Employee Misclassification 101: What You Need to Know

In 2020, 59 million Americans considered themselves freelancers; that’s 36% of the U.S. workforce. That number is expected to surpass 90 million by 2025

This has attracted the attention of both the legal and tax systems. The difference in the legal obligations whether a company classifies a worker as either an employee or independent contractor is significant, particularly in terms of worker protections and tax revenue. Therefore, governments, both state and federal, have been taking a hard look at how companies are classifying their workers.

Unfortunately, the result of this increased government involvement has created a complex patchwork of evolving laws on how to classify a worker – and an increasingly aggressive framework of penalties for employee misclassification. 

The legal and business consequences for a company that misclassified workers as independent contractors when the government or the tax authorities considers them to be employees can be costly to the tune of millions owed and a damaged reputation.

What is employee misclassification?

Classifying each worker is a legal decision that defines the legal relationship between the company and the worker. Classification impacts everything from what taxes are owed to how the worker delivers services. 

When companies decide to classify a worker as an independent contractor, they are responsible for ensuring that the worker is qualified as an independent contractor according to applicable federal, state, and local laws. Worker misclassification occurs when a company classifies a worker as an independent contractor, while the federal, state or local law consider them as an employee.

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Employee Classification

Why do the governments care?

The federal and state governments regulate many areas of the employer-employee relationship. Thus, they are concerned about worker misclassification because it defines people outside the regulated work relationship. Four reasons why they take employee misclassification seriously:

#1 Serious Loss of Public Revenue

Employers pay payroll taxes for each employee. Payroll taxes include Social Security, Medicare, and federal income tax withholdings. When an organization misclassifies an employee, it doesn’t pay these taxes for that worker. 

The government may also lose out on tax revenue when the worker files their individual income taxes. Independent contractors can make business expense deductions that employees cannot. 

They’re also required to contribute to funds like unemployment insurance and workers’ compensation. Misclassifying an employee results in employers not making their full contributions. Workers’ compensation insurance premiums are also determined based on employee count. Governments rely on this revenue to fund the social safety net and other public programs. 

#2 Lax Legal Protections for Workers

Local, state, and the federal governments all pass legislation providing worker protections. Minimum wage laws, required sick and leave time, overtime restrictions are but a few. None of these laws apply to independent contractors. 

Governments want as many people covered by these laws as possible as a matter of public policy. In contrast, contract law relies on the parties to negotiate for their interests. A negotiated relationship provides greater flexibility for the independent contractor, but also greater risk.

#3 No Social Benefits for Independent Contractors

Most Americans get their health care through work. Nearly all employers are required to offer health care to employees. Many contribute to employee retirement funds above compensation. Governments assert a public policy interest in ensuring everyone has health insurance and is preparing for retirement.

As companies compete for global talent, they also offer employees an increasing range of optional benefits. Benefits like student loan payments, wellness programs, and financial planning assistance. These benefits aren’t offered to independent contractors. The concern is that they are providing the same services to companies as employees, but on inferior terms.

#4 Level the Playing Field

Employees cost about 35% more than independent contractors. Their direct compensation may be comparable (this varies across industries and professions), but companies incur significant administrative and operations costs to manage employees.

All those laws that govern the employer-employee relationship come with a cost to the company, both monetary and in the flexibility they have to pivot with a changing market environment. Companies that work primarily with independent contractors don’t bear these costs or constraints, which provides them a competitive edge. Governments are concerned that some companies may avoid hiring employees specifically to avoid these additional costs.

The evolving legal landscape of employee misclassification

In 2020, there were 64.8 million independent contractors in the US. By 2027, that number is expected to hit 86.5 million, accounting more than 50% of the total US workforce. 

This massive growth in independent contractors, and the realization that soon enough non-payroll workers will make up for the larger share of the workforce has attracted the attention of the legal and tax systems.

Their main focus of the state and the federal government legislation is surrounding worker misclassification, both regarding how to classify workers and what the legal repercussions are for misclassification.

Unfortunately, in almost all cases the classification tests do not distinguish between white and blue collar workers, although there’s a significant difference for the two groups and one that needs more protection from the hiring companies.

Here are some of the state level legislation regarding worker classification in recent years:

New York: Establishing Protections for Freelance Workers Act

One of the first freelance focused acts legislated in recent years. The law enhances the protections for independent contractors, specifically the right to a written contract, timely payment within 14 days and protection from retaliation.

The law establishes penalties for violations of these rights, including statutory damages, double damages, injunctive relief, and attorney’s fees. The law also determines that if there is evidence of a practice of violations, the penalty can reach $25,000.

California: AB 5 and Prop 22

California passed the most stringent restrictions on who qualifies as an independent contractor.  In 2018 the California legislature codified the worker classification test set out by the state’s supreme court. The state starts with the assumption that a worker is an employee unless it is shown otherwise using the “ABC” test (see section 5.2). Under the ABC test, only a worker providing services “outside the usual course of the hiring entity’s business” can be an independent contractor. 

The bill (AB 5) contained other restrictions that made working as an independent contractor difficult. In response to criticism, the law was modified in 2020 (AB 2577) by creating exemptions to its application. 

Criticism of California’s approach to worker classification persists, mainly due to a $200M paid campaign sponsored by Uber and Lyft. In November 2020, Californians voted to approve Prop 22, which excludes gig workers, like Uber drivers, from the AB 2577. A new bill (AB 25) has been introduced in the California legislature that would repeal the ABC test. 

New Jersey: New Requirements and New Penalties

New Jersey is another state with new employee misclassification laws that went into effect in 2020. These address informing workers of the issue of worker misclassification.

Organizations must now post notices that inform workers that worker misclassification is prohibited. The notice, provided by the state’s department of labor, informs workers of the protections state laws provide for employees, the definitions of employee and independent contractor, remedies that exist if they’re misclassified and contact information where they can file a complaint if they believe they’ve been misclassified.

The new laws also allow workers to sue an organization for retaliating against them for filing a misclassification complaint or asking about employee misclassification.

How to classify employees?

As important as correctly classifying workers is –  one would think there would be a clear test to make a determination. Unfortunately, there isn’t and properly classifying workers is hard. 

First, there isn’t just one test. The test used by the IRS is not the same one used by the DOL under the Fair Labor Standards Act (FLSA). States each have their own worker classification tests too.

Second, none of the tests provide a bright line yes/no answer. They all weigh a variety of factors, a situation that lends itself to ambiguity and inconsistent application. 

Third, many organizations try to manage classification decisions manually, which increases the risks of inconsistent decisions and overlooked factors. It also makes the decision process more expensive.

The workforce is changing. Are you ready?

Companies rely more on non-payroll workers, and in a few years they will make up the larger share of the workforce.

Therefore companies need to ensure they have the required processes and tools to manage their contractors, including the ability to properly, accurately and continuously classify their non-payroll workers.

As long as the standards of worker classification are ambiguous, and the legal and business implications of misclassifying workers are high. 

The risk of employee misclassification is further complicated by the fact that the legal requirements about worker misclassification are in flux, and the legal and business implications of misclassification are high. 

Both state and federal governments are actively addressing the issue with new and changing standards. They’re also focused on increasing enforcement.

Thus, companies working with independent contractors have a heightened responsibility to ensure there’s no ambiguity in the work relationship. The potential financial costs of a government agency retroactively redefining it as an employer-employee relationship are too high. 

One issue that is certain is that how a company works with an independent contractor is more important than contract language stating the worker isn’t an employee. Thus, using  processes and platforms that show evidence of the worker’s autonomy are critical to protecting the company.

Written by
Shahar Erez

Co-Founder & CEO @StokeTalent

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