Employee Misclassification: What you need to know 

Worker misclassification is one of the most expensive mistakes a business can make – especially for those companies operating globally, which need to keep in mind multiple laws and regulations at once.

Worker misclassification is one of the most expensive mistakes a business can make – especially for those companies operating globally, which need to keep in mind multiple laws and regulations at once.

But if you think employee misclassification just comes down to slap-on-the-wrist penalties, think again. Just recently, Arise, a gig economy customer support company, was required to pay $2 million to the 250 workers it misclassified as contractors, as well as almost $1 million to the district in which they resided. On top of that, the company is now forbidden from ever doing business in Washington D.C. again.

Arise is not alone in facing heavy consequences like these as a result of misclassification. Many businesses don’t realize the risks they’re taking by overlooking the importance of correct classification – until it’s too late.

In this post, we dive into not only the risks and implications of misclassifying an employee as a contractor, but also how to avoid the mess altogether.

Determining worker classifications

To start with, it’s important to understand what the different classifications mean and how to determine them. This will of course differ from country to country, all the more emphasizing the importance of local expertise on these matters. Businesses need to be equipped with the highest level of understanding to ensure workers are getting the rights and benefits they’re entitled to, based both on how they’re classified and where they’re located.

Below is an overview of the three major categories:

Full time employee

A full-time employee is a worker hired by an employer to work a standard number of hours — usually within a set start and end time. This amounts to around 35 to 40 hours a week.

Full-time employees are also entitled to receive more extensive benefits from their employers, including PTO, retirement plans, health insurance, and more.

Part-time employees

Part-time employees are also hired by employers – but to fill fewer hours. They’re also entitled to certain benefits, but usually less extensive than those full-time employees are entitled to. Finally, their work schedule is likely to be more flexible, often depending on when they’re needed by the employer.

Independent contractors

Independent contractors are self-employed and can usually determine their own work schedule and projects.

Contractors are, for the most part, responsible for their own taxes and tend not to get the same benefits as employees. Their responsibilities are based on a contractual agreement.

The chart above is a general overview of the distinctions between employees and contractors. To really drill down into the specifics of each role, however, you can ask certain questions.

What is the difference between an ‘employee’ and a ‘contractor’?

By answering the following questions, you can understand whether to classify the worker as an employee or a contractor.

• Who decides when the work is performed?
• Where is the work done?
• Who provides the equipment?
• Who performs the work?
• How is the worker paid?
• How important is the work?
• What is the length of the relationship?

Accurately answering these questions helps you provide correct classifications and avoid misclassification.

How does employee misclassification differ from correct classification?

Employee misclassification is when employers illegally identify workers as independent contractors when they fall into the employee category. Misclassification results in worker exploitation that can lead to lower public taxes, employees losing benefits, unfair treatment of workers, and more.

Correct classification is when an employer uses IRS guidelines to ensure a worker who can legally create their hours, work with multiple clients at a time, and control the direction of work for any client is labeled an independent contractor. If workers must report to a direct manager who controls the direction of the work and when and where workers report to work, employers must classify these professionals as employees.
Though avoiding certain taxes though misclassification may feel tempting, employers who wish to comply with government regulations will submit correct classifications.

Misclassification under the Fair Labor Standards Act (FLSA)

The Fair Labor Standards Act (FLSA) sets the minimum wage and overtime pay protections for workers in the US. According to FLSA regulation:

• Employers can not misclassify an employee for any reason
• A worker is not an independent contractor solely because they work remotely or have flexible work hours
• Workers paid by cash or by check, on book or off, may still be classified as employees
• Receiving a 1099 does not make someone an independent contractor
• Even if someone is an independent contractor under another law (such as a tax or state law), they may still be an employee
• Signing an independent contractor agreement does not make them an independent contractor
• Having an employee identification number (EIN) or paperwork for a Limited Liability Company (LLC) or other business entity does not make them an independent contractor
• Common industry practice” does not allow businesses to misclassify employees

The risks of misclassification

Misclassifying an employee as a contractor comes with its share of risks, ranging from financial repercussions to reputational ones.

Below are some of the biggest risks associated with misclassifying an employee:

Legal and financial penalties

Violating labor and tax laws can lead to major repercussions. Misclassifying workers can result in companies being forced to pay fines, penalties, as well as back wages owed to the misclassified workers.

Employee misclassification lawsuits

Employees who’ve been misclassified may choose to file lawsuits against their employers to receive the benefit and compensation they deserve. This can cost employers dearly – not only in legal fees but also in reputational damage (many of these stories quickly reach the news.)

Business disruption

All these consequences and repercussions regarding misclassification are natural absorbents of time and resources – resulting in heavy disruptions of business operations. To add to that, an especially bad case of misclassification can lock businesses out of certain revenue streams altogether (think of the earlier example we mentioned with Arise, which is no longer permitted to do business in D.C.)

Reputational damage

When businesses misclassify workers, they’re removing benefits employees are legally entitled to. This can not only destroy trust within and outside of the workforce. Lack of trust and disregard for lawful practices could leave talent looking elsewhere.

Back wages and benefits

Employers charged with misclassification must pay workers the back wages, overtime, and benefits they should have received as employees. Benefit pay includes worker’s compensation, retirement, vacation, medical insurance, and sick pay.

Why does misclassification happen? (and what to do about it)

When considering cases of misclassification, it’s common to think about the ones involving deliberate misreporting to avoid payment of benefits or other employee-linked costs.

This is far from the only reason for misclassification, though. Often, employers end up misclassifying their workers unintentionally.

Here are just some of the reasons this may happen:

Misunderstanding of complex laws

Classification laws are notoriously complex and sometimes misclassifying workers comes down to simply overlooking a requirement or determining factor that turns a worker into an employee rather than a contractor. Employers are especially susceptible to mistakes like these when their workforce is spread across the globe.

Shifting workforce dynamics

The look and feel of the workforce are changing, making the lines between employee and contractor that much harder to discern, and adding to the difficulty of figuring out whether the worker you brought on is considered a contractor or an employee.

Increased regulatory scrutiny

This goes back to the previous point – as the dynamics of the workforce continue to shift and blur, regulatory scrutiny is at an all-time high, meaning that mistakes here and there are not an option, and compliance is a must.

Taking a worker’s word at face value

Some independent contractors may insist on defining themselves as such to keep their autonomy and their personal business going.

What to do to avoid misclassification

Avoiding misclassification altogether is no easy feat – especially for businesses operating a global workforce. But here are some pointers to get you started:

1. Employ boot-on-the-ground legal and tax expertise to stay up to date regarding regulations in every country you operate in.
2. Conduct regular audits of worker classifications to ensure consistency and compliance.
3. Draw up clear contracts and job descriptions to avoid misunderstandings.
4. Implement the right technological solutions to track hours and contributions and keep things in check.

Check out our course about Employee misclassification, in Papaya Global Academy.

The role of technology in worker classification

If you’re managing a global workforce, using the right technology is a must for ensuring consistent compliance – and that includes worker classification.

Here are some examples of what the use of technology might look like in the context of classification:

Data analysis

Using data analysis tools to process large volumes of data concerning contracts, worker activities and employment history to determine classification.

Tracking and monitoring

Tracking and monitoring software, allowing employers to make informed decisions regarding classification, based on hours worked and projects delivered.

Auditing and reporting

Using automated auditing and reporting tools to maintain accuracy and keep compliance in check.

Ensuring accurate Worker classification with Papaya Global

Since 2016, Papaya Global has dedicated itself to ensuring full compliance companies with workforces across the globe.

How do we do it?

We combine top-end technology with top-notch expertise so that you get the best and most up-to-date regulatory knowledge in real-time – including how to classify your workers.

Some of the features you can expect to find on our platform:

• An AI-driven global compliance engine designed to raise flags regarding any inaccuracies
• Real-time data analytics of your entire global workforce, including contractors, employees, and EOR workers
• Vetted boots-on-the-ground payroll and accounting experts in 160+ countries

Intrigued? Book a demo today and learn more about how Papaya Global keeps compliance constant.