Why Misclassification Risk Can’t Be Ignored

By MBO Partners | November 9, 2022

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Key Points

There are a number of laws, tests, and definitions to help businesses determine whether a worker is an independent contractor or an employee.

Business should audit their current independent contractor classification processes to identify gaps and areas for improvement.

Organizations can use existing federal, state, and government agency tests as guidelines to create a questionnaire or checklist to assess worker classification.

As the 64.4 million-strong independent workforce continues to grow, so does the issue of employee misclassification.

The IRS estimates that millions of workers have been misclassified, and according to state-level studies, 10-30% of employers misclassify their employees as independent contractors. While some misclassification is unintentional due to lack of understanding about laws regarding worker classification, sometimes it is done deliberately to reduce labor costs, and avoid paying state and federal payroll taxes.

High-profile lawsuits involving Uber, FedEx, Zenefits, Citigroup, and more have thrown the issue of misclassification into the spotlight. Unfortunately, misclassification truly affects everyone—business owners, workers, and the government—and occurs in nearly every sector of the economy from banking and financial services, to manufacturing, health care, and entertainment.

In this series, we’ll explore the cost of misclassification on businesses, independent contractors, and the government.

What is Worker Misclassification?

There are a number of laws, tests, and definitions to help businesses determine whether a worker is an independent contractor or an employee. Unfortunately, these guidelines lack uniformity, are often quite detailed and can be interpreted in various ways. This complicates classification as workers may be seen as employees under one set of tests or from one person’s perspective, but as independent contractors under another.

Correct classification is important because employers do not have to provide common benefits such as health care options, unemployment insurance, or minimum wage to independent contractors. Misclassification stems from the economic and business advantages of using independent contractors, coupled with a grey area of competing legal guidance.

Why Are Workers Misclassified?

When employers misclassify an employee as an independent contractor and avoid contributing to Social Security and Medicare, offering employee benefit plans, or abiding by minimum wage and overtime laws, they can save on labor costs.

Misclassification, however, can have serious consequences including fines, penalties, audits, back-tax payment, negative press, and loss of trust. For example, FedEx cut labor costs by misclassifying drivers as independent contractors, resulting in a $228 million settlement for California drivers. Citigroup has also been faced with a $325,000 settlement for misclassification of technology workers and Zenefits had to pay $3.4 million to misclassified employees for unpaid overtime.

How Do Organizations Avoid Misclassifying their Workers?

Business should audit their current independent contractor classification processes to identify gaps and areas for improvement. By creating guidelines for independent contractor engagement and ensuring enterprise managers and relevant staff enforce policies and procedures, businesses can minimize their exposure to misclassification liability.

Organizations can use existing federal, state, and government agency tests as guidelines to create a questionnaire or checklist to assess worker classification. Keeping supporting documents on file—such as business or professional licenses, marketing materials, personal websites, or insurance certificates—as proof of self-employment is another best practice. It is also incredibly important to use a written contract that clearly defines the business’s working relationship with an independent contractor.

However, partnering with a third party to manage the complex process of deciding how to classify and best engage independent talent is the safest solution. MBO Partners has an established methodology for evaluating and engaging independents, which minimizes or eliminates compliance issues.

The risk of misclassification shouldn’t deter business from utilizing the valuable pool of independent talent; it is simply important to remain informed about the latest laws and regulations, take compliance measures seriously, and ensure your business model includes processes to properly classify and engage independents.

The information provided in the MBO Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs.  Before acting on any information in the MBO Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.  

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