Avoiding Misclassification of Employees: What You Need to Know

In 2022, more and more companies recognise the benefits of engaging independent contractors instead of relying solely on full-time workers.

BLOG POST - Avoiding Misclassification of Employees

When you hire a contractor, you can stop and start their contract as you need to. You don’t have to pay for benefits like paid holiday, sick pay or maternity leave.

Plus, you get access to a wide range of highly-skilled, talented professionals, who simply aren’t available on the traditional job market.

But when you work with independent contractors, there’s always a risk of what’s called ‘worker misclassification’ or ‘employee misclassification’.

This is when someone who you’ve supposedly engaged as a contractor is found to be an employee in the eyes of the relevant local authority. 

And this is a real risk: companies who are caught engaging in ‘false self-employment’ can face significant tax bills, fines, and even legal consequences — even if they didn’t do it on purpose. 

But there’s no need to panic: by the end of this post, you’ll be able to confidently spot the signs of a ‘disguised employee’, and continue to enjoy the many benefits that working with contractors can bring to your business. 

Let’s get started.

What is Employee Misclassification?

Employee misclassification is when an employee is mistakenly classed as a freelancer or independent contractor by their employer.

Many companies mistakenly believe that it’s up to them to decide which workers are classed as independent contractors and which are employees — which is not the case. 

Companies that engage independent contractors need to make sure they correctly classify each worker they engage, produce the necessary paperwork and follow local tax regulations and employment law. 

Why Do Authorities Care About Employee Misclassification?

There are several reasons why authorities are concerned with the misclassification of employees as independent contractors: 

  • Taxes: In most countries, an employee’s income tax is deducted by their employer, while independent contractors are responsible for declaring and paying their own taxes. Since it’s more difficult for governments to monitor income tax from independent workers, worker misclassification can result in less tax being collected. 
  • Expenses: Independent contractors can often reduce their tax bills by deducting certain expenses from their taxable income — which isn’t the case for employees. Again, this means that incorrectly classifying workers could result in the government not receiving the tax they’re owed. 
  • Benefits: Employees are usually entitled to certain benefits under employment law, which independent contractors don’t have access to. This means that there’s a potential for exploitation, since workers who are really employees should be receiving those benefits.
  • Employee protections: In many countries, employees are covered by certain protections, including minimum wage requirements, sick leave, redundancy pay and the right to be treated fairly at work. These provisions don’t apply to contractors. Again, this poses a risk of exploitation.

The Risks of Employee Misclassification For Employers

Independent contractor misclassification is not just bad for misclassified employees themselves — it can hurt companies too.

Here are some of the biggest consequences that employers could face for misclassifying their workers:

  • Significant back-taxes: If someone you have hired as a contractor is found to be an employee, you could be asked to back-pay the taxes and social security contributions that you would have paid if they were correctly classed as an employee. This can result in a significant bill, especially if they’ve been working for you for a long time. 
  • Financial penalties: Companies can also face financial penalties from the government if they are found to have misclassified their workers. While fines are generally harsher when it’s determined that a company has misclassified its employees deliberately, you can still be fined even if you were acting in good faith.  
  • Legal action: Employees who were misclassified as independent contractors often take legal action against their employers — and the courts are not sympathetic to worker misclassification. You could also face legal action from other parties, like your insurer, clients or partners. 
  • Negative PR: Aside from the very concrete consequences outlined above, incorrectly classifying your employees as independent contractors just doesn’t make you look good as an organisation. This means that you might struggle to find contractors or even lose customers in the future. 

Correctly Classifying Workers: 7 Questions To Ask

There’s no one clear test for employee status, as it differs from country to country.

Generally, the authorities want to see what level of control you have over your workers and how much freedom they have to do their work as they see fit. 

If you’re unsure of a worker’s status, here are seven questions to ask yourself: 

1. Who decides when the work is done?

Employees usually have to work within certain set working hours.

An independent contractor or freelancer, on the other hand, usually has the freedom to work whenever they want, as long as they deliver on the project by your agreed deadline. 

On its own, this isn’t enough to determine a worker’s status, particularly since many employers are now introducing flexible work policies that allow employees to work to their own schedules.

However, when taken alongside the other things in this list, it can be a useful indication.

2. Where is the work done?

Employees often work on their employer’s premises, while independent contractors can usually do their work wherever they want to.

Again, this isn’t enough to classify someone as an employee or a contractor on its own, since many employees also have the freedom to choose where they work.

3. Who does the work?

Something that authorities often look for when determining worker status is whether they have the ‘right to substitution’.

If a worker has the right to send a replacement if they’re not available themselves, they’re probably a genuine independent contractor.

4. Who provides the equipment?

Employers usually provide their employees with the tools and materials they need to do their job.

This might include computers, work phones, and any software or subscriptions they need.

Independent contractors, on the other hand, generally have to pay for these things themselves.

5. How important is the work?

In many countries, a worker providing services that are essential to a business’s success is enough to classify them as an employee for the purposes of employment law.

Contractors tend to provide secondary services, which are further from the company’s core operations. 

However, this is somewhat open to interpretation. The same tasks could be considered ‘essential’ or not depending on the nature of the company.

For example, if a marketing agency employed someone to work on marketing plans for its clients, they would probably be considered an employee.

On the other hand, if the same freelancer created a marketing plan for another company — let’s say a food and beverage manufacturer — this probably wouldn’t classify them as an employee. 

6. How is the worker paid?

Employees are usually paid monthly and have their taxes, social security contributions and other charges deducted directly from their pay.

They receive a payslip each month, and the amount they receive is relatively stable from one month to the next.  

Contractors are not necessarily paid monthly, and generally invoice their clients for their services.

The amount invoiced might vary depending on the projects they’ve completed.

They’re also responsible for paying their own taxes, so the employer doesn’t deduct these from their pay.

7. How long have you been working with the worker?

The length of time you work with a particular contractor can also affect how the authorities view their status.

Generally speaking, if a contractor essentially works for you on a permanent basis, they’re probably an employee. 

A worker’s status can also change over time: many companies start out with a legitimate contractor/client relationship that evolves into an employee/employer one as the worker’s role within the organisation grows.

How should employers protect against employee misclassification?

You might think you’re not at risk of employee misclassification if you’re not deliberately misclassifying your employees.

However, many companies mistake their employees for independent contractors simply because they’ve failed to properly understand the law. 

To avoid this, it’s important to learn the local laws that govern compliance in your country, since these are different depending on where you are.

For example, the rules about 1099 misclassification in the US are different from the IR35 rules in the UK.

Here are some things you do to ensure you’re correctly classifying each worker: 

  • Review every worker on a case-by-case basis: Some companies have some genuine independent contractors and others who have been incorrectly classified. You need to look at each case separately to ensure you’re compliant. 
  • Use government resources to help you: Check what resources your local government has available to help you determine the status of your workers. In the UK, you can use this handy tool from HMRC
  • Train your managers on misclassification: Delivering training to every department leader can help you avoid worker misclassification. Managers should also know what they can and can’t do when working with independent contractors, even if the contractors don’t know themselves. 
  • Convert contractors to employees if they’re misclassified: If you find that you have an employee who has been accidentally misclassified as an independent contractor, you’ll have to convert them to employee status if you want to continue working with them.

CXC Comply: Your Workforce Compliance Solution

Overwhelmed by the prospect of determining the status of every one of your independent contractors?

We can help.

Our workplace compliance solution, CXC Comply, is designed to help companies that engage independent contractors to stay within the law. 

We’ll even perform background checks and right-to-work checks for each independent contractor you hire — and you can manage everything from a convenient online portal. 

Contact a contingent workforce expert to learn more about how we can help your organisation.