What is misclassification?

Impacts of misclassification

Misclassification of employees as independent contractors (also known as freelancers or contract workers) has significant impacts on both workers and employers, particularly regarding tax obligations, legal compliance, and employee benefits. When employees are incorrectly classified as independent contractors, it means their employers don’t withhold payroll taxes from their pay. It also means they’re classified as self-employed individuals, which requires them to pay additional income tax. But there are other implications beyond just the financial:

How does misclassification affect workers?

When workers are misclassified, they lose access to essential benefits and legal protections, including:

• Overtime pay: Misclassified employees may not receive overtime pay, even if they should be entitled to it.
• Workers’ compensation: Misclassified workers may not get coverage for injuries sustained on the job.
• Social security: Misclassified workers often have to pay all of their own Social Security contributions, where employees split their contributions with their employer.
• Medicare: Misclassified employees may lose employer contributions to Medicare.
• Unemployment insurance: Misclassified workers may not qualify for unemployment benefits when misclassified.
• Health insurance premiums: Misclassified employees might lose access to employer-sponsored health insurance and be responsible for covering costly premiums on their own.
• Sick leave: Misclassified workers may not receive the paid time off required by law in some states.
• Employee rights and protections: Protections under wage and hour laws, such as the Fair Labor Standards Act (FLSA), may not apply to misclassified workers.

How does misclassification affect employers?

For employers, misclassification can lead to:

• Tax liability: Employers may need to pay back payroll taxes, including Social Security, Medicare, and unemployment insurance.
• Penalties: Failure to comply with wage and hour laws can result in hefty fines and interest on unpaid taxes.
• Legal action: Misclassified employees can sue for back wages, overtime, and other lost benefits.
• Loss of trust: Misclassification harms company reputation and employee morale

Why do companies misclassify workers?

Companies often misclassify workers by mistake. But some do it intentionally to save on costs and reduce liabilities. 

By giving workers independent contractor status rather than designating them as employees, employers can avoid paying for benefits such as health insurance, unemployment insurance, and workers’ compensation. Misclassification of workers also allows employers to circumvent payroll taxes, making it a tempting—but illegal—practice to reduce expenses associated with full employee benefits and protections.

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How do you know if a worker is misclassified?

Determining whether a worker is misclassified often depends on the nature of their working relationship. The exact rules also vary by jurisdiction—but every country distinguishes between employees and contractors and has guidelines for how to classify them.

Let’s look at the US as an example. The US Department of Labor (DOL) sets guidelines under existing employment laws to help clarify worker classification and employment status, giving employers a few key factors to consider:

• Financial control: If the company controls the worker’s business expenses or provides tools and equipment, the worker may be an employee rather than an independent contractor.
• Working relationship: Long-term engagements and provision of benefits like health insurance suggest the worker might be an employee rather than an independent contractor.
• Degree of control: If the company decides when, where, and how the worker does their job, they might be an employee rather than an independent contractor.
• Investment in the business: If someone other than the worker owns the business, and the only way the worker can increase their pay is by working additional hours or getting a promotion, they might be an employee rather than an independent contractor.

Consequences of misclassification

Misclassifying workers can have serious financial, legal, and reputational impacts on a business.

Back taxes

Employers who misclassify workers as independent contractors may be required to pay employment taxes retroactively, including Social Security, Medicare, and unemployment insurance contributions. These unpaid taxes can quickly accumulate and lead to substantial financial burdens.

Financial penalties

In addition to back taxes, businesses may face steep fines from federal and state agencies. Financial penalties may increase significantly if the misclassification is found to be intentional.

Legal action from employees

Misclassified workers can file lawsuits against employers to recover lost wages, overtime, and benefits. They may also seek unemployment compensation if they were denied this benefit due to their misclassification.

Legal action from insurers or government agencies

Government agencies such as the Internal Revenue Service (IRS) or labor departments can pursue legal action against businesses for worker misclassification. Additionally, workers’ compensation insurers may also take action if workers were wrongly denied coverage. In some jurisdictions, employers can even face jail time for misclassification.

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How to prevent worker misclassification

Preventing misclassification starts with proper documentation and clear guidelines. Here are some steps you can take:

• Draft clear, comprehensive contractor agreements. Make sure that written contracts clearly define the working relationship and outline whether the worker is classified as an independent contractor or employee.
• Use the right tax forms. This will depend on the country and legal jurisdiction. For example, in the US, independent contractors typically require a Form 1099, while employees require a W-2.
• Regularly review worker roles. Regularly assess your workforce and workers’ roles to make sure no one on your team is at risk of misclassification.
• Consult legal experts. Stay up-to-date on employment laws by working with legal or HR professionals who can help you comply with state and federal guidelines.

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