Contractor & Employee Misclassification in the USA

International businesses expanding to the USA may consider engaging a mix of contractors and full-time employees, depending on their hiring needs, budget, and long-term US expansion plans.

Regardless of your approach to building a US workforce, employee misclassification can lead to significant issues. This includes fines, legal entanglements, and a damaged business reputation.

Our guide provides a detailed breakdown of employee misclassification in the USA, including a definition, a list of common causes specific to US regulations, a summary of the typical penalties under US law, and the standard steps for correcting misclassification. Plus, find out how to reduce your employee misclassification risk as you build your US team.

What is Employee and Independent Contractor Misclassification?

Misclassification of employees and independent contractors arises from complexities in employment and tax regulations. When a business expands internationally, these complexities can be further magnified, leading to inadvertent misclassification. This occurs when a worker is mistakenly categorized as an employee when they should be considered an independent contractor, or vice versa.

In an attempt to cut hiring costs, simplify payroll processes, and maintain a flexible workforce, some companies intentionally misclassify employees as contractors. However, these attempts to gain an advantage rarely succeed in the long run, as legal consequences are likely to follow.

Misclassification can also occur unintentionally. Companies may unknowingly violate worker classification laws, even if they initially correctly classified the working relationship. As the nature of the work arrangement or local employment laws evolves, the original classification may no longer be valid. This highlights the importance of staying up-to-date on US regulations to avoid unintentional misclassification.

Regardless of intent – deliberate or accidental – any company in the US that misclassifies workers faces legal and financial repercussions including fines, back wages, tax arrears, and other penalties. Correctly classifying your workforce is crucial to ensure your employees receive the rights and benefits they’re entitled to under US law.

Employee vs. Contractor: Navigating the Differences in the US

Classifying workers as employees or contractors can be complex, and the determining factors vary significantly worldwide. In the United States, however, there’s a general framework to distinguish between the two.

• Employees typically operate under the direct supervision and control of their employer, following instructions on how and when to perform tasks. They receive a regular salary (hourly, weekly, or bi-weekly) and may be eligible for a benefits package that can include health insurance, paid time off, and retirement contributions. Employees are typically classified as W-2 workers for tax purposes, with their employer withholding income and payroll taxes.
  
  
• Independent contractors, on the other hand, operate as their own businesses. They are responsible for finding and securing their own clients, setting their rates, and managing their work schedules. Unlike employees, independent contractors are not eligible for employee benefits from the companies they contract with. They are responsible for paying self-employment taxes, which cover Social Security and Medicare, and managing their own health insurance and retirement savings. Independent contractors often have more control over how they perform their work, and they may work for multiple clients simultaneously. This flexibility can be a major advantage for contractors who value autonomy and project-based work. However, it also means they are responsible for finding new work consistently and for covering their own business expenses.
  
  

Like many countries, US worker classification hinges on the level of control the employer exerts over various aspects of the work arrangement. The Internal Revenue Service (IRS) has established a three-pronged test for employee classification to provide a clearer picture. In the following sections, we’ll delve deeper into these categories—behavioral control, financial control, and the business and worker relationship.

1. Behavioral control

The first factor considered in US worker classification is behavioral control. This examines the extent to which a company dictates how a worker performs their duties, exceeding simply outlining the desired outcome.

For example, if the company specifies how, when, or where the individual can work, this extends beyond simply defining the task. Similarly, dictating the tools used, or even where supplies are purchased points towards an employee classification.

Furthermore, any training the employer provides regarding specific work procedures and methods implies a desire for the work to be completed in a particular way. This level of control typically signifies an employer – employee relationship.

Additionally, supervision is another key behavioral factor. Close employer supervision of the worker indicates behavioral control. Regular check-ins, progress assessments, and direct oversight are more commonly associated with an employee-employer relationship. Independent contractors typically have more freedom and may not require close supervision.

2. Financial control

The second pillar of US worker classification is financial control. Here, the focus is on a worker’s investment in their operations and their exposure to business-related risks. This helps determine the nature of the work arrangement.

For instance, if a worker invests financially in their business while working with a client, this strengthens the argument for an independent contractor relationship. This investment demonstrates the separate entity nature of their work. Examples of such investment include purchasing tools or equipment specific to the work they are hired to do, advertising their services to potential clients, or hiring and paying for assistance with their work.

Additionally, the method of payment is another factor to consider. Contractors are commonly paid per project or on a freelance basis, and they may invoice for their services, further emphasizing their financial independence. While employees typically receive regular, consistent paychecks, some contractors may also receive regular payments depending on the agreement.

It’s important to note that expense reimbursement doesn’t automatically disqualify someone as an independent contractor. Contractors can be reimbursed for expenses by their clients. While reimbursement practices may vary depending on the specific agreement, it’s common for clients to reimburse contractors for reasonable business expenses incurred during the project. However, reimbursement should be done in line with applicable tax laws and regulations.

3. Business and worker relationship

The final element of US worker classification hinges on the overall nature of the business and worker relationship. The presence of benefits offered by the company plays a significant role. If workers receive benefits like paid leave, retirement plans, or health insurance, they are most likely categorized as employees. However, the absence of benefits doesn’t automatically translate to contractor status. Other factors will ultimately determine the worker’s classification.

Several additional factors can influence classification under this element. Here are some key considerations:

• Exclusivity and Control: Employees are typically under the employer’s direction and control. The employer dictates work schedules, methods, and procedures. Contractors, on the other hand, have more autonomy and discretion in how they complete their work, as they are hired for their specialized skills or expertise.
• Integration into the Business: Employees are more integrated into the day-to-day operations of the business. They often work on-site and are subject to company policies, procedures, and supervision. Contractors may work remotely or autonomously and have more independence in how they manage their work.
• Termination and Duration of Work: Employees typically have ongoing, long-term relationships with the employer, and termination is governed by employment laws and regulations. Contractors are generally engaged for specific projects or a set period, and the relationship may end upon completion of the work or by mutual agreement.
  
  

As mentioned previously, if the factors discussed earlier (behavioral and financial control) leave room for interpretation, courts may analyze the independent contractor agreement to gain further insight. This agreement can clarify the intended nature of the working relationship. This underscores the importance of establishing clear and detailed work agreements to ensure compliance with US regulations.

Ongoing changes to worker classification regulations

The landscape of worker classification regulations is constantly in flux. Failing to stay updated on these changes can lead to legal trouble for employers who continue operating under outdated assumptions. Human Resources teams should prioritize regularly reviewing local regulations to ensure compliance.

For instance, on March 11, 2024, the United States Department of Labor (DOL) implemented significant updates to its employee classification regulations under the Fair Labor Standards Act (FLSA). These revisions make it more challenging for companies to classify workers as independent contractors, potentially impacting how businesses engage talent across the US.

The DOL’s new emphasis on a “six-factor test” prioritizes factors that suggest a worker is an employee, such as behavioral and financial control. This shift can lead to unexpected liabilities for businesses that misclassify workers.

Understanding and complying with these complex regulations can be a daunting task. Ensuring ongoing compliance requires a deep understanding of the nuances of the law and how it applies to your specific workforce. Partnering with a provider experienced in worker classification, such as Foothold America, can help you navigate these complexities and minimize the risk of costly misclassifications.

Common Pitfalls Leading to Misclassification

Employee misclassification arises from various factors, ranging from a simple lack of awareness of employment laws to industry-specific challenges.

The National Employment Law Project estimates a staggering 10% to 30% of employers in the US alone misclassify their employees as contractors. This translates to potentially millions of US workers being incorrectly categorized.