Imagine hiring a skilled overseas contractor to spearhead a critical project, only to realise afterwards that their role and responsibilities were akin to those of a full-time employee, despite being classified otherwise. The resulting penalties and legal fees could hit your budget and lead to reputational damage. We explore the causes, impact and hidden costs of independent contractor misclassification and how to avoid the pitfalls.
In today’s global business landscape, the proper classification of contractors and employees is one of the most important aspects of workforce management. A US Department of Labor study found that between 10% and 30% of employers audited had misclassified workers. What's more, nearly all (up to 95%) of the workers claiming misclassification were confirmed to be employees, upon review.
Let’s delve into the challenges and how to prevent the risks involved. We provide practical insights for navigating the complexities of global employment.
What is contractor misclassification?
Contractor misclassification occurs when a company mistakenly classifies a full-time employee as an independent contractor. Typically, an employee works under direct supervision, follows a company-set schedule and receives benefits. The company furnishes all the tools and equipment an employee needs to complete their work-related tasks.
A contractor, on the other hand, works independently, sets their schedule, uses their own tools, and doesn't receive employee benefits. In general, contractors have more control over their work tasks than employees. Additionally, an employee will usually have only one employer at a time, whereas most contractors work with multiple clients simultaneously.
Misclassifying an employee as a contractor denies them benefits like minimum wage, overtime pay and health insurance that they’re entitled to. So, when trying to determine if someone is deemed an employee or a contractor, your HR team should look beyond the surface-level indicators, such as:
- Tools and equipment: A worker supplying their own tools or enjoying flexibility in their schedule doesn't automatically make them a contractor. A programmer, for instance, might use their own laptop (a tool) but still be under direct employer supervision (indicating their role is closer to that of an employee).
- Written contract: Having a contract doesn’t guarantee contractor status. The contract should reflect the details of the actual working relationship, not simply state that someone is an ‘independent contractor’.
- Schedule control: Independent contractors must have extensive control over their schedules. If the company requires them to work set hours, attend mandatory meetings, and constantly monitor their progress, this could mean they’re actually an employee.
- Financial arrangements: Employees typically receive a regular salary or hourly wage, with benefits and taxes withheld. Independent contractors, on the other hand, are paid a project fee for completed tasks and are responsible for their taxes and benefits.
While these are common indicators of independent contractor status, their existence alone isn’t sufficient for proper classification. Relying solely on one or more of these indicators could lead to misclassification (and potential legal consequences). As an employer, you need to take into account the totality of the working relationship when classifying a worker.
Understanding the risks and costs of independent contractor misclassification
Misclassifying an employee as an independent contractor can have significant consequences for both the worker and the business. Here's why understanding the risks and costs is crucial:
- Depending on the jurisdiction, a business might be liable for unpaid payroll taxes for misclassified employees. Penalties can be substantial, with additional interest accruing.
- Misclassified workers may be entitled to back pay for overtime, minimum wage violations and lost benefits like vacation time and healthcare.
- Defending lawsuits from misclassified workers or government agencies can incur hefty legal fees. Plus, the government-imposed fines for misclassification can be significant.
- Public exposure of misclassification can damage a company's reputation, making it difficult to attract talent in the future
Impact on workers’ rights and benefits
Due to misclassification, workers may lose out on minimum wage protections, overtime pay, and unemployment insurance. These financial shortfalls could adversely affect both their quality of life as well as their performance at work. This often leads to high turnover. Employees who are financially secure (and compensated fairly) are more likely to be productive and committed to their jobs. So, ensure proper classification to reap the benefits of a loyal and high-performing workforce.
In some jurisdictions, full-time employees have legal rights against being fired without just cause. Misclassified workers, however, may not have those same protections. This makes them more vulnerable to being unfairly terminated. Plus, laws against discrimination based on race, gender, age, etc., often apply differently to employees and contractors. Misclassified workers may not be covered by these laws, leaving them with fewer options if they experienced discrimination.
In 2016, FedEx settled a lawsuit for $228 million for misclassifying delivery drivers as independent contractors. The drivers claimed they were denied minimum wage, overtime pay, and other benefits. They argued that given the level of control FedEx exerted over their work, they should have been classified as employees under California labour law. Also in the state, Uber reached an $8.4 million settlement in 2022, with drivers who alleged they had been improperly classified as contractors.
What are the main causes of contractor misclassification?
Several factors within the operations and policies of a company could result in independent contractor misclassification. Here are main causes:
Ambiguity in classification criteria
In certain jurisdictions, the criteria for distinguishing between employees and contractors might be vague or open to interpretation. Without clear internal guidelines, your HR team may struggle to accurately classify workers in such situations, leading to inadvertent misclassification.
Pressure to cut costs
In a competitive business environment, HR teams might feel the pressure to minimise expenses wherever possible. Classifying a significant chunk of the workforce as independent contractors, rather than employees, can reduce costs in the short term, since it entails fewer obligations in terms of benefits and taxes. However, exposes the company to risks of lawsuits, fines and legal fees that could dwarf any initial savings.
Misinterpretation of job responsibilities
If the tasks assigned to a contractor closely mirror those typically performed by full-time employees within the organisation, it could blur the lines between the two roles, leading to contractor misclassification.
As an example, let’s consider a software development company hiring a contractor to work on a long-term project. If, over the course of the project, the contractor starts working on-site, following a set schedule, and collaborating closely with the internal development team (to the point of becoming fully integrated into the team’s workflow), the company should reclassify them as an employee. Keeping them on as a contractor, in this situation, would be deemed as misclassification.
Regulatory complexity leading to confusion
Employment laws and regulations vary between jurisdictions and change from time to time, making them hard to navigate and track. Your team could misclassify workers due to a lack of understanding of the relevant labour laws, or simply a failure to stay abreast of regulatory changes in a given jurisdiction.
A multinational corporation with operations in various countries, for instance, will have to deal with several sets of labour laws, tax regulation, and employment standards governing the classification of workers. These laws can vary significantly from one country to another in their criteria for classification, worker rights, and employer obligations.
Companies in this situation, struggling to ensure consistent and compliant classification of workers across different jurisdictions, could benefit from outsourcing global entity management and other employment services to a provider like TopSource Worldwide.
Three ways to prevent incurring misclassification costs
To avoid incurring contractor misclassification costs, your business must implement proactive measures aimed at accurate and compliant worker classification. Here are our tips for mitigating the risks:
- Establish clear guidelines for classification: Develop a well-defined set of criteria for classifying workers as employees or independent contractors. These guidelines must be easily accessible to your HR team and any management staff involved in the hiring process. The worker classification policy should outline key factors like control over work location and schedule, benefits offered and whether the work is ongoing or a one-off project. Clear guidelines minimise ambiguity, ensuring consistent worker classification.
- Conduct regular classification audits: Schedule periodic reviews of your workforce classifications. These audits should involve a thorough examination of job responsibilities, working arrangements and contractual agreements. They can be conducted internally or by a third-party specialist. Conducting audits proactively helps to identify potential discrepancies and rectify misclassifications early on, mitigating the risk of legal problems or financial setbacks.
- Provide proper training to HR: Equip your HR department with proper training on all the relevant employment laws, classification criteria and compliance requirements. Your team should also be trained to leverage technology solutions that can streamline worker classifications. These tools can analyse data points related to worker responsibilities, schedules and compensation to assess the independent contractor misclassification risks and flag potential compliance issues.
By implementing these preventative measures, your business can reduce the risk of misclassification and avoid the associated costs and liabilities. For an additional layer of protection, consider partnering with a global employment services provider like ours. Leveraging our expertise to navigate complex employment regulations and ensure proper worker classification across different jurisdictions.
Summary
Independent contractor misclassification can be a costly mistake. Clear guidelines, regular audits and comprehensive HR training can help your company successfully navigate the complexities of contractor and employee classification across various jurisdictions.
You can further reduce the risk of errors by partnering with a global employment services provider. TopSource can help you ensure compliant worker classification across national and regional borders, saving you time, money and legal headaches.
Learn more about our Global Entity Management solutions and EOR services or get in touch with our team of experts.
