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Employee misclassification: The consequences and penalties

Compliance & Contractor Classification
CXC Global7 min read
CXC GlobalFebruary 23, 2024
CXC Global

These days, more and more companies are seeing the value of hiring independent contractors to support their business operations. The benefits are clear: engaging contractors allows you to hire anywhere, reduce payroll costs and inject flexibility into your operations. 

But this approach also comes with a big risk: worker misclassification. According to some estimates, as many as 30% of US employers have misclassified at least one employee as an independent contractor. 

And misclassifying your workers can have serious consequences, including fines, penalties, legal problems and damage to your reputation. Read on for our full guide to the repercussions of employee misclassification.

What is employee misclassification?

Employee classification is about determining the status of your workers in the eyes of the government. Every country has its own rules about the statuses that workers can hold. But in most cases, a worker is either an employee or an independent contractor. 

Why does this matter? Simple: employees are entitled to more benefits than contractors. And when you misclassify an employee as an independent contractor, they miss out on those benefits. 

Depending on the country, this might include things like: 

  • Minimum wage
  • Overtime pay 
  • PTO
  • Sick pay 
  • Maternity/paternity leave
  • Health insurance 
  • Protection from unfair termination 

In the US, for example, employers have to provide employees with healthcare, Workers’ Compensation coverage and unemployment insurance — but those rights don’t extend to independent contractors. 

There are also tax implications to misclassifying workers. In the US, employers are required to withhold and deposit FICA taxes, which include income tax, social security taxes and medicare taxes, from their employees’ pay. They’re then responsible for making the right contributions as both the employer and the employee. 

However, employers don’t have to do this when they hire independent contractors. That means that misclassifying workers leads to a big loss of tax revenue for state and national governments.

Classification of employees vs. independent contractors in the US

Generally speaking, whether a worker is an employee or an independent contractor comes down to how much control you exert over them. The more control you have, the more likely it is that your worker is an employee. 

Different states use different tests to establish whether someone is an employee or not. Two of the most common ones are the Common Law rules and the ABC test. 

The Common Law rules

The Common Law rules are a set of guidelines issued by the IRS to help companies with worker classification. Here’s what the rules say: 

“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.”

They also say: 

“If you have an employer-employee relationship, it makes no difference how it is labeled. The substance of the relationship, not the label, governs the worker’s status. It doesn’t matter whether the individual is employed full time or part time.”

In other words, it doesn’t matter if your contract with the worker says that they are an independent contractor — it’s the reality of your relationship that counts.

The ABC Test

The ABC test was established by the California Supreme Court as the result of an important court case where a group of delivery drivers were found to have been misclassified as independent contractors. It’s since been adopted by a number of other states

Under the ABC test, a worker is automatically assumed to be an employee unless the employer can prove otherwise. To be classified as an independent contractor, a worker must meet all three of the criteria below:: 

  • The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  • The worker performs work that is outside the usual course of the hiring entity’s business; and
  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

The real impact of employee misclassification

Employee misclassification is a serious issue — and the consequences can be significant. To illustrate this, we’ve gathered just a few examples of headlines we’ve seen in the US alone over the past five years:

  • 2020: Ridesharing platform Uber agreed to pay $20 million to settle a lawsuit brought by drivers in California and Massachusetts.
  • 2023: Sports retail giant Nike faced a potential $530m in tax fines for misclassifying thousands of temporary office workers. 
  • 2022: A Virginia construction staffing agency was ordered to pay $278,073 in back wages to more than 200 misclassified workers. 
  • 2019: IT consulting company Infosys was fined $800,000 for worker misclassification and tax fraud. 

What are the consequences of misclassifying employees?

Employee misclassification leads to a substantial loss of tax revenue. For this reason, governments around the world have cracked down on this issue by tightening guidelines, closing loopholes and increasing penalties. The growing gig economy and the rising use of contractors more generally have made this an even more pressing issue.

Here are some of the consequences you might face if you’re found to have misclassified workers: 

Financial and operational impacts 

In most countries, there are fines for misclassifying employees as independent contractors. In the US, for example, fines are usually

  • $50 per W-2 form that the company should have filed but didn’t
  • Up to 100% of the misclassified employee’s FICA taxes
  • Up to 3% of the misclassified employee’s wages 

Companies that misclassify their employees usually also have to pay those employees back wages and benefits equivalent to the amount they would have earned had they been properly classified. They also have to back pay any taxes they should have paid to the relevant tax authority. 

As you can imagine, these costs can quickly add up — especially if you’ve been misclassifying employees over a long period. 

Legal consequences

Misclassifying employees can also incur significant penalties, which could be up to $1000 per misclassified employee in the US. In very serious cases, business leaders who have deliberately misclassified employees to avoid paying taxes can even face jail time. 

Other possible consequences of misclassifying employees include class action lawsuits from misclassified workers seeking punitive damages, and additional wage claim audits looking for further irregularities. Both of these can be extremely damaging to a business. 

Broader business effects

Misclassifying workers can have serious financial and legal ramifications, but it doesn’t end there. Simply put: misclassifying workers is just not a good look for an employer. If word gets out, you might find that people no longer want to work for you. They might even tell their friends and networks to avoid you too. 

Not only can this badly damage your employer brand, but this negative PR could even have an impact on your revenue as customers choose to take their business elsewhere. 

Plus, worker misclassification has a ripple effect that extends well beyond the organisation doing the misclassifying. When a business deliberately misclassifies employees to avoid paying taxes and benefits, they get access to labour at a much lower cost than their competitors. This creates an unfair advantage and can have an impact on the market as a whole. 

How to correctly classify workers in 2024

Companies typically receive more substantial fines and penalties when they have deliberately misclassified their workers. However, you can still be fined for employee misclassification even if you didn’t do it on purpose. 

Here’s how you can avoid that in 2024:

  • Get familiar with the rules in your state: Worker classification works differently in every country (and state). That means you need to understand the laws where you are if you want to get it right. Careful: these change frequently, and not knowing about a recent change won’t be a valid excuse if you’re caught. 
  • Regularly conduct worker classification audits: Sometimes, the nature of your arrangements with a worker changes over time. And what might start out as a genuine contractor-client agreement could end up looking more like an employment relationship. It’s important to regularly reassess the status of every worker on your books to be sure they’re still correctly classified.
  • Consult with local legal experts: Employment and tax laws can be difficult to get your head around — especially as legislation changes frequently. For the best chance of avoiding any employee misclassification mishaps, it’s best to work with local legal experts who fully understand the rules in your jurisdiction. 
  • Create robust contractor agreements: Worker classification is determined by your actual treatment of your workers, not what’s written in their contract. That said, putting together thorough and compliant independent contractor agreements can provide a reminder to both sides about what your working relationship should look like. 
  • Train managers on misclassification: One of the main factors that determines whether someone is an employee or a legitimate independent contractor is the level of control you have over their work. That means that managers need to be aware of what is and isn’t appropriate in their handling of particular workers. Providing thorough training on this can help you to avoid accidentally misclassifying workers. 
  • Convert misclassified contractors to employees: If you do identify any misclassified employees, you’ll need to convert them to employees if you want to continue working with them. Keep in mind that even if you don’t do this, you could still be liable for fines, penalties and back payments of wages, benefits and taxes covering the period they worked for you — simply ending your relationship with them isn’t a solution. 

Easily classify every worker correctly with CXC

Want to take the headache out of worker classification in 2024? We get it. That’s why we created CXC Comply, our proprietary independent contractor vetting tool. 

Using CXC Comply, you can perform worker classification, right-to-work and background checks for every worker, all within one intuitive digital platform. Want to learn more? Get in touch with our team today.

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About CXC

At CXC, we want to help you grow your business with flexible, contingent talent. But we also understand that managing a contingent workforce can be complicated, costly and time-consuming. Through our MSP solution, we can help you to fulfil all of your contingent hiring needs, including temp employees, independent contractors and SOW workers. And if your needs change? No problem. Our flexible solution is designed to scale up and down to match our clients’ requirements.

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