Classifying employees and contractors

What Is Employee and Independent Contractor Misclassification? (And How To Avoid It)

Independent contractor misclassification happens every day. Learn how it damages employees and employers and how to avoid it.

What Is Employee and Independent Contractor Misclassification? (And How To Avoid It)

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Every business wants to save money, but more and more, companies are using independent contractor misclassification to skirt the law and avoid paying eligible benefits, minimum wages, or employee taxes. 

In 2020, a National Employment Law Project study found that 10–30% of employers were misclassifying their workers. Those millions of workers, treated as independent contractors instead of employees, lost vast sums of money and benefits, and the US government has missed out on collecting billions in taxes. 

The consequences of this widespread practice go beyond just financial losses; it leads to an inherently skewed and unfair labor market, where honest workers are deprived of their rights, and responsible employers are unfairly disadvantaged. 

With the world embracing a gig economy and more people turning to work on a project-to-project basis, it has become increasingly critical for workers and employers to recognize and understand the difference between contractors and employees. 

This article will delve into the defining characteristics of employees and independent contractors and discuss the potential consequences for businesses and workers involved in these inaccuracies and how to avoid the misclassification of employees. 

By raising awareness and promoting adherence to labor laws, we can work toward a business ecosystem that is transparent, accountable, and just.

What Is Employee and Independent Contractor Misclassification?

Employee and independent contractor misclassification occurs when businesses incorrectly label their workers—intentionally or unintentionally—as independent contractors (self-employed) instead of employees. 

This mislabeling often results in workers being denied essential employment-related benefits, legal protections, and the fair compensation they are entitled to under the law.

Additionally, it creates an inaccurate representation of the business’s labor relationships, which may lead to financial and legal complications.

How does employee misclassification happen?

Worker misclassification can arise from a genuine misunderstanding of the differences between employees and independent contractors or due to the unfamiliarity with the process of hiring remote workers.

Or, it may be deliberately done to reduce labor costs, avoid liability, and circumvent various employment regulations.

For instance, consider a small business that hires web developers to maintain its website. Suppose these developers follow a specific work schedule set by the employer, work exclusively for the business, and use the company’s resources and equipment—all things that wouldn’t normally be associated with independent contractor status. 

In that case, they should be classified as employees. However, if the business chooses to misclassify them as independent contractors, these developers may not receive benefits such as:

  • health insurance
  • overtime pay
  • workers’ compensation coverage
  • unemployment benefits 

This disadvantages the developers and saves the company from paying employer-related taxes and complying with other regulatory obligations. 

In the long run, the practice of misclassification has consequences for both parties involved: the workers lose out on crucial employee-type benefits, and the company could face severe legal penalties and financial liabilities when the misclassification is discovered.

Contractor, work from home, reading

What Happens if You Misclassify Employees As Independent Contractors?

Misclassifying employees as independent contractors can result in consequences that affect the worker’s rights and the company’s legal and financial liability. 

Lack of wage rights

When employees are misclassified as independent contractors, they are often denied their appropriate wage rights, including minimum wage and overtime pay.

Whereas employees receive at least the federally mandated minimum wage, independent contractors have no such guarantee. 

Furthermore, employees working over 40 hours a week are entitled to overtime pay, usually calculated as one and a half times their hourly rate. Misclassified workers miss out on these mandatorily required overtime premiums, leading to financial losses in their overall earnings potential.

May not receive required benefits

Misclassified workers do not receive essential employment benefits, such as paid sick leave, vacation time, health insurance, and pension plans that employees in the same organization might. 

By being categorized as independent contractors, workers often have to bear the huge costs of these benefits themselves or go without them, further burdening them financially and potentially affecting their long-term well-being.

Tax implications

W-2 employees—even remote workers—have their taxes withheld from their paychecks, with employers contributing their portion of the payroll taxes.

In contrast, independent contractors are responsible for calculating, reporting, and paying their taxes, including self-employment tax. The misclassification shifts the full tax burden onto the worker, often resulting in higher taxes, penalties, and complications in tax filing for the individual.

Uncollected Social Security and Medicare taxes

When an employee is misclassified, the employer avoids paying their share of Social Security and Medicare taxes, leaving the entire burden on the worker. If the worker realizes this, they can fill in IRS tax forms Form SS-8 and Form 8919 to report the amount of Medicare and Social Security taxes that were uncollected from their wages. This will save them from paying the employer contribution if it’s decided they were an employee. 

Legal ramifications

Businesses that misclassify employees face substantial legal risks, including fines, penalties, lawsuits, and potential damage to their reputation. Regulatory agencies and misclassified workers can initiate legal proceedings against these companies to recover lost wages, benefits, and unpaid taxes.

If a business has a reasonable basis for the worker misclassification, it can file for a tax relief using Section 530 if it meets certain requirements. It can also file for partial tax relief by reclassifying its workers as employees and using Form 8952, Application for Voluntary Classification Settlement Program.

As an example of an independent contractor misclassification case, in 2016, Uber agreed to a $100 million settlement in Massachusetts for a class-action lawsuit involving misclassified Uber drivers as independent contractors rather than employees. 

David Weil, a former administrator of the Wage and Hour Division at the US Department of Labor, wrote about his experience, suggesting that the issue is much more widespread than even the studies show. He predicts it will get even worse as we integrate more digital technologies into the workforce.

What Are the Ways To Tell Employees Apart From Independent Contractors?

employee vs. independent contractor infographic

Understanding the distinctions between employees and independent contractors is essential to categorize workers correctly. Proper classification ensures compliance with labor laws and prevents potential legal consequences. 

Here we outline some of the primary factors to consider when determining the classification of a worker:

Duration of work

The duration of the working relationship can serve as a key indicator in distinguishing between employees and independent contractors. 

Employees usually have open-ended relationships with their employers, characterized by the expectation of continuous work for the foreseeable future. On the other hand, independent contractors are typically hired for a specific project or limited time frame without guaranteeing future work once the project is completed.

Taxes

Tax considerations distinctly separate employees and independent contractors. For employees, the employer is responsible for withholding income taxes, Social Security, and Medicare taxes and reporting these amounts to the respective tax authorities. 

On the other hand, independent contractors are responsible for managing their tax liabilities, including paying self-employment taxes that cover Social Security and Medicare contributions (both employee and employer contributions).

The presence of tax withholdings is a strong indication of an employer-employee relationship.

Compensation

The method of compensation can also help differentiate between employees and independent contractors. 

Employees generally receive regular wages or salaries and potential bonuses and are compensated for overtime work. An employee can be a part-time or full-time employee and has the right to the minimum wage set by federal and state laws. An employer withholds income tax, Social Security tax, and Medicare tax from a W-2 employee’s wages.

On the other hand, independent contractors usually negotiate a contract for specific services or projects, detailing the payment arrangements, which could be hourly, project-based, or commission-based. No taxes are withheld from their compensation as they are expected to pay all taxes themselves. 

A fixed-wage employment suggests an employer-employee relationship, while project-based compensation is more consistent with independent contractor status.

Limitations

Assess the level of control and independence the worker exercises to help determine their classification. 

Employees are subject to company policies and managerial oversight, typically work at an employer-designated location, and use company-provided equipment. They have limited autonomy regarding working hours, project execution, and decisions related to their job. 

In contrast, independent contractors enjoy far more freedom when, where, and how they complete their tasks, using their methods and tools of choice while only being accountable for the final output. 

Subcontracting

Subcontracting further distinguishes independent contractors from employees. Independent contractors often have the freedom to subcontract or delegate portions of their work to other individuals, managing the completion of the project through their chosen resources. 

This flexibility allows independent contractors to work on multiple projects simultaneously by hiring individual workers or a team to assist in delivering the final output. An individual’s ability to subcontract, therefore, significantly supports their classification as an independent contractor rather than an employee.

Employee or Independent Contractor Classification Examples

Let’s compare a few common scenarios to classify workers as employees or independent contractors.

Scenario 1:

John is a graphic designer hired by a marketing agency to create brochures, logos, and promotional materials. 

The marketing agency provides him with a computer and software, assigns specific projects, and requires John to be available in the office from 9 am to 5 pm, Monday to Friday. He is paid a monthly salary and receives feedback and guidance from his supervisor on the designs he creates. 

Based on this scenario, is John an employee or an independent contractor?

Answer: 

Employee 

John’s work conditions, schedule, and salary all indicate an employer-employee relationship.

Scenario 2:

Jessica is a software developer who provides her services to a tech startup. 

The company hired her to build a new mobile application within three months. Jessica can choose her working hours, and she works remotely from her personal computer at home. 

She consults with the startup on weekly progress meetings to ensure the project is on track. Jessica receives payment for the project in installments based on reaching specific milestones. 

Based on this scenario, is Jessica an employee or an independent contractor?

Answer: 

Independent contractor 

Jessica controls her working hours, uses her equipment, and is paid based on project milestones, indicating an independent contractor relationship.

Scenario 3:

Mark is a freelance videographer who regularly works on video projects for various clients, including a local advertising agency. 

The advertising agency hires Mark on an ad-hoc basis, depending on the needs of its clients. Mark uses his high-quality video camera and editing software, sets his schedule, and manages the video production from start to finish. He is paid a negotiated rate for each project. 

Based on this scenario, is Mark an employee or an independent contractor?

Answer:

Independent contractor

Mark has multiple clients, works on a project-to-project basis, and controls his work process, reflecting an independent contractor relationship. 

signing contract

How To Avoid Employee and Independent Contractor Misclassification

Avoiding the misclassification of employees is essential to ensure compliance with labor laws, protect your business from potential legal consequences, and promote a fair and transparent working environment. 

To prevent misclassification, consider the following guidelines and steps:

1. Understand the legal definitions

Familiarize yourself with the federal and state labor laws, as well as the definitions of employee and independent contractor, as per the Fair Labor Standards Act (FLSA). Understanding these legal distinctions will help you make more accurate decisions when classifying workers and mitigate the risk of misclassification.

2. Review the US Department of Labor’s “Myths about Misclassification”

The Department of Labor has published a helpful resource called “Myths about Misclassification.” It clarifies common misconceptions about employee and independent contractor classification. 

By reviewing this information, you can further comprehend the key differences between these working relationships and avoid falling into classification pitfalls.

3. Conduct an honest evaluation of working relationships

Assess the true nature of the working relationships within your organization by examining factors such as duration, taxes, compensation, limitations, and subcontracting, as previously discussed. 

Use this analysis to objectively determine whether your workers should be classified as employees or independent contractors.

4. Draft clear and accurate contracts

Ensure every worker has a clear, written Statement of Work explicitly stating their classification as an employee or independent contractor. 

By documenting the terms of the working relationship, both parties can better understand their roles, rights, and obligations, making it more likely that the appropriate classification will be accurately assigned.

5. Regularly review and update worker classifications

Periodically review and update worker classifications to account for changes in working relationships or shifts in labor laws. By staying up-to-date on the legal landscape, you can make timely adjustments as necessary, including the reclassification of workers, keeping your classification system accurate and compliant.

6. Consider filing Form SS-8

If you are uncertain about the correct classification of a worker, you can file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. 

The IRS will then review the specifics of the working relationship and determine the worker’s status. Relying on this determination can provide additional guidance and help ensure your workers are classified correctly.

7. Consult with an HR or legal expert

Navigating the complexities of labor laws and worker classification can be challenging, especially in industries with fluid working relationships or rapidly evolving regulations.

Consulting with an HR professional or legal expert specializing in employment law can provide valuable insights and guidance on correctly classifying your workers. 

These experts can review your business’s practices, assess individual working relationships, and offer tailored advice to ensure compliance with relevant labor laws, reducing the risk of misclassification.

This investment in expert consultation protects organizations from potential legal consequences and fosters a workplace that respects and values the rights of all workers.

Final Thoughts

By taking these proactive steps, you can comply with labor laws, prevent employee and independent contractor misclassification, and create a transparent and fair working environment for all. 

Implementing accurate worker classification practices not only offers legal protection for you but also ensures that your workers receive the rights, benefits, and protections to which they are entitled.

If you regularly hire independent contractors, have a look at our downloadable independent contractor hiring checklist—because confirming whether the role is suitable for an employee or contractor is just the first step in the process. 

And if you’re interested in learning about the possibilities of hiring nearshore talent from Latin America for both employee and independent contractor roles, we encourage you to download our free guide on how to hire the top 1% of talent in under 21 days

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