Worker misclassification: How to know if you’re at risk—and what to do about it

Many of us have heard about governments pursuing gig economy giants for misclassifying their workers. For example, Uber was fined $20 million by the US Federal Trade Commission (FTC) for falsely claiming exaggerated earning potential and misleading drivers about the terms of its vehicle financing program. But companies of all sizes—including small businesses—can be held liable for violating labor laws. 

How to know if you’re at risk of misclassification

In the United States, worker classification rules are made by various federal and state agencies, including the Department of Labor, the IRS, and state labor departments and workforce agencies. These agencies are responsible for enforcing labor laws and regulations, including those related to worker classification. Compounding the complexity, the regulatory landscape and the enforcement focus on misclassification is evolving rapidly.

While government agencies and courts generally construe independent contractor status narrowly, different jurisdictions and different agencies apply different tests to determine independent contractor status. Even within the same jurisdiction, different tests are applied for different purposes. As such, one court or state agency could find a worker properly classified as an independent contractor for one purpose (e.g., wage and hour) and another court or agency in the same state could find the opposite for another purpose (e.g., unemployment compensation or workers’ compensation).  

In all of the tests, however, there are a few general concepts to keep in mind when looking at your independent contractor arrangements.  For example, merely labeling a worker as an independent contractor, or having them sign an independent contractor agreement, does not ensure that the person is properly classified as such – even if everyone agrees and wants it to be so. Additionally, one key concept in the various tests is the hiring entity’s right to control the independent contractor. Courts and government agencies look at factors such as whether the hiring entity supervises the worker, and whether the hiring entity provides the tools, equipment, and place of work, to determine whether a worker is properly classified as an independent contractor.

Different tests apply to determine whether a worker is classified correctly.  For example, the IRS's “multi-factor test” has three prongs: behavioral control (i.e. does the company control or have the right to control what the worker does and how the worker does his or her job?), financial control (i.e. are the business aspects of the worker’s job controlled by the payer?), and the type of relationship (i.e. are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?).

Many states have their own worker classification rules and tests. For example, California and several other states have adopted a version of the so-called "ABC" test, which applies in most situations:  :

1. That the worker is free from the control and direction of the company
2. That they perform work that is outside the usual course of the company's business
3. That they are customarily engaged in an independently established trade, occupation, or business

In California, even where an arrangement might be exempted from the “ABC” test, California applies another multi-factor test aimed at analyzing the economic realities of a given situation to determine whether a worker is properly classified as an independent contractor.  

Many warning signs of misclassification are lesser known. In our own analysis, we identified eight typical signs of misclassification.

Read on to learn more about the risks…

The risks of misclassification

Misclassification is when a business considers a worker to be an independent contractor when they should have considered them an employee. Whether your contractors are in the US or overseas, misclassifying a worker can run up huge penalties. Consequences can vary depending on the severity of the violation and the laws in the jurisdiction where the company operates. 

Different countries have different rules for what distinguishes a contractor from an employee, making the risk even higher for companies that hire global workers. Without HR admins experienced in the nuances of each country’s classification regulations, you may find that you inadvertently run afoul of the regulations applicable to your situation. Remember that a regulator, court, or arbitrator applying the rules of the jurisdiction, may conclude that a worker is misclassified even when both the company and the worker want an independent contractor arrangement and have a contract that says so. 

Below are some of the potential outcomes that can occur when a company is found to be misclassifying its workers.

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

Government or regulatory investigation

When workers are misclassified as independent contractors instead of employees, it can lead to potentially significant risks of government or regulatory investigation for employers. This is because misclassification can result in non-compliance with labor laws and regulations, which can attract the attention of government agencies such as the Department of Labor and the Internal Revenue Service (IRS). In some cases, an investigation into misclassification can lead to a full-scale audit of the employer's operations, which can be time-consuming and costly.

Furthermore, misclassification can create a ripple effect, as other government agencies may become involved. For example, if workers are misclassified, they may not be properly covered by workers' compensation insurance, which can result in claims against the employer's general liability insurance. This can lead to higher insurance premiums and even the loss of coverage. 

Fines, penalties, and other legal action

If a government agency concludes that an employer has misclassified workers, the consequences can be severe. For example, the hiring entity may be required to pay back wages, including overtime pay, payroll tax assessments and penalties, workers’ compensation premiums and penalties, and claims for benefits and leave entitlements and related penalties worked as employees. 

One recent example of this is the well-known battle between Uber and legal entities in California. In 2020, the California Labor Commissioner's Office filed a lawsuit against Uber, alleging that the company had misclassified its drivers as independent contractors instead of employees and failed to pay them appropriate wages and benefits.

In the lawsuit, the Labor Commissioner's Office sought millions in unpaid taxes and penalties, as well as other damages. The case was settled in 2022, with Uber agreeing to pay $8.43 million to resolve the lawsuit, an average payout of $8,000 per driver.

This settlement represents one of the largest payouts ever in a misclassification case and highlights the significant risks that employers face when misclassifying workers as independent contractors. The case has also had broader implications for the gig economy and worker classification practices, as many companies have faced increased scrutiny and legal challenges in the wake of the ruling.

Lawsuits from misclassified workforce

In addition to legal action from regulators, workers who believe they have been misclassified may file their own lawsuits seeking back pay, overtime, benefits, and other damages, which can be costly and time-consuming for employers. Additionally, misclassification audits from state workforce agencies are often triggered when a worker applies for unemployment benefits, and the agency discovers that the worker was paid as an independent contractor.  

In recent years, there have been a number of high-profile lawsuits filed by misclassified workers against companies in the gig economy, such as Uber, Lyft, and DoorDash. But lawsuits happen outside the gig economy, too—for example, electric scooter company Lime agreed to an $8.5 million settlement in a case that alleged the company misclassified its "juicers," people who charge the scooters, as contractors. And Holland Acquisition Inc. was required to pay over $42 million in back wages and damages to workers it misclassified from 2012 to 2019. 

Reputational damage

And finally, even if a company is not fined or sued, it may suffer reputational damage if it is found to have misclassified workers. If a company is seen as exploiting workers or violating labor laws, it can damage the company's brand, image, and relationships with customers, investors, and other stakeholders.

Reputational damage can have significant financial consequences for a company, including lost revenue, reduced market share, and decreased investor confidence. It can also lead to negative media coverage, boycotts, and other forms of public backlash, which can further harm the company's reputation and bottom line.

In addition to potential financial consequences, reputational damage can also lead to legal and regulatory consequences. Companies that are perceived as violating labor laws may face increased scrutiny from government agencies and other stakeholders, which can result in new or further legal and financial consequences.

Misclassifying people is easier than you think

Misclassification can happen over time—many of the warning signs are small and innocuous on their own, but when many of them are present, it becomes a slippery slope that can catch employers off guard.

Here's an example:

Fictional Enterprises (FE) hires John, a graphic designer, as an independent contractor to work on a specific project. John works remotely, sets his own hours, and uses his own equipment. FE pays John a flat fee for the project and does not provide him with any benefits.

After the project is complete, FE is impressed with John's work and decides to hire him for another project. This time, FE provides John with more detailed instructions on how to complete the project and sets a deadline for completion. John still works remotely and uses his own equipment, but he now feels like he is more closely supervised by FE.

Over time, FE continues to hire John for additional projects. The work becomes more regular and ongoing, and FE begins to rely on John's work to run its business. John continues to work remotely and use his own equipment, but he now works exclusively for FE and does not have any other clients or customers.

At some point, John realizes that he has been working for FE for several years and has never been classified as an employee. He starts to question whether he should be receiving benefits such as health insurance and vacation pay.

In this example, FE may have accidentally misclassified John as an independent contractor. While John may have initially met the criteria for independent contractor status, over time his work became more regular and ongoing, and he became more closely supervised by FE, and he became economically dependent on FE as his sole client. If John were to challenge his classification, a court might determine that he should have been classified as an employee and was entitled to benefits such as health insurance and vacation pay.

And in a case like this, FE would be at risk of many potential consequences. They might owe John back pay, back benefits, and other remuneration. They might be audited, fined, or sued by government agencies for violating labor laws. And government regulators may even take a closer look at all the other contractors at FE and layer on additional fines and penalties if they conclude that other workers were misclassified. And their company reputation could take a hit, making it harder to attract talented workers like John.

Misclassification can happen accidentally, unintentionally, and as illustrated here, gradually over time. One first step you can take to protect yourself and your company is to use Rippling's worker classification analyzer, which can help you understand whether there are potential issues with your workforce classifications. Take the quiz.

You can also learn to identify some of the warning signs of misclassification in our guide.

Rippling and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any related activities or transactions.