How to Avoid Contractor Misclassification
Contractor Management

How to Avoid Contractor Misclassification

Table of contents

As the nature of work and the workplace evolves, an increasing number of people are opting out of regular employment and joining the “gig economy.”  Numerous office jobs can be done from anywhere in the world with an internet connection. More people are choosing to live as “digital nomads,” doing skilled, white-collar jobs while traveling the world.

Instead of taking regular, full-time positions at companies,  a growing number of people are choosing freedom over stability through short-term contract work. There are currently 1.1 billion freelancers worldwide, with 59 million in the US alone, representing 36% of the American workforce. These numbers are expected to reach 90 million in the US by 2028. 

It’s imperative to realize that this engrossing growth comes with high risks, as state-level data indicate that between 10% and 20% of employers misclassify at least one employee. In other words, the lawsuit of 400,00 drivers against Uber and Lyft and this recent misclassification lawsuit is far from being unique, indicating a bigger issue in scale. 

What is the Risk of Misclassification

Misclassification of contractors is the practice of listing people as contractors when they actually qualify as regular employees. 

Since contract workers are self-employed, employers are exempt from many obligations they have to regular workers. There are no employee taxes, no social security payments, and no benefits like health insurance or pensions. Independent contractors are not entitled to the standard labor protections regular workers enjoy, including minimum wage requirements and extra pay for overtime.

Misclassification harms the employee by denying them benefits they are entitled to receive. It could harm the company in 3 ways: 

  1. Fines – Governments have been cracking down on misclassification to recoup lost taxes that should have been paid by employers. Fines generally involve payment of all back taxes, often at the highest tax rate, and an additional percentage as a penalty. Criminal charges can also be filed in cases where authorities believe the intent of the misclassification was to defraud.
  2. Reimbursement of Unpaid Benefits – employers will often have to pay back any unpaid funds to employees going back to the time of the misclassification. In many cases, interest is added to the total.
  3. Civil Lawsuits – employees can file lawsuits against the company to recoup lost compensation. Courts could add damages as a penalty.

Employers need to know what constitutes a regular worker compared to a contract worker so that they don’t misclassify them in error – and wind up paying the price.

Why Governments Care about Contractor Misclassification

The government has responsibility for regulating the relationship between employers and employees, ensuring that all rights and obligations are met.     Governments’ interests cover 3 main areas:

  1. Loss of Tax Revenue – employers pay payroll taxes for their employees, but not for contractors. Employee misclassification bypasses paying those taxes, leading to a loss of revenue for the government. The government could also lose revenue from the employees because tax laws are different between employees and contractors.
  2. Protecting Worker Rights – the government must ensure that employers meet their obligations to their workforce. Misclassification allows companies to avoid labor laws such as minimum wage, overtime pay, sick leave, and paid time off – which regular employees are entitled to receive.
  3. Ensuring Social Benefits – since contractors are officially self-employed, they do not receive the social protection employees receive, such as health insurance, pensions, and unemployment rights.

How to Determine Worker Status

If a company exerts substantial control over the worker, the worker is entitled to legal rights that go with it. There is no universal standard that applies to all cases. The following tests are among the most commonly used for determining a worker’s status in the US.

The “Right to Control” Test

This test, created by the IRS, establishes that the difference between an employee and an independent contractor is one of control. It contains 20 factors divided into 3 categories:

Behavioral Control – If an employer has the right to direct and control how work is performed or where it is performed, such as by providing office space to the worker, the worker may be an employee, not a contractor. In an employee relationship, the employer controls the finished product and directs the worker on how and where to do it. With a contractor, the employer only controls the finished product, not how it is done.

Financial Control – The more financial control an employer exerts over a worker, the more likely the worker is to be classified as an employee. If a person is paid at regular intervals, receives reimbursements for expenses, and is provided with specialized equipment, they are acting as an employee. Contract workers are paid in one lump sum, do not receive reimbursements for expenses, and invest in their own equipment.

Nature of Relationship – If a worker is providing a service that is vital to the business on a regular basis, and especially when the relationship is viewed as permanent between the worker and the company, the probability is high that the worker should be classified as an employee. Receiving benefits is seen as part of building an employee-employer relationship.

The “ABC” Test

This three-pronged test is a simpler version of other tests to determine the status of the worker. In California, all three factors have to be met for the worker to be classified as a contractor. If all three are not met, the worker is classified as an employee. Outside of California, the test is viewed more fluidly. 

A. The worker is not directed or controlled in the work they perform

B. The work is done outside of the usual course of business

C. The worker is typically engaged in an independently established trade, occupation, profession, or business of the same nature as the work performed

The Economic Reality Test

This test is used by the Fair Labor Standards Act (which established the minimum wage, 40-hour week, and overtime pay, among other laws). Its primary purpose is to determine if a worker is financially dependent on the employer or if they are truly independent. It is used to determine if the worker qualifies for minimum wage and other labor protections, as an employee.

Factors include:

  1. Is the work integral to the business?
  2. Does the management of the work influence profit or loss for the worker?
  3. How does the worker’s investment compare to the employer’s investment?
  4. Is there special skill involved in the work?
  5. Is the work relationship permanent or temporary?
  6. What is the nature of the employer’s control?

How To Calculate Misclassification

Employee misclassification is usually unintentional, where an employer considered a freelancer or a consultant to be an independent contractor, and was unaware that the nature of the relationship was actually one of employment. However, unintentional or otherwise – as soon as an employer recognizes the misclassification, they must take action.

Here are the questions an employer will need to answer:

  • How long has this employee been misclassified as an independent contractor?
  • How much money have you paid this employee during the time they have worked for you?
  • If you had hired this false contractor as an FTE originally, how much would their salary have been?
  • What would the associated taxes have been, both for the employer and the employee?
  • Which benefits would you offer an employee who had a similar role?

An employer should expect to pay the back income tax withholdings for the whole period of misclassification, as well as national insurance, pension or health insurance contributions according to the location. In the US, this would be Social Security and Medicare contributions.

Being proactive about this issue and reporting and amending the characterization of the employee yourself should help the company to avoid the strictest penalties by the government, who will take a more lenient approach than they would if they were the ones to uncover the misclassification.
However, don’t make the assumption that an employer won’t have penalties to pay. it’s important for the employer to learn what the government penalties are for misclassification so that they understand what they might incur in terms of fines and financial consequences.

How to Correct Employee Misclassification

It might feel tempting for an employer to simply end the relationship with this employee and try to put the whole thing in the past. However, this is one of the worst things that an employer can do, and will certainly lead to fines and penalties, plus the likelihood of further scrutiny and audit action from government agencies. It’s also unfair to the worker in question, who has a right to their benefits and contributions.

In the US, the IRS offers three options for remedying misclassification issues across a company.

1. Form SS-8

The simplest option, especially on a smaller scale is to use IRS Form SS-8. This is a legitimate method of querying the status of a worker at any stage, and is often used by a worker who believes they have been misclassified. After filling in this form, the IRS will return their own determination, and the tax liabilities can be reduced to a single year, lightening the load for the employer.

However, this form can’t be used once a business is already under audit, and it will not suffice for a business where misclassification appears to be willful or widespread. An example of this would be where the number of employees is being purposely held under 50 by the use of fake contractors so that the company doesn’t count as a medium employer under FLSA.

2.  Voluntary Classification Settlement Program

As long as an employer has not been audited during the previous three years, they can apply for recharacterization of employees using the Voluntary Classification Settlement Program. This is a great way to get ahead of the risk of misclassification, and the penalties are much less severe – just 10% of the employment tax liability to all misclassified workers during the previous tax year.

The government’s ultimate goal is to get workers classified correctly moving forward, and this scheme is intended to make that easier for businesses who have entered into misclassified relationships in genuine error.

3. Classification Settlement Program

If a company is already under audit, their best option is to use the Classification Settlement Program. Under this program, an employer can provide evidence that they have not been treating the worker as an employee, or that they had a reasonable basis for considering them to be a contractor, and a decision will be made on the validity of this claim.

If accepted, this will also allow the tax liabilities to be reduced to one year, and penalties are likely to be forgiven if requested.
For both of these settlement programs, an employer should be aware that leniences will not be granted multiple times. That means reporting and recharacterizing workers should be part of a new strategy for classifying a workforce accurately moving forward, and ensuring that all independent contractors fit that description according to all relevant laws and regulations.

Remember, misclassification can result in fines, damage to a company’s reputation, a possible limitation on a company’s ability to hire contract workers, and it can even impact the right to operate in certain regions. This means that companies must be proactive in ensuring they are in full compliance.

Tax forms overview

Form W-9 – this is the basic form an employer needs to fill out when hiring a contractor. It provides the contractor’s tax identification number. Unlike with a W-4, the employer does not need to see proof of citizenship. 

Form W8-Ben – The full name of the form is the Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting. It is for people who provide service in the US but live abroad.

Form 1096 – This is a summary tax that employers need to file for their contractors alongside the 1099-MISC form.

Form 1099 – This is the form employers issue to their contractors that indicates the amount of money earned in the past year.

Papaya Provides Payroll and Compliance

Papaya can help you ensure the proper classification of your entire workforce. Our network of local experts covers more than 100 countries worldwide and our dedicated CSM team is always available to assist on questions of workforce management.

Papaya can manage the payroll for any number of workforce options, including full-time workers, contractors, and workers paid through the Global PEO /Employer of Record model. Let our experts keep your payroll from worker misclassification or any other workforce management issue you might encounter.


What happens when an employee is misclassified?

An employee is misclassified when he or she is performing work under the control of the employer and entitled to the rights and protection of an employee but is classified incorrectly as a contractor. In those cases, the employer pays the contractors through an invoice, in a lump payment without withholding taxes or paying benefits. If a misclassification took place, the employer will owe payroll taxes to the government and benefits payments to the workers. The workers will have to pay their income and social taxes on their own.

What is a misclassification risk?

A misclassification risk is the possibility that a contractor should have been classified as an employee. The employer faces a risk of fines, owing back pay plus interest to the employee, and potential lawsuits, in addition to the loss of reputation.

How to report the misclassification of employees

As an employer, there are three ways to report employee misclassification. As long as you are not under audit, you can use IRS form SS-8 or use the Voluntary Classification Settlement Program, and if you are under audit, you can make your case using the Classification Settlement Program. All of these avenues should reduce the penalties and back tax withholdings you’ll need to pay.

If you’re an employee and want to report a company for misclassification, either of yourself or your colleagues, you can also submit Form SS-8. If you believe the infraction to be willful, you can use Form 3949 to report a failure to pay taxes.

What is the federal penalty for an intentional misclassification of an independent contractor?

If the IRS suspects that an employer has intentionally misclassified employees as independent contractors in order to avoid their employer responsibilities and taxes, businesses could incur criminal penalties of up to $1,000 per employee, plus potential prison time of as much as 5 years. This is on top of $50 for each non-filed Form W-2, 1.5% of the wages of each misclassified employee, 40% of the FICA taxes that weren’t withheld from the employee, and 100% of the employer contributions. These penalties will include any interest that would have accrued on those payments.