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The Essential Guide to Employee and Independent Contractor Misclassification

Business meeting on employee classification issues.

International businesses expanding to the USA may consider engaging a mix of contractors and full-time employees, depending on their hiring needs, budget, and long-term US expansion plans.

Regardless of your approach to building a US workforce, employee misclassification can lead to significant issues. This includes fines, legal entanglements, and a damaged business reputation.

Our guide provides a detailed breakdown of employee misclassification in the USA, including a definition, a list of common causes specific to US regulations, a summary of the typical penalties under US law, and the standard steps for correcting misclassification. Plus, find out how to reduce your employee misclassification risk as you build your US team.

What is Employee and Independent Contractor Misclassification?

Misclassification of employees and independent contractors arises from complexities in employment and tax regulations. When a business expands internationally, these complexities can be further magnified, leading to inadvertent misclassification. This occurs when a worker is mistakenly categorized as an employee when they should be considered an independent contractor, or vice versa.

In an attempt to cut hiring costs, simplify payroll processes, and maintain a flexible workforce, some companies intentionally misclassify employees as contractors. However, these attempts to gain an advantage rarely succeed in the long run, as legal consequences are likely to follow.

Misclassification can also occur unintentionally. Companies may unknowingly violate worker classification laws, even if they initially correctly classified the working relationship. As the nature of the work arrangement or local employment laws evolves, the original classification may no longer be valid. This highlights the importance of staying up-to-date on US regulations to avoid unintentional misclassification.

Regardless of intent – deliberate or accidental – any company in the US that misclassifies workers faces legal and financial repercussions including fines, back wages, tax arrears, and other penalties. Correctly classifying your workforce is crucial to ensure your employees receive the rights and benefits they’re entitled to under US law.

Employee vs. Contractor: Navigating the Differences in the US

Classifying workers as employees or contractors can be complex, and the determining factors vary significantly worldwide. In the United States, however, there’s a general framework to distinguish between the two.

  • Employees typically operate under the direct supervision and control of their employer, following instructions on how and when to perform tasks. They receive a regular salary (hourly, weekly, or bi-weekly) and may be eligible for a benefits package that can include health insurance, paid time off, and retirement contributions. Employees are typically classified as W-2 workers for tax purposes, with their employer withholding income and payroll taxes.

  • Independent contractors, on the other hand, operate as their own businesses. They are responsible for finding and securing their own clients, setting their rates, and managing their work schedules. Unlike employees, independent contractors are not eligible for employee benefits from the companies they contract with. They are responsible for paying self-employment taxes, which cover Social Security and Medicare, and managing their own health insurance and retirement savings. Independent contractors often have more control over how they perform their work, and they may work for multiple clients simultaneously. This flexibility can be a major advantage for contractors who value autonomy and project-based work. However, it also means they are responsible for finding new work consistently and for covering their own business expenses.

Like many countries, US worker classification hinges on the level of control the employer exerts over various aspects of the work arrangement. The Internal Revenue Service (IRS) has established a three-pronged test for employee classification to provide a clearer picture. In the following sections, we’ll delve deeper into these categories—behavioral control, financial control, and the business and worker relationship.

1. Behavioral control

The first factor considered in US worker classification is behavioral control. This examines the extent to which a company dictates how a worker performs their duties, exceeding simply outlining the desired outcome.

For example, if the company specifies how, when, or where the individual can work, this extends beyond simply defining the task. Similarly, dictating the tools used, or even where supplies are purchased points towards an employee classification.

Furthermore, any training the employer provides regarding specific work procedures and methods implies a desire for the work to be completed in a particular way. This level of control typically signifies an employer – employee relationship.

Additionally, supervision is another key behavioral factor. Close employer supervision of the worker indicates behavioral control. Regular check-ins, progress assessments, and direct oversight are more commonly associated with an employee-employer relationship. Independent contractors typically have more freedom and may not require close supervision.

2. Financial control

The second pillar of US worker classification is financial control. Here, the focus is on a worker’s investment in their operations and their exposure to business-related risks. This helps determine the nature of the work arrangement.

For instance, if a worker invests financially in their business while working with a client, this strengthens the argument for an independent contractor relationship. This investment demonstrates the separate entity nature of their work. Examples of such investment include purchasing tools or equipment specific to the work they are hired to do, advertising their services to potential clients, or hiring and paying for assistance with their work.

Additionally, the method of payment is another factor to consider. Contractors are commonly paid per project or on a freelance basis, and they may invoice for their services, further emphasizing their financial independence. While employees typically receive regular, consistent paychecks, some contractors may also receive regular payments depending on the agreement.

It’s important to note that expense reimbursement doesn’t automatically disqualify someone as an independent contractor. Contractors can be reimbursed for expenses by their clients. While reimbursement practices may vary depending on the specific agreement, it’s common for clients to reimburse contractors for reasonable business expenses incurred during the project. However, reimbursement should be done in line with applicable tax laws and regulations.

3. Business and worker relationship

The final element of US worker classification hinges on the overall nature of the business and worker relationship. The presence of benefits offered by the company plays a significant role. If workers receive benefits like paid leave, retirement plans, or health insurance, they are most likely categorized as employees. However, the absence of benefits doesn’t automatically translate to contractor status. Other factors will ultimately determine the worker’s classification.

Several additional factors can influence classification under this element. Here are some key considerations:

  • Exclusivity and Control: Employees are typically under the employer’s direction and control. The employer dictates work schedules, methods, and procedures. Contractors, on the other hand, have more autonomy and discretion in how they complete their work, as they are hired for their specialized skills or expertise.
  • Integration into the Business: Employees are more integrated into the day-to-day operations of the business. They often work on-site and are subject to company policies, procedures, and supervision. Contractors may work remotely or autonomously and have more independence in how they manage their work.
  • Termination and Duration of Work: Employees typically have ongoing, long-term relationships with the employer, and termination is governed by employment laws and regulations. Contractors are generally engaged for specific projects or a set period, and the relationship may end upon completion of the work or by mutual agreement.

As mentioned previously, if the factors discussed earlier (behavioral and financial control) leave room for interpretation, courts may analyze the work agreement to gain further insight. This agreement can clarify the intended nature of the working relationship. This underscores the importance of establishing clear and detailed work agreements to ensure compliance with US regulations.

Ongoing changes to worker classification regulations

The landscape of worker classification regulations is constantly in flux. Failing to stay updated on these changes can lead to legal trouble for employers who continue operating under outdated assumptions. Human Resources teams should prioritize regularly reviewing local regulations to ensure compliance.

For instance, on March 11, 2024, the United States Department of Labor (DOL) implemented significant updates to its employee classification regulations under the Fair Labor Standards Act (FLSA). These revisions make it more challenging for companies to classify workers as independent contractors, potentially impacting how businesses engage talent across the US.

The DOL’s new emphasis on a “six-factor test” prioritizes factors that suggest a worker is an employee, such as behavioral and financial control. This shift can lead to unexpected liabilities for businesses that misclassify workers.

Understanding and complying with these complex regulations can be a daunting task. Ensuring ongoing compliance requires a deep understanding of the nuances of the law and how it applies to your specific workforce. Partnering with a provider experienced in worker classification, such as Foothold America, can help you navigate these complexities and minimize the risk of costly misclassifications.

Common Pitfalls Leading to Misclassification

Employee misclassification arises from various factors, ranging from a simple lack of awareness of employment laws to industry-specific challenges.

The National Employment Law Project estimates a staggering 10% to 30% of employers in the US alone misclassify their employees as contractors. This translates to potentially millions of US workers being incorrectly categorized.

Employer penalties for worker misclassification information.

Source: NELP.org

Lack of Knowledge of Employment Laws

Companies often misclassify workers due to a lack of knowledge of complex US employment laws. Navigating the intricacies of classification regulations and the key factors differentiating employees from contractors, requires an HR team with solid legal expertise.

Misinterpretation of Job Responsibilities

Vague job descriptions are a recipe for misclassification. An unclear understanding of a team’s specific duties and overlapping job responsibilities can lead to confusion about the proper employment status of individual team members.

Overreliance on Past Practices

Classification regulations are not static. Companies that fail to keep pace with evolving regulations and adjust their approach accordingly risk falling out of compliance. Similarly, applying the same classification to similar positions without considering changes in workforce dynamics, even for roles with identical titles, can be problematic. Job duties and work dynamics can significantly impact classification.

Lack of Regular Audits and Reviews

Regular audits and reviews are a company’s best defense against misclassification. Without routine evaluations of workforce dynamics, including employment status and job duties, companies become susceptible to violations as work arrangements evolve and local regulations change.

Pressure to Reduce Labor Costs

As discussed earlier, engaging contractors offers companies advantages over hiring employees. Contractor-based workforces are often more scalable and less expensive, as companies don’t have to provide benefits, pay overtime, or withhold income taxes. This can incentivize some companies to misclassify employees as contractors deliberately. However, this strategy carries significant risks, including hefty fines, injunctions, substantial legal fees, and reputational damage.

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 HR 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 across multiple jurisdictions at local, state, and national levels 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 for your HR team on classification regulations and best practices is a must if you choose to handle US employment on your own.

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

Navigating worker classification is a complex task, and each industry presents its own set of challenges for HR teams. Ensuring compliance requires staying informed about evolving regulations, but there’s an additional layer of complexity: industry-specific nuances. Common practices within an industry might not comply with federal or state labor laws, creating a hidden minefield for employers. These misclassifications can go unnoticed for a while, but when they come to light, they can result in costly lawsuits and penalties.

For example, in the construction industry, many companies classify workers as independent contractors if they provide their own tools and transportation. However, these workers may still be considered employees under the law if the company exerts significant control over their work schedule, tasks, and training. This misclassification can leave workers without vital benefits and protections.

Employee Misclassification: The Costly Mistake

Below, you can find a list of the most common penalties for misclassifying employees as contractors:

  • Back Wages and Benefits: Employers usually must 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: Authorities often impose fines as an additional punishment in addition to back pay, back taxes, and benefits arrears.
  • 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.

 

Employer penalties for worker misclassification in the USA.

Source: NELP.org

How to Avoid the Risks of Employee and Independent Contractor Misclassification

Despite the challenges of independent contractor classification, several steps can significantly reduce your company’s risk exposure. Here are some essential best practices:

  • Review Local Employment Regulations: Contractor definitions and classification regulations vary significantly between regions at both local and state levels. Regularly familiarize yourself with the regulations in each state 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. These agreements should use relevant legal terminology when detailing talent’s responsibilities and the degree of influence you have over their work.
  • Utilize Self-Check Resources: Regulatory bodies in many countries provide online resources to assist employers in correctly classifying workers. For example, the US Internal Revenue Service (IRS) offers a list of factors to help companies classify their American workforce.
  • Consider Converting Contractors to Full-Time Employees: Converting contractors to full-time employees eliminates misclassification risk. Additionally, this approach allows you to protect your intellectual property, develop a more cohesive and committed workforce, and offer competitive employee benefits to attract top talent.

Independent Contractor Taxes and Forms to Know

In most countries, contractors are responsible for reporting their income, filing taxes, and submitting relevant forms to their local tax authority. However, there are still several essential forms that employers, particularly those hiring within the US, should be aware of for their year-end reporting purposes.

Below, we outline the critical tax forms relevant to American contractors and companies engaging US contractors:

  • Form W-9: This form requests a contractor’s Taxpayer Identification Number (TIN). Contractors complete and return this form during onboarding to allow clients to include it in their year-end information return to the IRS.
  • Form 1099-NEC: Form 1099-NEC is a mandatory tax form that reports the total compensation paid to a contractor throughout the previous year. Companies must send copies of the 1099-NEC to the IRS and their contractors at the end of the tax year.
  • Form 1096: This summary page accompanies all forms submitted to the IRS for reporting non-employee compensation, including Forms 1097, 1098, 1099, 3921, 3922, 5498, and W-2G. It’s important to note that Form 1096 is not required when filing electronically.
  • Form W8-BEN: This form classifies an international contractor’s non-US citizen status and determines their tax liability in the US. The specific tax implications depend on existing US and the contractor’s home country tax treaties. American employers should request Form W-8BEN from international contractors during onboarding.
  • Form SS-8: This optional form allows companies and workers to request confirmation from the IRS regarding the worker’s classification as an employee or a contractor. This can be a helpful tool for mitigating employee misclassification risk.

Recent Employee Misclassification Cases

Understanding worker misclassification’s legal and financial repercussions is crucial for ensuring compliance. Real-world examples can provide valuable perspectives on the potential risks. Here are a few high-profile employee misclassification lawsuits against well-known companies within the last two years:

  • Nike (2023): A lawsuit alleges Nike misclassified thousands of workers worldwide, including warehouse associates and retail store staff. The company faces potential fines and class-action lawsuits totalling over US$530 million in damages.
  • Arise Virtual Solutions (2023): In a landmark case, the US Department of Labor sued Florida-based Arise Virtual Solutions. Arise provides customer service representatives for major brands like Disney and Walgreens. The lawsuit alleges that Arise misclassified over 22,000 customer service workers as contractors, denying them minimum wage and overtime protections.
  • CrowdFlower (2022): This data labeling company faced a lawsuit from content moderators who claimed they were misclassified as independent contractors. The moderators argued they should have been classified as employees due to the company’s control over their work tasks and schedule.

Eliminate US Employee Misclassification Risks with an Employer of Record (EOR)

Employee misclassification is a major concern for US employers. At Foothold America, we understand you may have different needs when it comes to managing your US workforce. That’s why Foothold America offers two core solutions to ensure compliance and eliminate misclassification risks:

  • Employer of Record (EOR): As your legal Employer of Record, we take on the complexities of managing your US workforce. We handle everything from streamlined onboarding to US benefits administration, ensuring accurate and compliant US payroll processing. Our team also provides ongoing local HR support, regardless of your employees’ location within the US.

Read more: Employer of Record Service

  • People Partnership Service (PPS): Ideal for companies who prefer to be the direct employer of their US workforce, our PPS offering provides comprehensive HR support to simplify your operations. We’ll handle tasks like payroll processing, benefits administration, and local HR compliance, allowing you to focus on your core business objectives.

Read more: PEO Alternative (PPS)

By partnering with Foothold America, you can leverage a skilled, distributed workforce in the US while choosing the service that best suits your needs.

Contact us today to discuss your specific requirements and learn how Foothold America can help you build a compliant and successful US workforce.

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