When hiring global talent, proper employee classification quickly becomes complicated. Engaging a diverse workforce of remote workers, distributed employees, and international contractors while following various country laws and payroll regulations is an understandable challenge.
However, misclassifying an employee as a contractor seriously violates labor laws and employee rights.
Misclassification denies employees their entitlement to pay, benefits, tax withholdings, and other legal protections. Companies must ensure compliant employee classification or face severe misclassification penalties, including fines, back pay, tax and labor violations, legal disputes, loss of intellectual property, and reputational damage.
The following guide discusses the employee misclassification penalties to know and how businesses can avoid them.
5 employee misclassification penalties to avoid
Misclassification negatively impacts both the employer and the worker. An employer misclassifying employees risks severe legal, financial, and operational penalties.
Misclassification penalties depend on several factors, such as the severity of the misclassification, company size, and the amount of time the employer did not pay employment benefits and taxes.
Misclassification laws also vary worldwide, and countries have their own regulations and subsequent penalties for misclassification.
Some potential consequences of misclassifying workers include the following:
1. Tax violations and fines
In most countries, employers withhold and pay taxes for national programs like social security. For example, in the U.S., the Internal Revenue Service (IRS) requires employers with W-2 employees to withhold and pay Social Security and Medicare taxes, pay unemployment taxes, and withhold and remit employee income taxes.
Meanwhile, businesses that engage 1099 workers, also called contractors or contract employees, do not withhold or pay taxes on behalf of their contractors. Instead, contractors are responsible for paying their own taxes.
If an employer misclassifies an employee as a contractor, they must pay back taxes for their misclassified employees, along with any accrued interest.
Plus, employers may face additional fines and penalties if the local government determines that the misclassification of a worker was intentional. The employer responsible for misclassification may also incur legal fees and court costs if the misclassification leads to a legal dispute.
Additionally, employers may lose certain tax benefits, deductions, and credits associated with proper classification.
2. Wage and labor law violations
Employees are entitled to certain wage rights and labor law protections, such as overtime pay, minimum wage, worker’s compensation, retirement, medical insurance, vacation, and sick pay.
If an employer misclassifies an employee as a contractor, they deny these entitlements to pay and benefits. The employer must retroactively pay any unpaid wage or overtime and provide any owed benefits.
3. Legal disputes and costs
Misclassification can also lead to class-action lawsuits seeking punitive and special damages for the misclassification of employees. These legal disputes will incur additional costs, attorney fees, resources, and time.
Misclassification also increases the likelihood of additional wage claim audits and further scrutiny of the employer's tax practices.
4. Loss of intellectual property
Misclassification can create issues with intellectual property. If an employee’s misclassification leads to severing their employment relationship with an employer, they could claim ownership of their work and the company’s intellectual property.
An employer must include proper classifications and protections in employment contracts to ensure their intellectual property and any sensitive customer information are safe. These protections are especially critical when engaging contractors and remote workers in other countries.
5. Damaged business reputation
Employers who misclassify their workers risk a negative standing among industry peers, customers, and prospective talent.
A company violating labor laws may cause existing employees to leave in support of their misclassified co-workers or for fear of their own misclassification. An employer engaging in improper employment practices could prevent potential talent from engaging with the company.
A high-profile and disruptive misclassification case may also negatively affect the company’s reputation with investors and industry peers, even if it has full legal backing.
Are your workers compliantly classified? Use our classification risk assessment checklist to find out and learn how to avoid worker misclassification:
Why do authorities care about employee misclassification?
Governments worldwide are concerned about preventing employee misclassification to maintain a fair and equitable labor market.
For instance, U.S. agencies like the IRS and the Department of Labor (DOL) play critical roles in enforcing employment regulations and educating employers about proper worker classification.
Some key reasons why authorities care about preventing and addressing misclassification include the following:
- Tax revenue. Employers misclassifying workers may not withhold the appropriate taxes, depriving the government of crucial tax revenue.
- Government programs and benefits. Misclassifying workers undermines the funding of national programs, such as Social Security and Medicare in the U.S. Proper classification ensures workers are eligible for government programs and benefits, such as unemployment benefits, disability benefits, and certain tax credits.
- Worker protections. Misclassifying workers denies them various labor protections, including minimum wage, overtime pay, and workers' compensation, and could lead to unfair labor practices.
- Unemployment insurance. Misclassification may exclude workers from access to unemployment insurance and benefits during job loss or economic downturns.
- Health and safety regulations. Misclassified workers may miss out on health and safety regulations that ensure a safe working environment and protect them from potential risks in the workplace.
- Employment discrimination laws. Employers misclassifying workers may inadvertently remove their employees’ protections against employment discrimination laws based on race, gender, age, or other factors.
- Fair competition. Employers who misclassify employees as independent contractors may gain an unfair advantage against competitors by avoiding certain labor costs, taxes, and legal obligations.
Learn more in our complete guide to employee misclassification.
Recent examples of employee misclassification penalties
The following are examples of recent employee misclassification penalties faced by major companies around the globe:
United States
U.S.-based sporting goods brand Nike currently faces a potential $530 million fine for misclassifying thousands of workers.
A July 2022 review of Nike’s contractors in the U.S., U.K., Netherlands, and Belgium concluded that the company faces potential fines and possible class-action lawsuits for incorrectly classifying its temporary office workers as contractors.
The United Kingdom
U.K. national innovation agency, U.K. Research and Innovation (UKRI), misclassified its contractors’ IR35 status for the tax years spanning 2018-2019 to 2021-2022.
After a review revealed errors in classification, the organization owed £36 million in unpaid income tax and National Insurance Contributions (NICs).
Australia
In Australia, airport shuttle service Happy Cabby misclassified its drivers as contractors rather than employees in 2013.
The drivers were underpaid for over 11 months, which included failure to pay minimum hourly rates, casual loadings, overtime entitlements, weekend rates, and public holiday rates. The company also admitted to failing to keep employment records and not issuing any payslips to employees.
Happy Cabby was ordered to pay $334,488 in back pay, fines, and interest for treating its employees as contractors.
How to avoid employee misclassification penalties
Despite the severity of employee misclassification penalties, companies can avoid them with some due diligence. Below are a few ways businesses can reduce their chances of misclassifying workers:
Understand workforce differences
Employers should understand the difference between contractors and employees as regulated by local laws. Before hiring or engaging talent in other countries, you must familiarize yourself with local worker classification laws and use country-specific worker assessment checklists.
Draft compliant employment agreements
Establish transparent and compliant contractor agreements that define the nature of the working relationship, adhere to contractor tax requirements, and follow country-specific regulations.
Seek expert legal counsel
Consult legal counsel with a global expert such as an employer of record (EOR) to review worker agreements, help you navigate complex employment regulations, and ensure proper contractor classification and compliance.
Convert contractors to employees
Consider converting your contractors into employees to avoid misclassification risks altogether. Converting contractors to employees ensures compliance with international classification laws, allows you more control over your workforce, protects your intellectual property, and helps you attract and retain top talent worldwide.
How to Avoid Misclassification: Key Tips
Learn your options for mitigating misclassification risks when hiring a contingent workforce.
Avoid employee misclassification penalties with Velocity Global
Building a global team and avoiding employee misclassification penalties is easy when you partner with a hiring compliance expert like Velocity Global.
As an industry-leading EOR, we offer a full suite of global employment solutions that handle all risk mitigation and hiring compliance in more than 185 countries so you can focus on building a top-tier, long-term global workforce that helps you meet your business goals.
And when you’re ready to convert your contractors to full-time employees, our integrated Contractor Conversion solution helps global companies quickly and compliantly convert contractors to full-time employees around the world—without establishing entities.
We handle everything from onboarding to payroll, and we also partner with leading advisory firms to review employment contracts, determine accurate employer burden costs, and offer compliant total rewards packages.
Velocity Global ensures compliance every step of the way. Contact us today to learn how to quickly build your global team while avoiding employee misclassification penalties.
