How to Avoid Employee Misclassification in The USA

With the rise of remote work culture, the distinction between an independent contractor and an employee has increasingly become complex and critical.

As more businesses hire top talent from every nook and corner of the world, the need for proper independent contractor classification cannot be overstated.

It safeguards your company against international business legal challenges and hefty penalties and facilitates business efficiency by ensuring you only pay for the labor you need.

Unfortunately, however, as many as 10-30% of US employers misclassify their employees in the US.  

This brings us to the most crucial question: how can we avoid employee vs independent contractor misclassification? 

In this article, we will provide a detailed guide highlighting ways to prevent employee misclassification.

Understanding Employee Misclassification

Employee misclassification occurs when employees are wrongly classified as independent contractors.

This can happen intentionally to reduce hiring costs and simplify payroll or accidentally due to a lack of understanding of US worker classification laws. 

Companies may misclassify workers to maintain flexibility or because they fail to update their practices with legal changes. 

This is why most businesses seek the help of a contract management system that helps maintain a proper distinction and facilitates converting contractor to employee, as and when required. 

What is Employee Misclassification?

Classifying workers as independent contractors instead of employees can significantly impact different aspects of the relationship. 

This is especially true because independent contractors are not usually guaranteed the same legal rights, responsibilities, or entitlements as employees. 

For example, in the USA, independent contractors enjoy flexible schedules. This means they can determine the hours or days of work according to their convenience. 

Employees, on the other hand, do not enjoy such flexibility. Under this country's labor laws, they must work 40 hours per week. 

Therefore, hiring independent contractors in the USA but not providing them with the freedoms that come alongside genuine independent contracting becomes an employee misclassification. 

One of the most classic examples of employee misclassification was in 2023. Arise Virtual Solutions, a company based in the USA, came under extreme scrutiny after the Department of Labor (DOL) sued the business for employee misclassification. 

Deemed to be one of the most prominent misclassification cases in history, the company was asked to pay back the due wages and liquidated damages to 22,000+ workers, who were misclassified as independent contractors instead of employees.

How to Avoid and Correct Employee Misclassification

To avoid costly employee misclassification penalties and reputation damage, follow essential best practices.

• Familiarize yourself with the relevant labor laws: Carefully review all the relevant laws and regulations related to employee vs. independent contractor classification in the USA.
  • For example, employees in this country are guaranteed 12 weeks of unpaid maternity leave, which might not apply to independent contractors. 
  • Stay up-to-date with even the most minute changes or amendments in labor regulations, as they can directly impact your workforce. 

• Conduct regular audits: If your business hires multiple independent contractors simultaneously, conducting annual (or more frequent) employee classification audits would be wise.
  • This will include reviewing crucial aspects such as job descriptions, employment agreements, and payroll records.

• Provide relevant training to your HR team and hiring managers: While employee misclassification is more often than not done purposefully, it can also occur due to the simplest of mistakes.
  • Therefore, it is important that you train your HR personnel and hiring managers about proper employee and independent contractor classification. 

But what if it’s too late to avoid the mistake? How to correct employee misclassification, then? 

The US government already has a voluntary program for such scenarios called the Voluntary Classification Settlement Program. 

Under this provision, eligible employers can voluntarily change the prospective classification of their workers. 

In return, they will need to pay 10% of the employment taxes that would have been due for the misclassified workers during the previous tax year.

Implementing a Contract Management System

If all the steps mentioned above to avoid the risk of an independent contractor and employee misclassification seem too much to handle, don’t worry. 

We have another solution for you—a contract management system, such as Skuad. 

• Skuad’s robust AOR solutions simplify the entire contractor onboarding process, including managing crucial tasks related to payroll, invoicing, compliance, and more.
• With expertise in 160+ countries, Skuad is a unified platform that enables you to create country-specific contracts for your workers that comply with all the relevant labor and tax laws. 
• Additionally, Skuad features excellent payment capabilities, such as automated invoicing and payroll in 100+ currencies, so you can always guarantee that your independent contractors are paid accurately and on time.

Independent Contractors vs Employees: Key Differences

Determining worker status and paying employment taxes in the USA can be complex. 

Therefore, for your ease, we have highlighted three main factors that the IRS usually considers to differentiate between an employee and an independent contractor for tax purposes.

• Behavioral Control: This assesses if the business controls how, when, and where tasks are performed. These directives typically bind employees, while independent contractors can decide their work methods and use their tools. 

• Financial Control: This examines a worker's influence on financial decisions. Employees receive a fixed wage with taxes the employer withholds, whereas independent contractors manage their taxes independently since they are considered self-employed.

• Relationship of the parties: Employees usually have indefinite employment agreements with benefits like leave, pension, and insurance. In contrast, independent contractors are hired for specific projects and do not receive these statutory benefits.

IRS Right of Control Test

The primary aim of the IRS test, commonly referred to as the right of control test, is to evaluate who controls how work is performed. 

It lays down 20 different factors for this purpose. As mentioned below, we have highlighted ten of the most critical parameters. 

Due to its complexity, the IRS no longer uses this 20-factor test. 

Instead, the US government has revealed a new way of classifying workers by consolidating these factors into three categories: behavioral control, financial control, and the parties' relationship.

Consequences of Employee Misclassification

Whether or not employee misclassification is intentional, it can cause heavy damage to businesses. 

You risk facing serious legal consequences from government agencies and employees. 

The result? Significant reputational damage, hefty fines, and more. 

Employee Misclassification Penalties

As mentioned below, we have highlighted some significant employee misclassification penalties you will likely face in the USA. 

• FLSA Violations

The Fair Labor Standards Act is a federal law that protects full-time and part-time workers against unfair labor practices. 

Under this regulation, businesses operating in the USA must classify their employees as ‘exempt’ from FLSA provisions and ‘non-exempt.’

Independent contractors usually fall into the former category, meaning they are not entitled to FLSA coverage, such as minimum wage or compensation for overtime wage. 

Companies can face severe legal penalties and fines for employee misclassification. 

The DOL states that for each FLSA violation, businesses will be charged $1000 to compensate the employees for their due wages and liquidated damage. 

A second conviction may result in imprisonment. 

• IRS Tax Penalties

If found guilty, the IRS imposes two different employee misclassification penalties, depending on whether the misclassification was intentional or unintentional.

In the case of unintentional employee misclassification, you may incur the following penalties,

• $50 for failure to file a W2 Form due to improper classification 
• 1.5% of the wages, 20% of Social Security and Medicare taxes the employee should have paid, and 100% of the matching taxes the employer should have paid. 
• 0.5% of the unpaid tax liability for each month, up to 25% of the total tax liability.

In case of intentional misconduct, the cost of employee misclassification goes even higher, including,

• 20% of the workers' wages and 100% of FICA (Federal Insurance Contributions Act) taxes, including employer and employee contributions.
• Additional fines going up to $500,000
• Possible criminal penalties, leading to imprisonment.

Increased Risk of Employee Misclassification

We have highlighted some key factors contributing to organizations' increased employee misclassification risk.

• Misunderstanding of Complex Laws

Classification laws are notoriously complicated to interpret. More often than not, employee misclassification can come down to simply overlooking a requirement or determining factors that turn a worker into an independent contractor. 

This is especially true in today’s age when remote work has become so prevalent, and companies are always looking to hire talent globally. 

• Shifting Work Dynamics

The look and feel of today’s workforce constantly evolve, characterized by rapid technological innovations, globalization, and the increasing demand for flexible work preferences. 

This has, in turn, directly impacted the distinction between employees and independent contractors, making it much harder to discern. 

• Increased Regulatory Scrutiny

Lastly, as the workforce dynamics continue to change, there has been an overall increase in regulatory scrutiny worldwide, not just in the USA. 

This means that when it comes to proper employee and independent contractor classification, even the most minute mistakes are no longer an option, and 100% compliance is necessary.

Independent Contractor <> Employee Conversion

If you wish to convert an independent contractor to an employee or vice versa, please know it is possible. 

However, the process has its own unique set of challenges and requirements. 

As mentioned below, we have highlighted a few considerations regarding converting a full-time employee to a contractor or converting a contractor to an employee. 

How to Convert an Independent Contractor into an Employee

Converting a contractor to an employee or switching from Form 1099 to W2 involves a few crucial steps, such as the following.

• Verify the employee classification: Depending on the nature of their role, evaluate closely whether the contractor can become an employee.
• Research the employment laws: Conduct extensive research on the various provisions laid down by the labor laws of the USA. This includes understanding the minimum wage requirements, leave benefits and working conditions. 
• Put out a proposal: Inform the contractor of this change and present them with the most competitive benefits package.
• Create an employment contract: Create an employment contract that outlines all the essential aspects of the partnership, including pay, benefits, work schedule, and location.
• Onboarding and payroll addition: After signing the contract, include the converted workers in the current payroll system and manage the appropriate deductions and contributions. 

How to Convert an Employee into an Independent Contractor 

Moving on, to convert an employee to an independent contractor, you must follow the steps below.

• Assess whether the worker qualifies to become a contractor.

The Internal Revenue Service (IRS) and the US Department of Labor (DOL) have established several rules and requirements that must be met for an employee to become a contractor. 

Examine each condition closely and decide whether you can turn the full-time worker into a contractor.

• Work out a contract with the employee.

You can start negotiating a formal contract with the employee if all the requirements are satisfied. 

The contract must include all pertinent information, including the employee's rate of compensation, terms and conditions for termination, payment requirements, and length and scope of work.

• End the employment agreement.

Before hiring your employee as a contractor, verify that the prior employment contract has been canceled in compliance with US labor regulations. 

This step is crucial to reducing the possibility of employee misclassification.

• Hire the employee as a contractor.

After completing the procedures above, you can hire the employee as a contractor and create a formal independent contractor agreement that both parties can sign. 

Please note that a detailed understanding of the distinction between 1099 contractors and W2 employees is crucial to ensuring full compliance.

Conclusion

With expertise in 160+ countries and having worked with 600+ clients, Skuad has been the go-to AOR solution for multiple businesses worldwide. 

It is a comprehensive platform that guarantees 100% compliance and accuracy at every step of the hiring journey. 

Skuad features payroll in 100+ currencies, meaning you no longer have to worry about dealing with the complexities of international payment processes. 

Additionally, Skuad offers automated invoicing, a built-in IP protection system, and more. 

Schedule a demo today and hire seamlessly and compliantly from any corner of the world, only with Skuad!

FAQs

Q1: What is an example of employee misclassification?

One of the most notable examples of employee misclassification was in 2021, when Servant’s Quest, an at-home healthcare service provider, misclassified 50 workers as independent contractors and was sued by the DOL. They had to pay the workers $358,675 in back wages.

Q2: How to fix the misclassification of employees?

Employers who wish to correct employee misclassification can apply for the US government's Voluntary Classification Settlement Program. The program sets out a series of criteria that need to be fulfilled, following which organizations can voluntarily change the prospective classification of their workers.

Q3: How should employers protect against misclassification?

To avoid the risk of employee misclassification, it is essential to understand all the provisions set forth by the different employment laws in the USA. Train your HR personnel and hiring managers about the importance of proper classification and conduct regular audits.

Q4: What are the IRS penalties for employee misclassification?

The IRS provides two employee misclassification penalties based on whether the act was intentional or unintentional. Businesses falling under the former category must pay 20% of the workers' wages and 100% of FICA (Federal Insurance Contributions Act) taxes. Furthermore, they may be charged additional fines of up to $500,000 and face imprisonment.