance and reputation. Additionally, you could face legal action from insurers, clients, or partners as a result of independent contractor misclassification and its knock-on effects.

Back Taxes for the Period the Employee Was Misclassified

When a worker should be an employee but is classified as a contractor instead, the governing tax authority loses out on funds they’d otherwise receive, impacting their ability to fund essential programs.

If the governing tax authority discovers that your business is misclassifying workers, they could require your business to pay the income and employment taxes owed from the period the worker was classified with an independent contractor status.

Fines and Penalties

In addition to back-paying taxes, the local authorities could also charge you a fine or penalty for misclassifying employees. These may take the form of financial penalties or even restrictions on how you operate as a business moving forward. While deliberate attempts at misclassification typically result in harsher penalties, your business could be punished for mistakenly misclassifying employees, too.

How to Prevent Employee Misclassification

Employee classification laws vary by country. While many rules and distinctions are similar, you must comply with each country’s laws, regulations, and technicalities. Otherwise, your business could face fines, penalties, and even lawsuits.

To prevent employee misclassification as you start hiring abroad, you need to do ample research into the country you’re planning to expand in. However, that research takes a significant amount of time and additional resources, and without local expertise, your business could still misclassify workers by mistake.

If your business has violated any type of classification regulation, you will want to correct the misclassified employee within your annual report to avoid penalties and fines.