Employee Misclassification: Independent Contractor vs. Employee
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- Employee misclassification is the illegal practice of categorizing workers as independent contractors when they should be classified as employees.
- Misclassification is a form of worker exploitation that can result in the loss of public tax revenue and create unfair business competition.
- Companies and contractors are responsible for educating themselves on their local guidelines regarding worker classification to prevent misclassification and the associated repercussions.
Uber isn’t the only company accused of assigning contractor status to workers who fit the definition of employees better. Studies show that between 10% and 30% of audited US employers misclassified some workers. In addition, up to 95% of workers who said they were misclassified as independent contractors were reclassified as employees following review.
For some companies, misclassification is an honest mistake; for others, it’s an unlawful way of cutting costs and avoiding employment taxes. However, the legal and financial penalties of worker misclassification are not worth the risk. This guide walks you through the definition of employee misclassification, how employee and contractor relationships differ, and how companies can classify their team correctly.
What is employee misclassification?
Employee misclassification is the illegal practice of categorizing workers as independent contractors when they should be classified as employee status, which entitles them to certain worker protections and benefits.
Employee misclassification is also called worker misclassification or independent contractor misclassification.
Worker classification hinges on factors like a worker’s financial relationship with a company and the degree of flexibility and control over their work. We’ll explain these factors in more detail later in this article.
Why is employee misclassification a problem?
Misclassification is a form of worker exploitation that can result in the loss of public tax revenue and create unfair competition. We explain these issues in more detail below.
One of the primary issues with misclassifying workers as contractors is that they do not benefit from employee rights and protections. Depending on the contractor’s country of residence, typical employee rights include the following:
- Minimum wage
- Unemployment benefits
- Pension plans
- Hour laws
- Rest breaks
- Sick leave
- Overtime pay
Loss of public tax revenue
In the US, for example, the federal government’s Fair Labor Standards Act (FLSA) stipulates that all employers must withhold and deposit income taxes, social security taxes, and Medicare taxes from the wages paid to an employee. When a company misclassifies an employee as a contractor, companies do not withhold or pay any taxes on payments to independent contractors. Misclassification results in a loss of billions of dollars each year in the US.
Disclaimer: This post is provided for informational purposes and should not be considered legal advice. Talk to a legal professional such as an employment lawyer for more info.
What factors dictate worker classification?
The working relationship between the hiring company and the worker determines worker classification. Below we explain the difference between a contractor relationship and an employee relationship.
Employees typically work for a single employer.
Independent contractors are self-employed and often work with one or more client companies.
Employees typically work according to a company-regulated schedule.
Contractors set their own hours and schedules.
Employees receive tools or reimbursements from their employer.
Contractors typically have their own tools and cover any business expenses.
Employees receive continued training and development.
Contractors already obtain the skills and expertise required to perform their roles.
Employees share taxes with the employer and have taxes withheld from their gross pay.
Contractors withhold and pay their own self-employment/income taxes.
Employees receive mandatory benefits like health insurance and retirement contributions.
In many countries, contractors aren’t entitled to mandatory benefits.
Employees receive a salary via the company’s payroll.
Contractors receive compensation which they often request through invoicing.
A manager directly supervises employees.
Contractors receive minimal supervision and control their own processes.
Watch the video below to learn how to manage payments and compliance for independent contractors.
Are there only two worker classifications?
No. There is a third worker classification for workers that act as independent contractors but qualify for employee treatment. In the US, these workers are called statutory employees, while the UK refers to them as “workers.” For UK help, use the Check Employment Status for Tax (CEST) tool to find out the appropriate classification for tax purposes.
Statutory employees are contractors that engage with another contracting party. There is no hiring company, client, or employer.
Unlike contractors, statutory employees qualify for employee treatment. Depending on their jurisdiction, these workers may receive certain protections and rights such as minimum wage, statutory time off, and rest breaks.
In the US, the IRS considers statutory workers employees for tax purposes. However, this worker classification is very rare. The IRS names only four categories of workers who can be statutory employees:
- Drivers in charge of trucking and distributing meat, beverage, fruit, vegetable, or bakery goods; or in charge of picking up and delivering laundry and dry cleaning
- Insurance sales agents who work with a single contractor whose primary business activity is selling insurance
- Full-time salespeople who sell merchandise to buyers such as hotels, restaurants, and retailers as their primary business activity
- Piece workers who work at home on the material or goods that must be returned to the other contracting party when completed
What are the penalties for misclassifying workers?
In the US, the penalties are as follows:
- Tax violation fines: $50 per W-2 tax form that the company did not file and a percentage of the misclassified employees’ wages and FICA taxes
- Payment penalties of up to $1,000 per misclassified worker
- Employee benefits insurance repayments
- Class action lawsuits
- Wage claim audits
- Punitive damages
- Jail time
How to avoid misclassification risks
As we mentioned above, misclassification isn’t always intentional. Sometimes the relationship between a contractor and client company can become blurred, which is common with long-term contracts. Companies must be proactive and maintain the correct working relationship to avoid misclassification.
Create thorough independent contractor agreements
A robust independent contractor agreement outlines the relationship between the contractor and the hiring company. The agreement can also serve as legal evidence should a misclassification allegation arise.
Still, this document won’t hold up if you treat the worker as an employee, but it’s an excellent first line of defense and helps to set clear expectations for both parties.
Use an employment service
Delegating the hiring process to an employer of record (EOR) is one of the easiest ways to ensure accurate worker classification since compliance experts will classify your worker in line with employment laws in whichever country you hire.
Watch the video below to discover how you can fend off misclassification with Deel Shield.
Run regular misclassification audits
If a company works with several independent contractors, it’s wise to run employee classification audits at least once a year. Reviewing your workers’ status will help ensure your independent contractors aren’t drifting toward employment status.
Use the five methods below to evaluate your working relationships with team members.
5 ways to determine worker status (US examples)
Each country and jurisdiction has a governmental body that provides guidance and classification tests to categorize workers correctly. Below we share five US-based tests and methods to determine worker classification.
Reasonable basis test
According to the reasonable basis test, you can categorize your workers as independent contractors if there’s a reasonable basis for such a decision. This test gives a general baseline based on how the IRS looks at workers in similar situations rather than the specific relationship between you and your workers.
Some of the reasonable bases that justify a worker’s independent contractor status are:
- Past IRS audits that didn’t discover any irregularities in your worker classification
- Previous official consultation with a CPA or an attorney
- Workers in similar situations are considered independent contractors across your industry
Read more about this test here.
IRS’s 20-factor or common law test
The IRS 20-factor or common law test consists of 20 questions divided into three main categories: behavioral control, financial control, and nature of the relationship.
This test is very thorough and covers many aspects of the employer-worker relationship. The common law test examines:
- Whether the employer controls where, when, and how the worker completes their work
- Whether the employer provides the worker with training, tools, and equipment
- Whether the worker has multiple clients or works for a single employer
- Whether the employer reimburses the worker’s business expenses
The worker is an employee if the employer controls most aspects of the business relationship.
You can see the full list of questions here.
Department of Labor’s Economic Reality test
The US Department of Labor (DOL) has a multi-factor test to determine a worker’s status based on their financial dependence on an employer. Unlike full-time employees, independent contractors are self-employed individuals whose livelihood doesn’t depend on a sole employer. If their livelihood depends on a single employer, they are probably employees.
The DOL’s test, among other factors, questions if:
- The worker’s services are a core business activity for the employer
- The relationship between the worker and the employer is permanent
- The worker needs to invest in facilities and equipment to perform the job
- The worker has opportunities for profit and loss
Read more about DOL’s test here.
The ABC test
Codified by the California Supreme Court, the ABC test is a common way to determine a worker’s status across the US. It uses three critical elements of a business relationship to determine that an independent contractor is not an employee.
To be considered an independent contractor, a worker must:
- Be free to organize their own working hours and methods of work
- Do the same type of work for other client companies
- Do work outside of the client’s regular business activities
Learn more about this test here.
IRS Form SS-8 allows individuals and companies to request that the IRS conduct an audit and officially determine a worker’s status.
A hiring company can submit this form if they’re unsure how to classify their workers
Are there any protections for contractors?
To help protect contractors from the exploitation that can arise with misclassification, local governing agencies have created their own sets of rules.
In Australia, for example, contractors have the same protections against discrimination as employees, and the hiring company may need to comply with tax withholding requirements.
In Spain, contractors who receive at least 75% of their income from a single client are entitled to employee benefits.
In the US, despite the Internal Revenue Service (IRS) establishing a set of county-wide rules regarding employee misclassification, state governments have also come up with their own protections for contractors. Below are some notable state laws.
California: AB 5 and Prop 22
California’s Assembly Bill 5 (AB5) extended employee status to companies employing gig workers in large numbers, such as Uber or Lyft. In November 2020, Prop 22 allowed employers to exempt app-based drivers from this regulation and still treat them as contractors. But Prop 22 was declared unconstitutional in 2021, meaning companies must treat these gig workers as employees.
New York: Freelance Isn’t Free
New York’s Establishing Protections for Freelance Workers Act took a different approach. Rather than forcing companies to classify certain workers as employees, it provided additional rights to contractors. These rights include required written contracts for freelance projects, protection from retaliation, and timely and full payments.
Companies that hire independent contractors can’t create waivers to limit their rights or include a provision that stops workers from discussing their contracts with governing bodies.
New Jersey: New laws to identify and penalize misclassification
In July 2021, New Jersey voted on a new law to prevent employee misclassification. The new regulations facilitate the identification of employers who categorize employees as contractors and penalize them. The state also created the Office of Strategic Enforcement and Compliance under the new law, as a part of the Department of Labor and Workforce Development, focused on the misclassification of workers.
How can workers report a business for misclassification?
Workers should visit their local government website to gain information on the specific process for reporting a business for misclassification.
In the UK, individuals can contact Acas or Citizens Advice for information and support. The government website encourages individuals to first speak with the hiring company to resolve the dispute. If both parties disagree, the worker can make a claim to the Employment Tribunal.
In the US, individuals can use IRS form 3949-A to report a business for misclassification. The form collects information about the individual and company you suspect has violated tax laws by misclassifying the worker.
Education is key to preventing the misclassification of workers. Try your hand at some common conceptions:
Employers decide the worker's status.
While the employer assigns worker classification based on government guidelines, the local governing body determines a worker’s status. If the employer gets it wrong, they are liable and may face a penalty.
Honest mistakes do happen. An employer might put workers on the payroll even if they’re independent contractors or classify them as contractors when they should be employees. The governing body will take action on a case-by-case basis.
Once you're hired as an independent contractor, it's not possible to change the role.
Part-time workers are considered independent contractors.
The length of time worked does not define contractor status. Part-time workers can be considered employees, and contractors can work for a company equivalent to full-time hours. The main point here is that the hiring company cannot have control over the contractor’s work schedule or hours worked.
Remote workers are independent contractors.
Independent contractors can work remotely, but so can employees. A company can hire full-time employees and allow them to work remotely. Equally, a contractor may choose to work on-site, but ultimately the decision is theirs as a company cannot dictate where the contractor operates.
Independent contractors don’t qualify for social security, medicare, or unemployment insurance in the US.
Independent contractors qualify for social security, medicare, unemployment, and health insurance. The only difference is that independent contractors pay these taxes by themselves. However, they may get a tax deduction for the employer’s portion of the FICA benefits.
Chloe Riesenberg, People Specialist, Project44
Get classification right every time with Deel
Are you a worker trying to determine your classification for a new job? Or perhaps you’re a business owner looking to expand your global team and want to classify your new hires correctly. In either case, Deel is here to help.
We have heaps of resources on misclassification to help you determine your misclassification risk.
Alternatively, Deel can help companies hire full-time employees and engage with contractors worldwide under locally compliant contracts. Deel's Worker Classification Tool combines academic research from Deel Lab with AI to draw upon local laws and legal cases, helping you assess your workers against misclassification issues and mitigate compliance risk. After your workers are hired, our Compliance Monitor will automatically monitor and interpret regulatory changes across 150 countries, reducing the burden of manually researching these changes.
Sound like something your business could use? Book a demo to see Deel in action.