Consequences and penalties for misclassifying 1099 contractors and employees

Published

Jun 29, 2023

Author

Misclassifying employees as independent contractors is a more widespread issue than most people realize. Companies are often ready to take on the risk of misclassification because it may be cheaper to hire contractors than employees. There's also a widespread mentality of "it won't happen to me—my company won't be audited.”

But misclassification can result in significant risks for both employers and workers.

For employers, misclassification can lead to legal and financial liabilities, including penalties for failure to comply with labor laws, back pay for wages and benefits owed, and lawsuits brought by workers.
For workers, misclassification can result in the loss of important benefits and protections, such as minimum wage, overtime pay, workers’ compensation, and unemployment insurance, as well as the ability to collectively bargain for better working conditions.

Companies of all sizes can be held liable for violating labor laws—with massive penalties:

In 2020, UK-based courier company CitySprint was ordered to back pay holiday pay to five couriers who were misclassified as independent contractors. CitySprint had previously lost misclassification cases in 2019 and 2017.
In 2019, Handy Technologies, a cleaning and handyman services company based in New York, agreed to pay $1.2 million to settle a lawsuit that alleged it misclassified workers as independent contractors and denied them benefits such as minimum wage and overtime pay. Handy had under 1,000 employees at the time.

It's vital that companies know the warning signs of misclassification—and commit to classifying their workers correctly. A good place to start is by understanding the differences between employees and contractors.

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Employee vs. independent contractor

One of the key differences between employees and independent contractors is that employees are typically subject to more control and supervision by the company, while independent contractors have more autonomy over their work. The more control a company has over how the work is done and how the worker is paid, the more likely it is that the worker should be classified as an employee. If a company is treating independent contractors like employees, it could be a sign that those workers are misclassified.

Every country has its own guidelines regarding independent contractor and employee classification. Despite the differences, employee classification usually rests on some basic distinctions. In the United States, there are some key differences between employees and independent contractors.

Payment and tax contributions: Most employers pay employees regularly through a company payroll system, which makes contributions to Medicare and Social Security Taxes and Unemployment Insurance on behalf of their employees. Contractors are self-employed so they submit invoices and receive payment for their work, and then make their own self-employment tax contributions when they file their income taxes.

Hiring and training: Employees are generally hired for a specific role on an ongoing basis. After they’re hired, they typically receive training about the company, its mission and culture, their role and responsibilities, and other workplace-required topics. Contractors, on the other hand, are generally brought on for a specific project or for a specified period of time. Training is usually minimal and related to the task at hand rather than the more comprehensive training employees receive.

Schedule and location: Employees are usually expected to work on a company-mandated schedule, generally 9-5pm. Also, although conventions have changed with the rise of remote work, employees may still be required to work in the company office for at least part of the workweek. Contractors can work whenever and wherever is convenient for them as long as they deliver their work on time.

Equipment: Generally, employees receive equipment to do their jobs—which may include computers, cell phones, specialized software or subscriptions, and other necessary tools— whereas contractors are responsible for supplying their own equipment at their own expense.

Centrality of work: In some countries, employees are hired to do work that is vital to the company’s core operations whereas contractors do work that is supplementary. However, this guideline is subject to interpretation.

9 employee misclassification consequences and penalties

The risks of employee misclassification can be grave and costly, affecting not only a company’s bottom line but its reputation as well. The following is a list of potential consequences a company might incur if they misclassify their workers.

1. Fines and penalties

If you misclassify an employee, your business may not only be subject to heavy fines from federal agencies like the DOL (Department of Labor) and IRS (Internal Revenue Service), there are also state laws that could levy fines and penalties.

2. Back wages and unpaid benefits:

In addition to fines from the government, if your company is found to be in violation of FLSA (The Fair Labor Standards Act) laws, your company is liable for any back wages, unpaid overtime, and benefits such as vacation days, sick days, pension, health insurance plan coverage, paid leave allowances, and possibly more that the employee is owed.

3. Legal disputes and lawsuits

An employer who misclassifies employees is also at risk for workers taking matters into their own hands if they don’t want to wait for the government to impose misclassification penalties. Workers may sue their company which could escalate into a class action lawsuit. Between payouts to employees and legal fees, a company is on the hook for a significant financial hit.

4. Non-compliance with I-9 documentation

Workers misclassified as independent contractors could also create a liability risk for an employer based on their I-9 status. Employers are required to keep I-9s for all employees. A company risks being in violation of this law If they are audited by Homeland Security, ICE (Immigration and Customs Enforcement), and the Department of Labor.

5. Workers' compensation liabilities

Another risk of misclassifying workers is incurring penalties for violating state workers' compensation insurance laws, and being legally liable for unpaid workers' compensation premiums.

6. Anti-discrimination law violations

Employers who misclassify employees as independent contractors may not provide them with required protections under anti-discrimination laws which is in violation of the anti-discrimination protections that employees are entitled to under federal and state laws.

7. Violations of wage laws

If a contractor is misclassified as an employee, an employer may also be held liable for failure to pay overtime and minimum wage.

8. Unpaid payroll taxes

For workers misclassified as independent contractors, employers may also face penalties for unpaid state and federal payroll taxes including Social Security and Medicare taxes and state Unemployment Insurance tax.

9. Reputational damage

Maintaining proper worker classification is crucial for maintaining a positive reputation as an employer. Legal issues and bad press cause damage to your standing with employees, customers, and business partners.

For startups that are fundraising, misclassification can scare off investors. In fact, according to our report, 71% of respondents believe VC firms are less likely to invest in a startup that has faced compliance issues.

A bad reputation can also make recruiting and retaining top talent more difficult. In addition, if misclassified employees believe they’re not getting the wages or benefits they deserve, it could result in high turnover and mistrust of management.

8 warning signs of employee misclassification

In our own analysis, we've identified eight signs of misclassification that can put your company at risk. Note that none of these are sure signs of misclassification on their own, but if any of them apply to any of your workers, you may want to check their classification—especially if you have a number of contractors in a given country.

Sign #1: Using a company email

It's very common for a contractor to receive a company email address from a client—typically for access reasons.

But when a worker uses a company email address, it can suggest that they're more integrated into the company's operations and are potentially under more control from the company than an independent contractor would be. This is because employees typically use company email addresses, while independent contractors would typically use their own personal or business email addresses. This sign becomes more concerning when compounded with another sign.

Sign #2: Working continuously for longer periods, like more than 12 months

In general, employees tend to work for a company for an indefinite period of time, whereas independent contractors are typically hired for a specific project or set period of time, with no guarantee of ongoing work.

That's why, if a worker has been continuously working for a company for longer periods, such as for more than 12 months, it may suggest that they're more likely an employee than an independent contractor.

Sign #3: Receiving equity

Equity compensation, such as stock options or restricted stock units, is often used to incentivize employees and align their interests with the company's success. Equity compensation is typically required to vest over a longer time period before it can be optioned, creating an incentive for employees to stay in their roles for the long term. For plans that allow independent contractors to receive equity compensation, a continuous engagement for multiple years, and as mentioned above, i.e., working through a vesting period could be a red flag that the independent contractor is misclassified.

Are you misclassifying your contractors? Find out in 90 seconds.

Sign #4: Being paid in regular intervals

Generally, employees are paid on a regular and consistent basis, such as weekly, bi-weekly, or monthly. Independent contractors, on the other hand, are usually paid on a per-project or per-deliverable basis, rather than a regular and consistent basis. Unlike employees, independent contractors are generally expected to track their progress in deliverables, project milestones, or project hours. They also tend to negotiate the frequency of pay and invoice their clients before receiving payment.

Sign #5: Expense reimbursement

Typically, employees are reimbursed for business-related expenses incurred in the course of their employment. Independent contractors, on the other hand, are responsible for their own expenses, as they are considered to be running their own businesses. As such they either build in expenses to their negotiated rates or ensure that their engagement agreement outlines the expense-related fees that their clients will pay.

Sign #6: Participating in employee engagement surveys

The terms of engagement are different for employees and independent contractors. As such, any sort of engagement survey would be asking different questions of independent contractors than of employees.

Many companies encourage independent contractors to participate in employee engagement surveys as a way to improve communication and engagement with their contracted workforce.

But if a company is using employee engagement surveys as a way to measure the satisfaction or productivity of workers who are classified as independent contractors, it may suggest that the company is blurring the line between employees and independent contractors.

Sign #7: Receiving company training

Receiving company training is not necessarily a warning sign of misclassification on its own. It is common for independent contractors to receive context and insights from the companies they work with in order to better understand the project requirements and expectations.

It's the level and nature of the training provided that companies need to be cognizant of—this can be a factor considered in determining whether a worker is an employee or an independent contractor. Generally, employees receive more comprehensive training than independent contractors (such as conscious bias training, sexual harassment training, etc.) because they are more closely integrated into the company's operations and culture.

If a company is providing extensive training to a worker who is classified as an independent contractor, it may suggest that they are exerting a level of control and supervision over that worker that is more consistent with an employment relationship. This could be another lesser-known warning sign of misclassification.

Sign #8: Integration with performance management software

Performance management software is often used to track and evaluate employee performance. If a company is using performance management software to track the work of independent contractors in a manner similar to employees, it may suggest that the company is treating those workers as employees rather than independent contractors.

Contractors don’t participate in typical company processes—like performance improvement plans or salary reviews—or enjoy the same benefits as full-time employees. They’re typically responsible for their own work and travel expenses, and shouldn’t receive equipment from their employer to perform work-related tasks. These are all signs of integration that could indicate an employer-employee relationship instead of a contractor one—especially if any of these signs exist in tandem with the contractor using their client's performance management software.

How to prevent employee misclassification

The obvious way to avoid employee misclassification penalties is to be aware of laws and regulations and ensure you’re abiding by them. This is trickier than it seems because there aren’t consistent guidelines, and laws vary from country to country and even within the United States depending on location.

The following are some guidelines a company should follow to mitigate the risk of employee misclassification.

1. Clearly define roles and responsibilities

Ensure that managers are trained on proper employee classification and encourage them to play it safe and stay close to the rules when assigning work to contractors.

2. Regularly review worker classifications

Consult with legal experts, regularly review your contracts for independent contractors, and utilize government resources and self-check services to make sure you’re compliant.

3. Understand federal and state laws

Learn the laws and regulations for classifying employees in your location.

4. Implement automated compliance tools

You’ll save yourself major headaches when it comes to properly classifying employees if you utilize tools that automatically monitor your compliance with international, federal, state and local employment laws.

Avoid employee misclassification with Rippling

An efficient way to make sure you’re properly classifying employees is by using an EOR (employer of record) like Rippling. An EOR is a third-party organization that takes on the legal responsibilities of employing employees for your company.

Rippling helps prevent worker misclassification with automated worker classification, real-time compliance alerts, and integrated payroll and tax management.

Workers are automatically classified as employees or contractors when they’re hired. Rippling stays up to date with the latest labor laws to help companies maintain compliance with federal, state, and local laws. Automatic compliance audits ensure legally required forms and documents are in order. Full-service payroll software calculates all taxes and submits tax forms and payments automatically. Employee withholdings automatically flow into payroll, so there’s no need to manually enter withholding amounts.

Rippling supports international contractors, EOR employees, and HR and payroll for employees across your entire organization whether you’re local or global. And with Rippling, you can convert a contractor into an employee quickly and compliantly. Unlike other providers, Rippling can transition workers while keeping all their data across documents, time tracking, expenses, and more intact.

Protect yourself and your company with Rippling's worker classification analyzer, and find out in just 90 seconds whether there are potential issues with your workforce classifications—across the globe. Take the quiz.

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