Contractor Management 20 min

Employee and independent contractor misclassification: Expert guide

July 10, 2024
Preston Wickersham

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Avoiding employee misclassification is more about action than intent. Treat a worker like an employee, and eventually, regulators will see that worker as an employee — even if you never intended to create that relationship.

Your intent matters, of course. Many countries levy heavy penalties against companies that break the law intentionally. If you want to stay compliant, though, you have to follow through on your good intentions.

A guide to employee and independent contractor misclassification

More and more companies are recognizing the value of using independent contractors. You’re no longer bound by the talent in your area, and contractors can be easier to hire and pay. Win-win, right?

Unfortunately, hiring contractors carries an inherent risk of misclassification. So how do you minimize risk of employee misclassification while managing international workers? Keep reading. We’ve developed this guide to help you avoid misclassifying employees. You can also try our free employee misclassification risk calculator to find out your risk level — and what you can do to fix it.

What is misclassification?

Misclassification occurs when a business gives a worker the wrong designation, whether by mistake or on purpose. Although fines and penalties tend to be more severe for deliberate misclassification, businesses still face penalties for honest mistakes.

Unfortunately, many employers deliberately misclassify workers to get the best of both worlds. You are not required to pay taxes and insurance for contractors, and your employment contract can be much more flexible in favor of the company. It’s much easier to fire contractors, and payroll is much more straightforward without the need to calculate benefits or social contributions.

Even if you try to classify workers properly, you still might struggle. For example, you may have hired a contractor to do a small job for your company. And they may have done such a great job that you hired them for more jobs. Over time, the nature of your relationship may shift. Unless you’re doing regular classification reviews, you could overlook the fact that your old contractor is now technically an employee.

Classification isn’t always straightforward. Local laws vary, and those laws change over time. For example, in 2021, the Netherlands changed rules regarding misclassification and increased enforcement of those rules. That means you need up-to-the-minute information to stay compliant.

Misclassification not only deprives workers of benefits and protections, but it also denies revenue to state and federal governments. Consequently, more countries are cracking down on the practice of misclassification, especially as the gig economy grows. Governments are ramping up enforcement, increasing penalties, and tightening legislation.

What is employee and worker classification?

Employee and worker classification refers to the status of the worker in the eyes of the local government. In most cases, workers are either employees (meaning the company holds more responsibility) or self-employed contractors.

Different countries have different definitions of employees and contractors for the purposes of employment law and taxation. When a business hires a worker, that business must classify that worker appropriately, using the proper documentation, and follow all applicable laws.

Employees are entitled to more benefits and protections than contractors. Depending on the country, these benefits may include:

  • Minimum wage

  • Overtime pay

  • Vacation

  • Family and medical leave

  • Social security or pensions

  • Unemployment benefits

  • Health insurance

  • Safe workplace protections

  • Termination protections

Payroll and reporting are also handled differently for employees and contractors. For employees, employers are responsible for withholding payroll contributions (and sometimes matching contributions), paying payroll taxes, and paying into insurance programs.

Employee vs. contractor: Which is which?

What makes one worker an employee and another a contractor? The answer depends on a series of questions, including a worker’s time, place of business, equipment, payment structure, and freedom to pursue other jobs.

 Differences in an employee versus contractor

In general, the distinction between an employee and an independent contractor depends on the level of control the business has over the worker. The more control a business exerts over how the work is performed and how the worker is paid, the more likely it becomes that the worker should be classified as an employee.

Each country will have its own guidelines. For example, according to the Internal Revenue Service (IRS) in the United States, “Anyone who performs services for you is your employee if you can control what will be done and how it will be done.

This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.” Be sure to check the guidance for each country in which you use global contractors.

While rules may vary by country, you can usually guess whether an employee is misclassified based on the answers to the following questions:

Table depicting employee vs independent contractor rules of employment

Who decides when the work is performed?

Employees typically work on a schedule, with the business designating the hours and days to be worked. Many employees work from 9 a.m. to 5 p.m., Monday through Friday. By contrast, contractors can work whenever they want and take as many breaks as they want, as long as they deliver the product or service by the deadline.

Where is the work done?

Employees often work in a company’s office space or other defined property, while contractors can do their work from anywhere. However, remote work for employees was on the rise even before the global pandemic.

Now, it’s common practice for employees to work from home or another location of their choosing. In these cases, a person working in a company office is more likely to be an employee, but an employee working outside that office is not necessarily more likely to be a contractor.

Who provides the equipment?

Employers typically provide resources for employees to do their work. These resources may include computers, cell phones, specialized software or subscriptions, and other necessary tools. On the other hand, contractors use their own equipment and subscriptions purchased at their own expense.

Who performs the work?

When an employer hires an employee, the expectation is that the product or service is done by the employee themselves. If the work must be done by the worker, they are an employee. By contrast, a contractor may be able to delegate work as needed.

How is the worker paid?

Most employees are paid on a regular basis through a payroll system. As part of payroll, businesses deduct necessary taxes and make social contributions on behalf of the worker.

Contractors, however, are paid without tax withholding, often based on invoices. Employees, on the other hand, do not have to submit invoices for their regular pay. Instead, they either receive regular distributions of their salary or clock in and clock out using an hourly system.

How important is the work?

Here’s where things start to get tricky. In many countries, if a worker provides a service that is vital to the business, they are likely to be an employee. By contrast, contractors are often used to provide supplementary services, such as a marketing plan or website build. However, this can be subject to interpretation.

Think about it like this: if the company makes websites for clients and hires someone to make some of those websites, that person is probably an employee. If the company makes lightbulbs and asks a self-employed website builder to create a website for the company, that worker is probably a contractor.

What is the length of the relationship?

The question of permanency can be the difference between an employee and a contractor. In some countries, a worker may be correctly classified as a contractor, then become an employee if the engagement with the company continues beyond a certain time frame.

In countries with fixed-term contracts, workers often cannot sign multiple fixed-term contracts with the same employer. Instead, the employer must either terminate the relationship at the end of the term or offer the employee an indefinite position at the company.

link to Independent contractor vs. employee: which should you hire?

Independent contractor vs. employee: which should you hire?

Understand the key differences between independent contractors and employees and determine which arrangement might work best for your business.

Misclassification under the Fair Labor Standards Act (FLSA)

The FLSA is a federal law that protects workers in the US by setting rules regarding minimum wage, overtime pay, and other work-related issues. It safeguards employees by guaranteeing them decent pay and safe working conditions. You must understand and comply with the FLSA’s requirements to maintain a lawful, ethical workplace and avoid legal trouble.

You can misclassify your workers by wrongly labeling them as independent contractors when they’re actually employees, or as exempt employees instead of non-exempt employees.

Employers who fail to classify their employees properly may be subject to heavy fines, penalties, and back pay obligations, as outlined in the FLSA. The Department of Labor (DOL) has the authority to conduct investigations and impose compliance regulations.

It is also important for employees to understand their rights and classification under the FLSA so they can receive fair compensation and protection.

Here are some common misconceptions about being an independent contractor:

Some think a 1099 makes them an independent contractor. If your employer labels you an independent contractor for federal tax purposes, you’ll receive a 1099 tax form. However, this form doesn’t mean you’ve been correctly labeled an independent contractor for federal tax purposes.

Some employees believe they're independent contractors because they work remotely or have flexible hours: Working off-site doesn't mean you're an independent contractor. Independent contractors and employees can both telework, work from home, or work on-site.

Some believe an independent contractor agreement makes them an FLSA-compliant independent contractor: Any label you or your employer give to the employment relationship — even if it’s in an agreement you signed — is irrelevant. What matters is whether your current situation shows that you depend on your employer for payment (as an employee) or work for yourself (as an independent contractor).

Some think an employee identification number and paperwork stating they work for an LLC or another business entity makes them an independent contractor: Having an EIN or paperwork stating that you’re an LLC, sole proprietorship, or another business type doesn’t make you an independent contractor. This is especially true if your employer needs you to file business paperwork and come up with a business name to get the job or be paid. If your work falls under a law's definition of employment, you're an employee, regardless of your relationship on paper.

Correct classification helps keep the workplace fair and equal, which protects both workers' rights and employers' legal and financial security.

What are the risks of employee misclassification?

The risks of employee misclassification can be severe. Some consequences might include:

Overview of the risks of employee misclassification

Penalties and fines 

If the DOL and IRS find that your company has misclassified an employee, you could face heavy fines or penalties. In cases where you misclassify numerous employees or the misclassification persists for an extended duration, these fines can mount rapidly, posing a substantial financial burden.

Back wages and benefits 

When you misclassify your workers, their payroll taxes — including those for Social Security, Medicare, and unemployment — may go unpaid. Your company could face legal consequences if it fails to pay its employees for benefits like retirement contributions, health insurance, and other perks. Failure to withhold and remit these taxes may result in penalties with the IRS. You may also be required to compensate workers for lost wages or benefits that resulted from the misclassification.

Recognizing and ensuring proper worker classification is crucial to maintaining a positive reputation as an employer. Legal battles, bad press, and close public scrutiny can make employees, customers, and business partners less likely to trust you. Negative publicity can also tarnish your company’s good name, making recruiting and retaining top talent harder.

Also, if misclassified employees believe they are not getting fair wages or benefits, high turnover and distrust in management may result.

Operational disruptions

Employee misclassification can disrupt regular business operations. Legal proceedings, audits, and compliance efforts can significantly sidetrack core business activities. 

Additionally, if a regulatory agency discovers that your company is misclassifying its workers, they may launch more investigations and audits to scrutinize your internal operations further. This disruption can potentially hinder productivity and your business's overall performance.

Reputational damage

A common consequence of employee misclassification is the infringement of various labor laws under the FLSA. Misclassified workers might not get the minimum wage or overtime pay that federal and state laws stipulate. As such, you, as the employer, may face serious legal risks, like investigations or enforcement actions for non-compliance.

Misclassified workers can sue their employers for compensation for unpaid wages and overtime. Fighting these lawsuits can be expensive, and you may have to pay large settlements. Misclassification cases also frequently escalate into class action lawsuits, which can increase the substantial financial and reputational harm you already face.

Misclassifying employees can have hidden costs as well. Workers who discover they should have been employees instead of contractors may view the company unfavorably. Some workers may even stop working with the business and tell others to avoid the company.

Penalties for employee and independent contractor misclassification vary by country, but most countries follow a similar playbook. The company in question is responsible for paying fines, penalties, back taxes, and back benefits, both to the employee and to the government.

How do I avoid employee misclassification as an employer? 

If you have employees and contractors, you can avoid wrong classification by learning the local laws that govern compliance where your workers live. For example, rules regarding 1099 misclassification in the United States are different from rules governing IR35 in the United Kingdom.

While every situation is unique, you can follow a few best practices to avoid misclassification of employees:

  • Consult with local legal experts.

  • Take advantage of government resources and self-check services.

  • Review your contracts with all self-employed contractors.

  • Train your managers on proper classification and encourage them to err on the side of caution when assigning work to contractors.

  • Convert contractors to employees if you discover that you have misclassified them.

Another helpful way to keep employees from being wrongly classified is to use an employer of record (EOR). This third-party entity assumes legal responsibility for hiring workers on behalf of a client company.

EORs stay updated on changes in labor laws to help companies like yours maintain compliance with federal, state, and local laws. They guarantee conformity with foreign labor rules and regulations if your company has a global workforce. Part of this is ensuring that employees are correctly classified and you’re following local employment laws, which helps to minimize the chances of misclassification.

So, with an EOR, you can rest easy knowing your company is compliant with employment laws and you face no risk of employee misclassification. Delegating hiring responsibilities allows you to concentrate on your core business activities.

When selecting a partner, it is important to work with an EOR that has a history of following all applicable local labor regulations. The EOR must know the labor laws of the countries where you're hiring people to ensure compliance.

How to calculate employee misclassification

Calculating compensation for employee misclassification is not an exact science. What works in one country might not work in another. Regardless of location, though, you must usually prepare to pay back employees for any benefits and social contributions they would have been entitled to had they been classified correctly.

If you discover you have misclassified an employee, you can estimate how much you will owe by considering a few factors:

  • How long has the employee been misclassified?

  • What have you paid the employee?

  • What would a person in a full-time position at your company performing similar duties earn?

  • What company benefits would you normally offer an employee of that seniority level?

  • How much would you have paid in taxes on behalf of the employee?

  • How much in taxes would the employee have been responsible for?

  • What are the government’s guidelines for misclassification penalties?

In addition to these questions, you must also consider whether you identified the misclassification yourself. If you did, you may avoid the harshest penalties and fines. If the government discovered the issue or if the employee lodged a complaint, however, you could end up paying the maximum amount.

How to correct employee misclassification

If you discover that you have misclassified workers, do not simply end the relationship and expect the problem to go away. You are still responsible for compensating the employee (and potentially the government) for benefits, taxes, and other perks.

You can correct employee misclassification only by making the employee and the government whole. That means paying whatever back taxes, benefits contributions, pension contributions, and fines may be associated with the issue.

You may be tempted to terminate the relationship with the employee and hope the problem goes away on its own, but that strategy can backfire badly. Governments are much harsher on companies found to have broken misclassification laws deliberately.

Famous employee misclassification lawsuits

Several lawsuits should make companies think twice before misclassifying contractors.

  • Dynamex Operations W. v. Superior Court: This case in California places the burden on the business to prove the worker is not an employee. In addition, this case outlined the “ABC” test, which determines whether the worker is sufficiently independent of the business to be considered a contractor.

  • Uber BV and others (Appellants) v Aslam and others (Respondents): Uber lost this court case in the U.K., which determined that its drivers are, in fact, “workers” and not independent contractors. The U.K. has a three-tiered hierarchy of working relationships in which employees, workers, and contractors all have certain rights.

  • Van Dusen et al. v. Swift Transportation: This case, which lasted more than nine years, eventually saw Knight-Swift Transportation pay out more than $100 million in damages to around 20,000 workers who were found to be misclassified as owner-operators. Businesses must consider the financial harm arising from a decade-long court case and a nine-figure settlement before treating classification concerns lightly.

Even if these lawsuits occurred in a different country or state, employers should heed their warnings. Laws can change quickly, and employers found to be in violation cannot continue to operate outside the law once the rules change.

An overview of independent contractor taxes and forms

In the United States, the forms to file related to independent contractor taxes have changed recently. Here are a few of the forms companies need to know:

  • Form W-9: This form collects information from the contractor, including name and tax identification number (TIN).

  • Form W8-BEN: This form determines the foreign status of non-resident aliens for the purposes of taxation.

  • Form 1096: This form acts as a cover sheet for forms pertaining to contractors that are physically mailed to the IRS. You do not need to file Form 1096 when filing digitally.

  • Form 1099: While employers of US contractors previously had to file Form 1099-MISC, today, those companies file a 1099-NEC instead. Short for “non-employee compensation,” Form 1099-NEC reports payments made to individuals not employed by the company.

Every country has its own unique requirements related to contractor classification and tax forms. Be sure to consult with a local legal expert in the countries where your contractors operate to ensure you file all taxes properly.

What are the complexities of managing contractors globally?

Although you may have a good grasp of your own country’s laws and statutes, it can be difficult to manage risk across multiple countries without the support of local labor experts. You must consider how:

  • Laws vary from country to country.

  • Laws change over time.

  • Laws can be subject to interpretation.

  • The nature of your relationship with a worker may change over time.

Complexities come into play when you work with global contractors. For example, you may be required to make payments in a local currency from an approved bank, as is the case with employees in Mexico.

Filing the appropriate tax forms also depends on accurate classification. In the United States, businesses report contractor payments via Form 1099-NEC, while full employees fill out Form W-2.

In addition to whatever penalties are associated with misclassification, you could also face penalties for failure to file forms. In the US, penalties start at $50 per form and rise with time and the seriousness of the offense.

Further complexities arise if you have difficulty designing an attractive compensation package because you don’t fully understand the local economy. Without that understanding, your business will struggle to stay compliant and compete for the best local talent.

With so many factors making global contractor management a challenge, you may want to enlist some expert help.

What’s the best way to manage compliance for a globally distributed team?

You have two primary options to manage compliance for your global contractors and employees.

Invest in a local entity and develop a network of local partners

If your company has lots of cash and time, you can establish a local legal entity and an HR presence in each country in which you operate. In that case, you’ll be able to hire your own local specialists who understand classification, who are legally empowered to employ and pay workers, and who are deeply knowledgeable about all local laws and regulations. In addition, you will want to create partnerships with local lawyers, payroll companies, and benefits administrators.

Typically, only large enterprises consider this option. Unless you plan to expand aggressively into a single country, it might not make sense to spend tens of thousands of dollars and wait several months (or longer) to open your own foreign entity.

Work with an EOR

Most companies hiring employees in other countries choose to work with an EOR. Your EOR employs workers in other countries on your behalf, handling payroll, benefits, taxes, and compliance for your international team members.

Classify your workers correctly with Remote

As the most trusted EOR in the industry, Remote provides the security and expertise you need to expand your global workforce. We only offer services in countries where we own our own local legal entities, which means we can guarantee local expertise wherever you hire — a guarantee no other EOR can match. Because we own all our own entities, we can also provide you with fully transparent pricing and no hidden fees.

If you are concerned about contractor misclassification at home or abroad, don’t let doubt stop you from growing your business. Sign up with Remote today and let our employment experts help you manage your contractors, onboard your employees with ease, and provide your company with the global HR services you need.

Use our Contractor Compliance Checklist to avoid misclassification

Work through this checklist to help determine if a new hire should have a contractor or employee relationship.

A tablet with the title contractor compliance checklist.

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