Employee Misclassification Penalties: What Are They and How to Avoid Them

The prospects of new markets are exciting and challenging at the same time. 

While exponential business growth and recognition exist, managing operations with the local workforce is a complex administrative task. 

You could attract employee misclassification penalties even before you can realize it! 

The consequences of misclassifying workers as contractors rather than employees can be severe, including hefty fines, back wages, and legal disputes. 

The complexities of international employment laws make the issue delicate. Even your in-house HR team may not ensure total compliance, adding to the multifaceted challenges in international business administration. 

In this article, we will discuss various penalties for misclassifying employees as independent contractors per the IRS and other major countries. 

We will also provide practical tips on avoiding these costly contractor misclassification penalties.

What is Employee Misclassification?

Employee misclassification is a legal issue of misclassifying employees as independent contractors. 

You end up depriving your workers of statutory benefits and protections and are liable for significant worker misclassification penalties, including: 

• Employee misclassification can result in incorrect tax reporting and potential tax liabilities, as the tax treatment of employees and independent contractors differ based on location.
• You may harm your company's reputation by misclassifying employees as independent contractors and avoiding compliance with various labor laws related to minimum wage, overtime, and termination.

What’s the difference between contractors and employees, anyway? 

The following table highlights the primary differences between the employees and independent contractors:

How Employee Misclassification Happens

Misclassifying employees as contractors can happen for several common reasons, including misinterpretations or attempts to avoid labor law obligations. 

The complexity of labor laws in different countries makes it a unique challenge:

• United States and Canada: You must follow IRS guidelines to determine the degree of control over a worker's activities and follow the Fair Labor Standards Act (FLSA) to determine financial and relationship aspects. 

You may follow Canada Revenue Agency (CRA) guidelines for employee classification in Canada. 

However, companies often rely on gig economy roles and short-term contracts to replace non-essential full-time job roles. 

• European Union: European countries tend to have more stringent labor protections, which can lead to misclassification of workers who circumvent regulations related to minimum wage, working hours, and workplace safety. 
• Australia: The Fair Work Act differentiates employees from contractors, focusing on control and independence. However, more regular workers are labeled as contractors to avoid employment responsibilities. ‍
• Asia-Pacific and Latin America: Lack of labor law enforcement, cultural differences in employment practices, and large-scale informality in economies like India and Brazil can lead to misunderstandings and misclassifications.

IRS Penalties for Misclassification

Moreover, misclassification can be used as a means of tax evasion, as independent contractors are typically subject to different tax rules than employees. 

However, the consequences of misclassifying workers as contractors rather than employees involve fines & penalties, including reputational damage or imprisonment.

Here is a table detailing the IRS worker misclassification penalties:

Refer to this detailed checklist to avoid IRS employee misclassification penalty.

3 Employee Misclassification Penalties You Don't Want to Mess With

You can avoid significant employee misclassification penalties by protecting yourself against the following violations and risks: 

1) Wage and labor law violations

The key impacts of employee classification fines due to violating wage and labor laws include:

• The FLSA in the United States enforces one-and-a-half more pay for any hours worked over 40 in a week. 
• The penalty for misclassification of employees also includes interest payments on unpaid wages. 

• You may be required to enroll them in retroactive benefit plans like health insurance and retirement plans. 
• Further, mandatory paid leave laws (e.g., sick leave, family leave) enforce compensation for denied statutory benefits as part of contractor misclassification penalties.
• Moreover, any wilful misclassification may result in criminal charges, including imprisonment. 

2) Legal disputes and costs

The financial and legal cost of misclassifying employees includes individual lawsuits to recover unpaid wages, benefits, and other compensation. 

Additionally, class-action lawsuits are common in cases of widespread misclassification of employees as independent contractors. 

The out-of-court settlement remains the preferred route to avoid court trials. In many cases, you may also be required to cover the legal fees of the misclassified workers.

3) Intellectual property risks

Misclassification of employees as independent contractors penalties will include dispute settlement over ownership and access to sensitive company information, such as trade secrets, customer data, and proprietary technology during the worker's tenure.

In many jurisdictions, you own the copyright for work created by your employee during their employment. However, this may not be the case if the worker is misclassified as an independent contractor.

Fortunately, you can protect company assets through independent contractor agreements and regular workforce classification reviews.

Damage to business reputation

Misclassification scandals can damage a company's reputation, leading to negative media coverage and harm to employer branding. 

This can affect your ability to attract and retain talent on behalf of the company. 

If a misclassification lawsuit goes to trial, companies risk an unfavorable verdict, which could lead to even more considerable employee misclassification penalties. 

Trials are also highly public, leading to greater media scrutiny and potential damage to the company’s stakeholders.

Global Perspective: Penalties Around the World

Employee misclassification penalties may vary across countries, but the core principle of protecting individual rights remains the same. 

Subsequently, failure to comply can result in severe financial and reputational consequences, for instance: 

How to Avoid Misclassification Penalties

Here are some actionable tips for businesses to avoid the costly consequences of misclassifying employees into independent contractors:

1) Understanding local employment laws

• This includes minimum wage requirements, overtime rules, benefits entitlements, and workplace safety standards.
• Consider subscribing to industry news to monitor changes in labor laws and regulations. 

2) Drafting transparent and compliant contracts

• You can include specific terms related to control, compensation, and benefits in your contracts to demonstrate the nature of the employment relationship.
• You must develop a comprehensive employee handbook that clearly outlines the company's policies on employee classification, benefits, and other employment-related matters.

• Maintaining accurate time sheets and records to document work hours will act in your favor in case of legal disputes.

3) Deploying technology to avoid employee misclassification

• Modern companies are deploying technologies such as HR management systems, Time-tracking tools, AI-powered compliance tools, Digital contracts, and modern communication platforms to avoid employee misclassification. 
• Moreover, if you're unsure about your classification practices or want to reduce your administrative burden, consider using an Employer of Record (EOR) service.

How Skuad Can Help

Skuad is the leading EOR service provider that can help you manage payroll and benefits administration following labor regulations. 

We provide a centralized platform integrated with the latest technology to help businesses efficiently manage their teams in over 160 countries. 

Book a demo today to discover how our platform can streamline your global workforce management and ensure compliance with local labor laws.

FAQs

1) What happens when an employee is misclassified?

You are not obliged to extend employee rights and statutory benefits prescribed under the local labor laws when an employee is misclassified as a contractor. However, wilful misclassification can lead to significant legal and financial consequences.  

2) What is the penalty for misclassification of employees in NY?

The penalty for misclassification of employees in NY is up to $2,500 per misclassified employee for a first violation and up to $5,000 per employee for subsequent violations within five years. You may also be liable for back wages and overtime pay. There is a provision for criminal charges in case of willful misclassification. 

3) What is the penalty for misclassification of an employee in California?

The penalties for misclassifying employees as independent contractors in California may range from $5,000 to $15,000 per violation. However, if the authorities establish a pattern of misclassification, you could be fined between $10,000 and $25,000 per violation. Further, you are liable for back wages, overtime pay, and other employment-related benefits.

4) How do you fix misclassification?

To fix misclassification, leverage factors such as control over the work, payment methods, and the worker's ability to set their hours. You can remedy misclassification by paying any owed back wages, overtime pay, and employment taxes. You can connect with EOR services like Skuad to comply with specific labor regulations.

5) Is misclassification an unfair labor practice?

Yes, misclassifying employees as independent contractors is an unfair labor practice in most jurisdictions. By doing so, you are denying employees their rights and statutory benefits under labor laws. You could face significant legal and financial penalties for misclassification. Fortunately, Skuad can help you follow fair labor practices in over 160 countries.