Misclassification refers to the act of assigning an individual or something to the wrong group or category.
In the workplace, misclassification of employees is the illegal practice of categorizing employees as contractors, which denies them their entitlement to benefits and other legal protections.
Employees are entitled to employment rights and benefits, such as minimum wage, overtime pay, and statutory benefits. Contractors, on the other hand, are self-employed individuals, and employers have fewer legal obligations to them.
Misclassification often occurs when an employer incorrectly classifies an employee as a contractor, which denies them their legal protections and entitlements.
Factors contributing to worker misclassification
Several factors contribute to an employer misclassifying an employee, whether intentional or unintentional, including the following:
- Economic incentives. Companies do not owe contractors any benefits, unemployment, or income tax withholdings, so an employer may attempt misclassification to avoid paying employee taxes and benefits to save money.
- Misunderstanding employment laws. When expanding into a new market and hiring internationally, employers may not understand foreign employment laws and how to maintain global compliance.
- Changing workforce dynamics. An employer may restructure a team and change a worker’s status from contractor to employee but neglect to reclassify the new employee.
Read more in our complete guide to employee misclassification.
Criteria for classifying employment status
The relationship and degree of control between the worker and the business determines whether an individual is an employee or contractor.
In the U.S., the Internal Revenue Service (IRS) uses a common-law employee test to decide and classify employment status using the following three categories:
- Behavioral control. The business has a right to direct and control the work and how the work is done through instructions, training, or other means. Employers directly supervise their employees’ work and schedules, while contractors choose where and when they work.
- Financial control. The business has a right to direct or control the financial and business aspects of the worker's job. Employers control how they pay their employees and withhold payroll taxes from their salaries, while contractors are not on the company’s payroll and pay their income taxes.
- Relationship of the parties. The business provides the worker with employee-type benefits, the relationship is permanent, and the services performed by the worker are a key aspect of the company’s regular business. Employers provide statutory benefits to their employees under a permanent employment contract, while contractors often work for multiple clients and do not receive employee benefits.
Consequences of misclassification
Misclassification of employees results in serious risks and penalties for both employers and employees, including the following:
Impact of misclassification on employers
Employers misclassifying their employees may be liable for the following penalties:
- Legal fines. Misclassification can lead to class action lawsuits, and employers may incur costs from damages and attorney fees.
- Back taxes. Employers must pay back federal, state, and local taxes for misclassified employees.
- Back benefits. Employers are liable for paying benefits owed to the employee, such as workers' compensation, medical insurance, vacation, and sick pay.
- Reputational damage. Employers risk negative standing among peers and may have difficulty recruiting prospective talent.
Impact of misclassification on employees
Employees who experience misclassification from their employers may also experience the following:
- Lost pay. Employees may wrongfully lose pay and their rights to minimum wage and overtime pay.
- Reduced benefits. Misclassification denies employees basic workplace protections, including workers’ compensation, unemployment insurance, and statutory benefits.
- Tax trouble. Misclassified workers will have to pay taxes themselves.
- Poor job security. Losing pay and benefits to misclassification makes it harder for employees to support themselves or find work elsewhere.
Is your talent correctly classified? Get our free contractor compliance checklist to learn about misclassification in global markets and assess the risk it poses to your business’s success.
How to fix misclassification
While the below is not an exhaustive list, the following tips can help companies correct misclassification issues:
- Cooperate with legal authorities. Work with the applicable local tax authorities and government to correct the issue.
- Research country-specific classification programs. Some country-specific programs provide opportunities for taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes. The Voluntary Classification Settlement Program in the U.S. is one such program, and other countries may have similar initiatives.
- Conduct a tax audit. The local tax authority may audit your company to discover any additional misclassification issues and errors.
- Pay back wages, benefits, and taxes. Pay misclassified employees back their missing entitlements, including wages, employment benefits, and applicable taxes.
- Pay applicable fees and fines. You may incur costs from misclassification fines, liquidated damages, and attorney fees.
How to prevent misclassification
Despite the risks, employers can prevent employee misclassification by practicing due diligence. The following steps help employers avoid employee misclassification risks:
Stay informed about classification criteria and legal changes
Contractor definitions and classification laws vary between countries and evolve over time. Employers must understand the differences for all locations of their employees and contractors to avoid noncompliance risks.
Stay regularly informed on the regulations for any legal changes that may require changes to your employment contracts and classification processes.
Seek legal guidance
Consider working with an experienced partner or legal expert who can provide in-country insight into locally compliant employment contracts. A global partner, such as an employer of record (EOR), can help companies manage their distributed workforce and ensure compliance with classification laws.
Convert contractors to employees
Converting contractors to employees allows companies to avoid misclassification risks and ensure compliance with classification laws.
Velocity Global's Contractor Conversion solution helps companies compliantly and quickly convert contractors to full-time employees without needing entity establishment. As your EOR partner, we quickly and compliantly reclassify your talent as full-time employees, protect your intellectual property, streamline onboarding, oversee talent work schedules, offer competitive employee pay and benefits, and provide ongoing HR support on your behalf.
Contact Velocity Global and learn more about how to expand globally without the worry of facing misclassification risks.