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How To Avoid Employee Misclassification

How To Avoid Employee Misclassification


  1. Distinguishing Between Employees and Independent Contractors

  2. Causes of Employee Misclassification Errors

  3. High Profile Cases of Misclassification

  4. Legal Penalties of Misclassifying Workers

  5. Risks and Penalties of Employee Misclassification

  6. Strategies to Avoid Misclassifying Contractors

  7. The U.S. Department of Labor’s (DOL’s) New Rule

  8. Remedying Employee Misclassification

Working with independent contractors is nothing new. Most businesses today engage freelancers and contractors in some form or the other. 

Yet, there are still a surprising number of employers who do not know what exactly are the practical differences between these workers and their employees. After all, they operate in much the same way that their remote or work-from-home staff does. What’s more significant is that employers don’t often understand that there are implications of confusing the two types of workers!

At TalentDesk, we have discussed the importance of correct classification before. Now, let us explore the various nuances of misclassification, understand their significance and see how they can be avoided.

Distinguishing Between Employees and Independent Contractors

Clarifying the Criteria

Let us begin by establishing the key differences between contractors and employees. Employees essentially are the people who work for you. As their employer, you have certain rights – you can decide their work hours, tell them where to work from and dictate how they work.

But these rights also come with responsibilities – as their employer, you will need to provide them with benefits like sick leaves, paid holidays and overtime pay. You will need to train and guide them, and ensure they have the equipment they need to do their job. You will also need to withhold taxes for your employees and offer them severance pay if you terminate their contract.

An independent contractor does not come with those rights – or the responsibilities. With them, you are free to engage them as and when business needs arise. You do not have to offer them benefits when they are working with you; nor do you have to pay a severance if you don’t renew their contract. But keep in mind that you also cannot dictate when, where and how they work, the way you do for employees.

Assessing Control and Independence

As you may have realized, direction and autonomy are the two key factors that differentiate these workers. To define this better, the IRS has prescribed some common law rules that encompass:

Behavioral control. You can control how, when and where your employees work. With independent contractors, you only get to control the results they produce – not how they get there.

Financial control. As an employer, you bear financial responsibilities for your employees – be it in terms of their salary, benefits, training costs, equipment costs and more. However, independent contractors will need to bear these costs themselves, only billing you for the services they provide.

Type of relationship. With employees, your relationship is more indefinite, ending only if you terminate them for legitimate causes or if they resign. With an independent contractor, both parties have more flexibility – you can choose to start or stop working with them as per your needs. They in turn, can take up or turn down any work you offer them, and are free to pursue other contracts even while working with you.

Causes of Employee Misclassification Errors

Accidental vs. Intentional Misclassification

So if these differences are clearly set out, why does employee misclassification happen?

1. Deliberate attempt to cut costs. Hiring independent contractors is often more economical, given that there’s no need to pay for benefits or overtime. Some companies take advantage of this by hiring employees but terming them as independent contractors to get out of these cost obligations.

2. Ignorance. Sometimes, employers genuinely do not know the practical differences between the two types of workers. They may engage an independent contractor – and then proceed to assert control over their work, not knowing that this crosses a line.

3. The ever-changing rules. The formal freelancer and contractor economy is still evolving. As newer nuances of work come to the fore, the rules are updated to address changing needs. So even if an employer may have correctly classified a worker while onboarding them, there’s still a possibility of misclassification if the rules change later.

Misclassification, however, is punishable by law – done intentionally or not. Ignorance or lack of knowledge does not exempt you from the fallouts. The only difference is in degree – intentional misclassification is obviously worse, and may carry heavier fines and greater penalties.

Gray Areas in Classification

Though there are rules in place, there’s still a lot of scope for ambiguity and confusion. The definitions are not always black and white, and can be open to interpretation.

For instance – there’s a lot of discussion around how delivery workers should be categorized. They usually are engaged as independent contractors. But given that many of them work on a full-time basis for e-commerce aggregators, and are essentially the on-ground driving forces behind the success of those businesses, should they be considered full-time employees?

There are similar considerations around drivers for ride-hailing cab companies. Though they are gig workers, they are core to the success of these companies. However, these businesses often define themselves as tech companies – thus arguing that the services the drivers provide are not key to their business, and hence they cannot be termed as employees. Unfortunately, this leaves the drivers open to exploitation and vulnerable to job insecurities.

High Profile Cases of Misclassification

Landmark Legal Battles

These debates are not always restricted to online debates and labor law platforms. Sometimes, they blow up into courtroom dramas that lead to landmark rulings.

As the most recent example, the Nike case comes to mind. The global sportswear giant has 79,000 workers around the world, and many of these are independent contractors driving their t-shirt design, event planning, photography and marketing functions among others. However, Nike made the mistake that many employers make – they neglected to have company-wide processes to establish how their contractors should be classified.

And this mistake has the potential to cost them big! In a recent audit, 3670 entities in the US were reviewed, and more than a quarter of them were found to be potentially misclassified. That’s not all – more cases are being reviewed in Belgium, Netherlands and the UK. So far, the liabilities of these contractor misclassifications could cost Nike an eye-watering $530 million in penalties!

Another well-known misclassification case put Uber in the spotlight. The ride-hailing app has over 1 million drivers in the US, of which 150,000 are in California. Many of these drivers claimed that they were misclassified as independent contractors when they should rightfully have been seen as employees. They brought a class action lawsuit in California, which led to Uber having to pay $8.4 million in settlements.

Impacts on Industry Standards

With more and more of these high-profile cases making the headlines, we are seeing industry standards going through an irrevocable change. Employers are sitting up and taking notice of the very real and practical implications of worker misclassification.

Aside from raising general awareness, this is paving the way for legal changes too. For example, in the US, the National Labor Relations Board went back to a previous standard of determining worker status. This standard uses a list of common-law factors to establish worker status and had originally been passed as a result of a 2014 FedEx case. It had subsequently been overturned in 2019 – but that move was seen to have increased cases of worker exploitation, thus leading to the standard being reinstated now.

Legal Penalties of Misclassifying Workers

Understanding the Legal Framework

As we have seen, the legal framework is not static – it is constantly being updated in different countries. The recent years have seen many new legislations and rulings coming into play, all aiming to determine worker status.

One such law passed in the UK was IR35, which aims to prevent worker misclassification. As per its most recent update in 2020, the legislation shifted the responsibility of classifying workers on to private sector employers (as opposed to the responsibility being on the contractors themselves, previously).

In California, the Assembly Bill 5 (AB5) was signed in 2019, which put forward the ABC test to determine worker status. This test examines whether a worker is under the control and direction of the employer, whether the scope of their work falls within the employer’s core business, and whether they are engaged in an independently established trade.

Meanwhile in Spain, the Royal Decree Law 9/2021 was enacted, leading to the Law 12/2021 being passed. Under this, their Labour Act was amended to bring digital platform workers under the scope of employment.

While legislations like these are meant to make the labor economy fairer and more equitable, the impact is not always so straightforward. The challenge lies in prescribing rules that discourage worker exploitation – without limiting entrepreneurial opportunity. This is why each new law or standard undergoes heavy debate, with new nuances emerging every day.

Risks and Penalties of Employee Misclassification

Financial and Operational Risks

Even as the laws evolve and change, it is up to employers to adhere to the current standards and prevent misclassification. Getting this wrong can open the employer up to immense risks like:

  • Legal fines. Misclassifying workers essentially means violating an employee’s federal rights and denying them the protections they are entitled to. An errant employer may be charged fines, penalties, attorney fees and other damages, adding up to a hefty amount.

  • Back taxes. The employer would need to pay back all the unpaid federal, state and local taxes that they should have filed over the years. Additionally, they may also need to pay up to 3% of the wages of each misclassified employee.

  • Back pay. Then, there’s the question of compensating the wronged employees for the rights that they were entitled to – including unpaid overtime, insurance and other benefits.

  • Tax fines. Adding to this, the tax authorities may impose fines for every W2 form that was not filed. At approximately $50 per form, this can quickly add up too.

  • Criminal charges. More seriously, if the misclassification is found to be a deliberate case of exploitation, the employer may face criminal charges – involving jail time, attorney fees and more.

  • Reputational damage. More intangibly, but just as importantly, there’s the company’s reputation to be considered. Being publicly known as a discriminatory and exploitative employer can only make it tougher for them to find new clients or hire talent. Additionally, attrition may increase with their current employees getting demoralized and leaving too.

  • Contract breach lawsuits. Finally, depending on the severity of the issue, the aggrieved employees may not be happy with just back pay – and may decide to opt for a lawsuit. Again, this would involve further penalties and settlement costs.

Strategies to Avoid Misclassifying Contractors

The best course of action thus, is to take every possible step to ensure that you don’t breach the misclassification laws. Having a formal strategy in place is crucial.

  • Comprehend Local Employment Laws

    As the first step, ensure that you understand your local laws – not just as it currently stands but also on an ongoing basis. If you are engaging freelancers in other countries, you will also need to know about the laws there so that you can operate compliantly. It is recommended that you involve your legal team to stay ahead of all these complexities.

  • Mastering Contractor Identification

    Study the factors that impact classification so that you can correctly determine the status of your workers. Understand the dos and don’ts of working with a contractor – especially when it comes to what you can and cannot ask of them.

    Even something as simple as inviting them to join your daily huddle calls can be construed as an employer trying to assert their rights over an employee! Your HR department may be able to help you understand these nuances, so involve them from the start.

  • Educating Your Hiring Team

When working with just a few contractors, you may be able to guarantee that you are personally involved in each interaction. But you’ll find that quickly becomes impossible as your team gets bigger. So it’s not just enough that you understand the various aspects of worker classification – anyone in your company involved in hiring or working with freelancers and contractors must be equally knowledgeable too. 

  • Benefits of Using an EOR or AOR

    Fortunately, it’s not necessary that you stay ahead of every law, rule and regulation yourself. Today, there are various services that are specifically designed to help you manage compliance.

    An Agent of Record (AOR) is a prime example. An AOR is an entity that works on your behalf to hire and pay contractors. They take over all your operational, compliance-related responsibilities – managing contracts, onboarding and payments. It is their job to stay ahead of changing laws, especially in different countries, and ensure you update your policies to adhere to them. AORs also work to periodically review your contracts and audit your interactions with contractors – thus ensuring ongoing compliance every step of the way.

    An Employer of Record (EOR) is a similar service – but instead of contractors, they help you manage employee compliance around the world. They ensure that you are offering the right benefits, filing the right taxes, paying out the right insurances and more. Essentially they act as your representative as an employer in different global locations.

    Having these partners in place can be immensely helpful in segregating the two types of workers and managing them both as necessary.

The U.S. Department of Labor’s (DOL’s) New Rule

As per the latest update, the U.S. Department of Labor (DOL) introduced a new rule to determine worker status. Effective from 11 March, 2024, this involves a 6-factor test to establish the economic reality of whether a worker is an independent contractor – or is actually an employee.

To clarify, there is an independent contractor rule in place already, which also prescribes a multi-factor test. But this test puts greater weight on the degree of control the employer has over the worker, and on the financial opportunities and obligations of the worker.

Now, this will be rescinded with the new rule coming into play. What’s more, the new rule will give equal weight on all the 6 factors, namely:

  1. Opportunity for profit or loss: Whether the worker in question can potentially increase their profits through the way they negotiate, market or expand their business.
  2. The investments made by both parties: Whether both parties are making similar types of investments – or whether the financial obligations are being disproportionately borne. 
  3. The permanence of the relationship: Whether the engagement is open-ended and recurring on a steady basis or if it is bound by a contract and is more sporadic.
  4. The nature and degree of control: Whether the employer controls how, when and where the worker operates, or if the worker is free to control their own work and prices.
  5. The role the services of the worker plays in the employer’s business: Whether the work done is core to the employer’s business offerings.
  6. The skills of the worker: Whether the worker offers any highly specialized skills that they have acquired independently, without any training from the employer.

Remedying Employee Misclassification

So what happens if you analyze your current worker contracts and find that some of them are indeed misclassified as independent contractors? There are some immediate steps you will need to take.

  • Immediate Steps to Correct Misclassification

    The first thing to do is to understand the severity of the issue. Reach out to an AOR or a legal team right away to discuss the matter with them. Find out how many workers are wrongly classified, for how long and to what extent.

    Once this is established, immediately set out to file the correct forms and pay any fines you have accrued. The fact that you are doing this proactively will work in your favor. After you’ve taken care of this, go on to draw up new agreements and contracts – with a special focus on compliance. The assistance of an AOR should make this easy.

  • Long-Term Strategies for Compliance

    Once you’ve taken the immediate damage-control measures, set out some long-term steps to prevent future misclassification. Create a process to periodically audit all contracts, update freelancer information, and revise your internal policies if required. You may want to engage the services of an AOR on an ongoing basis, to ensure that compliance is being seriously and professionally handled.

    Not only will this save you trouble in future, it will also help you avoid being marked out as an employer that repeatedly misclassifies workers – a serious allegation indeed!

Avoiding Contractor Misclassification with TalentDesk

At TalentDesk, our Agent Of Record (AOR) service is designed to help you stay compliant with your worker contracts, now and in the future. We ensure this right from the start – by verifying your workers for you and classifying them correctly even before you bring them on board. 

We handle all the necessary contracts and onboarding formalities – so you can rest assured that every document or form that should be collected, will be. What’s more, we offer you a shield service where we sign the contracts on your behalf, reducing your liabilities.

The contracts are then stored safely and compliantly, all in one place, in the cloud. This makes it incredibly easy to pull them up when you need to file your 1099 forms or conduct audits. We do offer this AOR support globally, so we can guarantee compliance no matter what country you engage your contractors in. 

So if you want to work with the top global contractors, without ever having to worry about misclassification, this is a great way to go about it!

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