5 Employee Misclassification Mistakes to Avoid

When deciding how to classify workers, there are important factors that should be considered. Whether you classify someone as an employee or a contractor will dictate how you pay taxes as an employer, how the worker is paid, whether they are eligible for benefits, and how they are managed on a daily basis. Below, we explore five common employee misclassification mistakes that can be avoided.

1. What happens if I treat employees and contractors the same?

In general, a full-time employee works for a single employer who dictates the work performed as well as the hours and location of work. An independent contractor, on the other hand, operates as an independent business and may perform work for multiple clients. Contractors submit invoices for completed work and provide their own tools and equipment. Independent contractors are responsible for both the individual and employer side of taxes whereas employees are entitled to legal benefits of a W-2 employee.

These are very general differences between employees and independent contractors, but things can get complicated quickly. There are several laws, tests, and definitions that distinguish these two types of workers. Becoming familiar with how the IRS and Department of Labor (DOL) categorize workers is a good first step. Individual states may have particular laws as well, but many are based off of the IRS or DOL rules.

The DOL looks at a number of factors to determine if a worker is an employee or independent contractor under the Fair Labor Standards Act (FLSA). These factors include:

• The permanency of the relationship.
• The amount of the alleged contractor’s investment in facilities and equipment.
• The nature and degree of control by the principal.
• The alleged contractor’s opportunities for profit and loss.
• The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
• The degree of independent business organization and operation.

The IRS looks at common law rules—facts that provide evidence of the degree of control and independence in the relationship between a worker and a business. These degrees of control fall into three categories: behavioral control, financial control, and relationship of the parties.

Learn more: Worker Classification Tests: DOL, IRS, State Tests for Classifying Workers

2. What happens if I manage a contractor in the same way that I manage an employee?

One of the most important factors both to the IRS and the DOL comes down to degree of control. Independent contractors are responsible for providing the work outlined in their contract. Unless otherwise specified, they can work when, where, and how they want. If they are performing a job that an employee is already doing, or if a manager is treating them like an employee, your company may be at risk for misclassification.

When in doubt, just remember that independent contractors are part of a business-to-business relationship. If you try to control how they do their job or over-supervise their work, your risk of misclassification increases. Use your initial conversations and your contract with an independent worker to guide you in establishing rules, communication, and management expectations.

Up next: Top 5 Employee Misclassification Penalties to Avoid

3. What happens if I don’t use a written contract?

Using a written contract can be one of the best ways to define a working relationship with an independent contractor and protect your company from misclassification. A written contract should outline the scope of work, define how managers and contractors will communicate, specify payment terms, and explicitly state that the person you are engaging is an independent worker free from control. If your company requires insurance, the contract can be a good place to put this information as well.

Another good practice is to conduct an internal audit of your current classification processes. This is a helpful way to see if what you are doing is compliant. It can also provide valuable insight  into what HR personnel and hiring managers understand about working with independent contractors.

Check out: 3 Reasons to Use a Written Contract for Consultants

4. How do I make sure my FTEs understand how to work with contractors?

There is so much to learn when it comes to working with independent contractors. While hiring managers will need to know the details of independent contractor engagement, it is also important to keep your general employee population in the loop.

Talk to employees about the role of independent contractors at your company and how they will be working together. If a contractor will be working remotely, only available as a resource for a specific project, or keeping a certain set of hours, make sure employees know this information and understand why the contractor is allowed to work this way. Talking openly about the role of independent contractors in your company will help normalize the concept of a blended workforce and give employees the confidence they need to work successfully with contractors.

Up next: 10 Ways Enterprises Can Prepare for Independent Contractor Compliance

5. How do I make sure my contractors are satisfied?

In order to attract top independent talent, it is important for companies to be aware of independent contractor satisfaction. If a contractor has a negative experience with your company because they are being treated like an employee, they might raise a red flag for misclassification. Keeping contractors happy not only helps boost your business reputation—it can help you stay compliant as well.

Top points of satisfaction for independents include a simple onboarding process, a positive work environment, and fast and reasonable payment terms. When you are able to offer independents a place to safely and compliantly provide their expertise, everyone leaves happy. You can see more of what independents look for in a client relationship in our Client of Choice research.

Happy contractors are also more likely to re-engage with your organization on another project in the future. Re-engaging talent already familiar with your company, your culture, and your expectations provides an easier and more productive experience for everyone. Also, re-engaging talent that is already onboarded and vetted saves you time and money as the talent can get to work faster.

Frequently Asked Questions About Worker Misclassification

1. What is worker misclassification?
Worker misclassification occurs when a company incorrectly classifies a worker as an independent contractor instead of an employee. This can result in unpaid taxes, penalties, back wages, and legal exposure.

2. What are the penalties for misclassifying a worker?
Penalties may include IRS fines, unpaid payroll taxes, overtime back pay, employee benefits reimbursement, and state-level penalties. In severe cases, companies may also face audits or class-action lawsuits.

3. How does the IRS determine worker classification?
The IRS evaluates worker classification using common law rules that focus on behavioral control, financial control, and the nature of the relationship between the worker and the company.

4. How is the Department of Labor (DOL) test different from the IRS test?
The DOL applies an “economic realities” test that examines whether the worker is economically dependent on the company. This analysis may differ from IRS criteria, creating additional compliance complexity.

5. How can companies reduce the risk of worker misclassification?
Companies can reduce risk by implementing structured classification reviews, maintaining clear contracts, limiting managerial control over independent contractors, and conducting periodic compliance audits.

6. Why is worker misclassification a growing risk for companies?
Increased federal and state enforcement, evolving labor laws, and the growth of the independent workforce have heightened scrutiny around classification decisions.