Global companies often engage a mix of contractors and full-time employees as they expand, depending on their hiring needs, location, budget, and long-term business goals.
Regardless of your approach to building a global workforce, employee misclassification poses a serious risk that can lead to fines, legal entanglements, and a damaged business reputation.
This guide provides a detailed breakdown of employee misclassification, including a definition, a list of common causes, a summary of the typical penalties, and the standard steps for correcting misclassification. Plus, find out how to reduce your employee misclassification risk as you build a global workforce.
What is employee misclassification?
Employee misclassification occurs when a company misclassifies an employee as a contractor or vice versa, subjecting the company to fines, back wages, tax arrears, and other penalties.
Misclassification may be deliberate or accidental; however, any company that misclassifies its workers faces repercussions. Correctly classifying talent is important for ensuring workers receive the rights they are entitled to.
Employees are limited in their freedom to set their work schedule and how to complete their work, and they often work for one employer at a time. Still, employees receive various perks, such as healthcare, unemployment insurance, minimum wage protections, overtime protections, and paid leave.
Conversely, contractors have an independent relationship with their clients—contractors generally choose what projects to take on, when to work, and what tools to use. At the same time, they are responsible for paying their own income taxes and purchasing insurance, like healthcare and pension.
Some companies intentionally misclassify employees as contractors to reduce hiring costs, simplify their payroll, and maintain a flexible working relationship with talent, although they rarely get away with it.
In many cases, employee misclassification results from companies unknowingly violating worker classification laws. Even if a company correctly classifies a contract employee from the start of their working relationship, they may violate classification regulations later on as the nature of their work arrangement shifts and local employment laws evolve.
Is your workforce compliantly classified? Use our contractor risk assessment checklist to find out and learn how to avoid misclassification:
Employee vs. contractor: What’s the difference?
The factors determining whether someone is an employee or a contractor vary worldwide. Generally speaking, contractors operate as separate entities responsible for paying their own income taxes, and they usually don’t receive benefits, such as healthcare and pension, from their clients.
Most countries’ worker classification regulations use a similar, general set of guidelines that revolves around how much influence the employer has over things like the contractor’s work schedule, the equipment the contractor uses, and the exclusivity of their relationship.
For example, in the U.S., employee classification is based on a list of factors that the Internal Revenue Service (IRS) divides into three categories: behavioral control, financial control, and the business and worker relationship.
We discuss each of these categories in detail below.
Behavioral control
If a company directs or controls a worker’s duties beyond telling them what to do, that worker is likely an employee.
For instance, if the company directs how, when, or where the individual can work, including what tools to use, who they can hire as an assistant, or where to buy supplies, that worker is an employee in most cases.
Additionally, any training the employer provides regarding work procedures and methods indicates that the employer wants the work done in a certain way, usually resulting in an employee-employer relationship.
Financial control
A person’s investment in their own operations and their exposure to the risks associated with running a business are key factors for determining employee classification in the U.S.
For example, if a person is financially invested in their business while working with a client, this reinforces the independent nature of their work arrangement, deeming it a contractor-client relationship.
Or, if an individual incurs business-related expenses without reimbursement from their client, and they can realize a profit or a loss upon project completion, they are a contractor.
Business and worker relationship
The general nature of the working relationship between two parties also carries weight in determining employee classification in the U.S.
If a worker receives benefits of any kind, such as paid leave, retirement, or health benefits, they are an employee. If they don’t receive benefits, they may still be an employee, although other factors will ultimately determine their employment status.
For instance, if a court struggles to determine a worker’s classification based on other factors, the court may review the work agreement to help clarify the nature of the working relationship. This is why establishing clear, detailed work agreements is important for compliance.
Ongoing changes to worker classification regulations
Classification regulations evolve. If an employer continues operating unaware of recent changes to the law, they may inadvertently find themselves in hot water. HR teams must regularly review local regulations to ensure compliance.
For instance, the U.S. Department of Labor is updating its employee classification regulations on March 1, 2024, to include additional factors making it more difficult to classify workers as contractors. Any company currently engaging talent in the U.S. is responsible for ensuring ongoing compliance with this and any future changes in the law.
Lawmakers in the EU have also tentatively agreed to update employee classification regulations, tightening restrictions on what constitutes a contractor in platform industries like food delivery and car sharing. The new regulations will designate millions of platform workers in the EU as employees, granting them the full range of national and EU employment rights.
Common causes of employee misclassification
Companies violate employee classification regulations for various reasons, ranging from a lack of knowledge of employment laws to industry-specific challenges.
In fact, the National Employment Law Project states that at least 10% to 30% of employers misclassify their employees as independent contractors in the U.S. alone, indicating that several million U.S. workers may be misclassified.
Source: National Employment Law Project
We detail the most common causes of employee misclassification below.
Lack of knowledge of employment laws
Companies often misinterpret their misclassification liability because they struggle to understand complex local employment laws.
Having an HR team with the legal expertise to navigate the nuances of classification regulations is critical for clarifying things like exempt versus non-exempt employee status and accurately identifying the conditions that differentiate between an employee and a contractor.
Misinterpretation of job responsibilities
Ambiguous job descriptions often lead to employee misclassification. Having a vague understanding of your team’s job duties and establishing roles with overlapping responsibilities leads to uncertainty over the correct employment status of each team member.
Overreliance on past practices
Many companies overlook the fact that classification regulations change. Instead of staying abreast of evolving regulations and making necessary adjustments over time, they continue applying the same classification patterns they are used to, putting themselves at risk.
Some companies also have a habit of applying the same classification to similar positions without considering changes in workforce dynamics. Even if job titles are the same or similar, job duties and employment dynamics may differ, which affects classification.
Lack of regular audits and reviews
Regular audits and reviews are among the best ways companies can reduce employee misclassification risk.
Suppose a company rarely evaluates its workforce dynamics, including each team member’s employment status and job duties. In that case, the company may likely violate classification regulations at some point as work arrangements change and local legislation evolves.
Pressure to reduce labor costs
As mentioned earlier, engaging contractors offers companies unique advantages over hiring employees. Hiring a contingent workforce is more scalable and less costly and offers employers more flexibility as they don’t have to provide contractors benefits, pay them overtime, or withhold income taxes from their wages.
As a result, some companies might deliberately misclassify employees as contractors. However, these companies often face the most severe penalties, including fines, injunctions, large legal fees, and damaged business reputation.
Read also: Should You Hire a Contractor or an Employee?
Poor communication
A lack of clear communication between employers and talent often leaves both sides with a vague understanding of their work arrangements and the rights to which workers are entitled. This creates confusion for both sides while leaving classification entirely at the employer’s discretion.
Clear communication between employers and talent helps both sides understand the nature of their work arrangement and rights. It also helps employers better understand how to classify talent for each role correctly.
Complex regulations
Navigating employment regulations requires legal expertise. Companies that go it alone often feel overwhelmed by complex and evolving employment laws, especially when navigating local and national regulations in other states and countries.
The best ways to mitigate noncompliance are to properly train your HR team or partner with a third-party legal expert, such as an employer of record (EOR), who can handle compliance on your behalf and reduce risk.
Lack of HR training
Your HR team’s ability to accurately navigate evolving employment regulations at local, state, and national levels across multiple jurisdictions ultimately depends on their background, expertise, and ongoing training.
If your HR personnel and managers aren’t well-versed in classification laws, this significantly increases your chances of noncompliance. Offering ongoing training and educational programs on classification regulations and best practices is a must.
Not understanding the consequences
Companies often overlook employee misclassification because they’re unaware of its legal and financial ramifications. Not understanding the importance of misclassification risk may lead to oversight, noncompliance, and litigation.
Industry-specific challenges
Each industry poses unique challenges to employers, creating added difficulty for HR teams ensuring compliance. Not only do companies have to stay abreast of evolving regulations, but they must thoroughly understand the nuances that apply specifically to their industry.
Employers should be careful not to adopt industry-standard, noncompliant practices that may go unnoticed for months or years but lead to lawsuits later.
What are the penalties for the misclassification of employees as independent contractors?
The penalties for misclassifying employees as independent contractors vary between jurisdictions and depend on individual circumstances. In most cases, they range from benefits arrears and back wages to legal fees, injunctions, and reputational damage.
Source: Internal Revenue Code
Below, you can find a list of the most common penalties for misclassifying employees as contractors:
- Back wages and benefits. Employers usually have to pay back wages and benefits arrears to misclassified workers. This includes minimum wage violations, overtime pay, leave entitlements, and other unpaid forms of compensation.
- Tax and withholding penalties. This includes income taxes and contributions to public insurance programs, such as retirement, unemployment, and workers’ compensation.
- Legal fees. Companies often face legal fees and high court costs due to the litigation that arises from worker misclassification.
Fines. In addition to back pay, back taxes, and benefits arrears, authorities often impose fines as an added punishment. - Liquidated damages. In some cases, employers must pay liquidated damages—these are additional payments to compensate workers for the intangible harm the misclassification caused them, such as compensation for missed work breaks.
- Injunctions and corrective action. Authorities may issue injunctions forcing employers to correct their classification practices to prevent future violations.
- Reputational damage. Employee misclassification damages a company’s reputation, negatively impacting its relationships with clients, partners, and the public.
How to avoid the risks of employee misclassification
Despite the challenges of trying to classify talent on your own, there are several steps your HR team can take to reduce your risk exposure drastically. These include regularly reviewing local employment regulations, drafting clear work agreements, using self-check resources, and converting contractors to full-time employees.
We summarize each of these classification best practices below:
- Review local employment regulations. Contractor definitions and classification regulations vary between regions at local and state levels. Be sure to familiarize yourself with the varying regulations in each jurisdiction where you engage talent.
- Draft clear work agreements. Establish work agreements that clearly define the terms of service and the nature of the working relationship. Your agreements should use relevant legal terminology when detailing talent’s responsibilities and the degree of influence you have over their work.
- Use self-check resources. Regulatory bodies in many countries provide online resources to help employers correctly classify talent. For example, the Internal Revenue Service (IRS) provides a list of factors companies can use to help correctly classify their American workforce.
- Convert contractors to full-time employees. By converting contractors to full-time employees, you eliminate employee misclassification risk. Plus, this approach allows you to protect your intellectual property, develop a cohesive and committed workforce, and offer competitive employee benefits to secure top talent.
Learn more: How to Avoid the Risks of Worker Misclassification
How to correct employee misclassification
If you suspect you have misclassified talent, you should correct the issue as soon as possible. Depending on the jurisdiction in which your talent resides, you’ll likely need to work with local tax authorities, such as the one auditing your company, to resolve the issue.
Ultimately, you’ll need to settle up with all the affected parties, including talent and government authorities. This involves paying back wages, benefits arrears, tax deficits, fines, and, in some cases, liquidated damages.
Tax authorities in some countries allow companies to rectify employee misclassification and reduce their penalties voluntarily. For instance, in the U.S., companies can apply to the Voluntary Classification Settlement Program (VCSP), which allows them to reclassify their contractors and reduce their tax liability on the compensation they paid to contractors in the previous year by 90%.
Below, we provide a general summary of how to correct employee misclassification in most countries.
Conduct a compliance audit
Begin by reviewing your team’s job duties, the degree of influence you have over their work, and the details of your work agreements to determine which workers’ classifications still comply with local regulations.
Labor laws are often complex and vary between regions. At this stage, consulting an employment attorney or tax specialist knowledgeable in employment classification is advisable.
Adjust worker designations
Once you have reviewed your worker misclassifications, make the necessary adjustments. This stage usually involves cooperating with local tax authorities with whom you’ll disclose the misclassification and begin reclassifying talent, updating work contracts, and revising all relevant documentation.
Remember to notify the affected workers and inform them of the changes to their employment status.
Address back pay and benefits
Pay your misclassified workers the back wages, benefits arrears, leave entitlements, overtime wages, minimum wage violations, and all other unpaid forms of compensation you owe them.
Adjust tax withholdings
Pay back taxes to local authorities. The percentages you’ll pay and the periods you’ll be liable for covering will vary depending on local regulations. In some cases, you’ll also pay additional fines and may face injunctions, reputational damage, and legal fees.
Convert contractors to employees
Even after updating company policies and agreements, you may still risk noncompliance and further setbacks later on. Consider converting your contractors to full-time employees to mitigate your worker misclassification risk altogether.
By converting your contractors to employees, you can avoid the risk of reputational damage, establish a cohesive and committed workforce, and expand your operations globally without interruption. A team of full-time employees also develops your employer brand, boosting investor appeal and increasing your valuation should you seek investors or eye an initial public offering.
Establishing a team of full-time employees is the wisest and safest approach to building a resilient workforce that can expand with your company, no matter what the future holds.
Learn more: How to Convert Contractors to Employees: A Guide for Global Businesses
Independent contractor taxes and forms to know
In most countries, contractors must report their own income, file their own taxes, and submit relevant forms to their local tax authority. Still, there are several important forms that employers should know about, some of which are mandatory for their year-end reporting.
Below, we list the tax forms that American contractors and companies hiring American talent should know:
- Form W-9. Form W-9 is a request for a contractor’s Taxpayer Identification Number (TIN). Contractors complete this form during onboarding and return it to their client to include in their year-end information return to the IRS.
- Form 1099-NEC. Form 1099-NEC is a mandatory tax form that indicates the total compensation you paid a contractor throughout the previous year. You must send copies of your 1099-NEC to the IRS and your contractors at the end of the tax year.
- Form 1096. Form 1096 is a summary page that accompanies all the forms you submit to the IRS for reporting non-employee compensation, such as Forms 1097, 1098, 1099, 3921, 3922, 5498, and W-2G. You don’t need to submit Form 1096 when filing electronically.
- Form W8-BEN. Form W8-BEN classifies an international contractor’s non-U.S. citizen status and determines their tax liability in the U.S., depending on which tax treaties exist between the U.S. and their home country. American employers should request Form W-8BEN from international contractors during onboarding.
- Form SS-8. Companies and workers can file Form SS-8 to the IRS to request confirmation of whether the services the worker provides to the company are those of an employee or a contractor. This is an optional form that helps clarify your employee misclassification risk.
Remember that countries have different regulations and requirements regarding mandatory contractor taxes and forms. Employers must do their due diligence to determine which taxes and contributions they are liable for withholding and which forms they must submit.
For instance, U.S. employers are not responsible for withholding income taxes from contractors’ wages. However, employers in the U.K. that engage contractors working inside legislation IR35, or contractors who work under similar work arrangements as employees, must withhold income taxes and National Insurance contributions (NIC) from contractor earnings just like they would for an employee.
Recent employee misclassification cases
Understanding the implications of worker misclassification is critical for ensuring compliance, but seeing real-world examples of misclassification lawsuits helps put this risk into perspective.
Below, we list several high-profile employee misclassification lawsuits involving well-known companies within the last five years:
- Nike. An ongoing lawsuit from 2023 alleges Nike misclassified thousands of workers worldwide. The company faces potential fines and class-action lawsuits that could amount to more than US$530 million in damages.
- Uber. In 2022, Uber paid US$8.4 million to settle a class-action lawsuit with California drivers who alleged Uber misclassified them as contractors.
- UK Research and Innovation (UKRI). In 2021, the British non-departmental funding body UKRI paid £36 million in back taxes to British authorities for misclassifying its contractors’ IR35 status.
- FedEx. A 2021 employee misclassification lawsuit in New Jersey forced FedEx to pay US$2.4 million to 192 drivers. This is the latest in a series of misclassification lawsuits FedEx has faced over the past two decades in the U.S. that have resulted in damages ranging from US$5.3 million to US$228 million.
Mitigate global employee misclassification with an EOR
Misclassification poses an enormous risk to global employers, and the best way to mitigate this risk is to convert your contractors to full-time employees. While this may seem daunting, partnering with an EOR like Velocity Global makes it easy.
Our integrated Contractor Conversion solution helps global companies quickly and compliantly convert contractors to full-time employees in more than 185 countries without establishing entities.
As your legal employer of record, we handle the heavy lifting associated with converting your contractors to employees, including streamlined onboarding, global benefits administration, running compliant global payroll, and offering ongoing local HR support to your team in their language, no matter where they reside.
With Velocity Global at your side, you can enjoy the benefits of establishing a world-class distributed workforce without the added burden.
Contact us today to learn how to quickly and compliantly convert your contractors to employees and set your company up for uninterrupted growth, no matter what the future holds.
Disclaimer: The intent of this document is solely to provide general and preliminary information for private use. Do not rely on it as an alternative to legal, financial, taxation, or accountancy advice from an appropriately qualified professional. © 2024 Velocity Global, LLC. All rights reserved.
