Contractor Management 17 min

Employee and independent contractor misclassification: Expert guide

August 31, 2021
Preston Wickersham


share to linkedInshare to Twittershare to Facebook
Link copied
to clipboard

Avoiding employee misclassification is more about action than intent. Treat a worker like an employee, and eventually regulators will see that worker as an employee — even if you never intended to create that relationship.

Your intent matters, of course. Many countries levy heavy penalties against companies found breaking the law intentionally. If you want to stay compliant, though, you have to follow through on your good intentions.

A guide to employee and independent contractor misclassification

More and more companies are recognizing the value of using independent contractors. You’re no longer bound by the talent in your area, and contractors can be easier to hire and pay. Win-win, right?

Unfortunately, hiring contractors carries an inherent risk of misclassification. In the United States alone, some estimates say nearly 10% of workers are misclassified and that 10-20% of businesses have misclassified an employee. Because your responsibilities to employees are much more substantial, misclassification can have serious consequences for your business.

So how do you minimize risk of employee misclassification while managing international workers? Keep reading. We’ve developed this guide to help you avoid misclassifying employees. You can also try our free employee misclassification risk calculator to find out your risk level — and what you can do to fix it.

What is employee and worker classification?

Employee and worker classification refers to the status of the worker in the eyes of the local government. In most cases, workers are either employees (meaning the company holds more responsibility) or self-employed contractors.

Different countries have different definitions of employees and contractors for the purposes of employment law and taxation. When a business hires a worker, that business must classify that worker appropriately, using the proper documentation, and follow all applicable laws.

Employees are entitled to more benefits and protections than contractors. Depending on the country, these benefits may include:

  • Minimum wage

  • Overtime pay

  • Vacation

  • Family and medical leave

  • Social security or pensions

  • Unemployment benefits

  • Health insurance

  • Safe workplace protections

  • Termination protections

Payroll and reporting are also handled differently for employees and contractors. For employees, employers are responsible for withholding payroll contributions (and sometimes matching contributions); paying payroll taxes; and paying into insurance programs.

Details vary from country to country. Remote’s complete Guide to Global Payroll Management has more information.

Employee vs. contractor: which is which?

What makes one worker an employee and another a contractor? The answer depends on a series of questions, including a worker’s time, place of business, equipment, payment structure, and freedom to pursue other jobs.

In general, the distinction between an employee and an independent contractor depends on the level of control the business has over the worker. The more control a business exerts over how the work is performed and how the worker is paid, the more likely it becomes that the worker should be classified as an employee.

Each country will have its own guidelines. For example, according to the IRS in the United States, “[A]nyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.” Be sure to check the guidance for each country in which you use global contractors.

While rules may vary by country, you can usually guess whether an employee is misclassified based on the answers to the following questions:

Who decides when the work is performed?

Employees typically work on a schedule, with the business designating the hours and days to be worked. During that time, the employee is expected to devote all of their time to the business. Many employees work from 9 a.m. to 5 p.m., Monday through Friday. By contrast, a contractor can work whenever they want and take as many breaks as they want, as long as they deliver the product or service by the deadline.

Where is the work done?

Employees often work in a company’s office space or other defined property, while contractors can do their work from anywhere. However, remote work for employees was on the rise even before the global pandemic. Now, it’s common practice for employees to work from home or another location of their choosing. In these cases, a person working in a company office is more likely to be an employee, but an employee working outside that office is not necessarily more likely to be a contractor.

Who provides the equipment?

Employers typically provide resources for employees to do their work. These resources may include computers, cell phones, specialized software or subscriptions, and other necessary tools. On the other hand, contractors use their own equipment and subscriptions purchased at their own expense.

Who performs the work?

When an employer hires an employee, the expectation is that the product or service is done by the employee themselves. If the work must be done by the worker, they are an employee. By contrast, a contractor may be able to delegate work as needed.

How is the worker paid?

Most employees are paid on a regular basis through a payroll system. As part of payroll, businesses deduct necessary taxes and make social contributions on behalf of the worker. Contractors, however, are paid without tax withholding, often based on invoices. Employees, on the other hand, do not have to submit invoices for their regular pay. Instead, they either receive regular distributions of their salary or clock in and clock out using an hourly system.

How important is the work?

Here’s where things start to get tricky. In many countries, if a worker provides a service that is vital to the business, they are likely to be an employee. By contrast, contractors are often used to provide supplementary services, such as a marketing plan or website build. However, this can be subject to interpretation.

Think about it like this: if the company makes websites for clients and hires someone to make some of those websites, that person is probably an employee. If the company makes lightbulbs and asks a self-employed website builder to create a website for the company, that worker is probably a contractor.

What is the length of the relationship?

The question of permanency can be the difference between an employee and a contractor. In some countries, a worker may be correctly classified as a contractor, then become an employee if the engagement with the company continues beyond a certain time frame. In countries with fixed-term contracts, workers often cannot sign multiple fixed-term contracts with the same employer. Instead, the employer must either terminate the relationship at the end of the term or offer the employee an indefinite position at the company.

link to Independent contractor vs. employee: which should you hire?

Independent contractor vs. employee: which should you hire?

Understand the key differences between independent contractors and employees and determine which arrangement might work best for your business.

What is employee and independent contractor misclassification?

Misclassification occurs when a business gives a worker the wrong designation, whether by mistake or on purpose. Although fines and penalties tend to be more severe for deliberate misclassification, businesses still face penalties for honest mistakes.

Unfortunately, many employers deliberately misclassify workers to get the best of both worlds. You are not required to pay taxes and insurance for contractors, and your employment contract can be much more flexible in favor of the company. It’s much easier to fire contractors, and payroll is much more straightforward without the need to calculate benefits or social contributions.

Even if you try to classify workers properly, you still might struggle. For example, you may have hired a contractor to do a small job for your company. And they may have done such a great job, you hired them for more jobs. Over time, the nature of your relationship may shift. Unless you’re doing regular classification reviews, you could overlook the fact that your old contractor is now technically an employee.

Classification isn’t always straightforward. Local laws vary, and those laws change over time. For example, in 2021, the Netherlands changed rules regarding misclassification and increased enforcement of those rules. That means you need up-to-the-minute information to stay compliant.

Misclassification not only deprives workers of benefits and protections, but it also denies revenue to state and federal governments. Consequently, more countries are cracking down on the practice of misclassification, especially as the gig economy grows. Governments are ramping up enforcement, increasing penalties, and tightening legislation. You could be subject to many consequences, even if your misclassification was an honest mistake.

What are the risks of employee misclassification?

The risks of employee misclassification can be severe. Some consequences might include:

  • Penalties and fines: You may be liable for back taxes and associated penalties for paying late.

  • Back wages and benefits: You may be required to compensate workers for lost wages or benefits that resulted from the misclassification.

  • Legal issues: You may be vulnerable to lawsuits from groups or individuals harmed by misclassification.

Misclassifying employees can have hidden costs as well. Workers who discover they should have been employees instead of contractors may view the company unfavorably. Some workers may even stop working with the business and tell others to avoid the company.

You do not want to be known as a company that deprives workers of benefits and security. Even if you’ve made an honest mistake, the negative PR can seriously harm your company’s ability to compete.

How do I avoid employee misclassification as an employer?

If you have employees and contractors, you can avoid misclassification by learning the local laws that govern compliance where your workers live. For example, rules regarding 1099 misclassification in the United States are different from rules governing IR35 in the United Kingdom.

While every situation is unique, you can follow a few best practices to avoid employee misclassification:

  • Consult with local legal experts.

  • Take advantage of government resources and self-check services.

  • Review your contracts with all self-employed contractors.

  • Train your managers on misclassification and encourage them to err on the side of caution when assigning work to contractors.

  • Convert contractors to employees if you discover that you have misclassified them.

How to calculate employee misclassification

Calculating compensation for employee misclassification is not an exact science. What works in one country might not work in another. Regardless of location, though, you must usually prepare to pay back employees for any benefits and social contributions they would have been entitled to had they been classified correctly.

If you discover you have misclassified an employee, you can estimate how much you will owe by considering a few factors:

  • How long has the employee been misclassified?

  • What have you paid the employee?

  • What would a person in a full-time position at your company performing similar duties earn?

  • What company benefits would you normally offer an employee of that seniority level?

  • How much would you have paid in taxes on behalf of the employee?

  • How much in taxes would the employee have been responsible for?

  • What are the government’s guidelines for misclassification penalties?

In addition to these questions, you must also consider whether you identified the misclassification yourself. If you did, you may avoid the harshest penalties and fines. If the government discovered the issue or if the employee lodged a complaint, however, you could end up paying the maximum amount.

How to correct employee misclassification

If you discover that you have misclassified workers, do not simply end the relationship and expect the problem to go away. You are still responsible for compensating the employee (and potentially the government) for benefits, taxes, and other perks.

You can correct employee misclassification only by making the employee and the government whole. That means paying whatever back taxes, benefits contributions, pension contributions, and fines may be associated with the issue.

You may be tempted to terminate the relationship with the employee and hope the problem goes away on its own, but that strategy can backfire badly. Governments are much harsher on companies found to have broken misclassification laws deliberately.

What are the penalties of employee and independent contractor misclassification?

Penalties for employee and independent contractor misclassification vary by country, but most countries follow a similar playbook. The company in question is responsible for paying fines, penalties, back taxes, and back benefits, both to the employee and to the government.

The penalties do not end there, however. In many cases, the contractors themselves could end up owing money to the government, which will seriously harm their impression of the company and could affect the willingness of others to work with the business. That kind of negative press may make it difficult to attract good freelancers in the future.

For more information, read Remote’s guide on the consequences of contractor misclassification.

Famous employee misclassification lawsuits

Several lawsuits should make companies think twice before misclassifying contractors.

  • Dynamex Operations W. v. Superior Court: This case in California places the burden on the business to prove the worker is not an employee. In addition, this case outlined the “ABC” test, which determines whether the worker is sufficiently independent from the business to be considered a contractor.

  • Uber BV and others (Appellants) v Aslam and others (Respondents): Uber lost this court case in the U.K., which determined that its drivers are in fact “workers” and not independent contractors. The U.K. has a three-tiered hierarchy of working relationships, in which employees, workers, and contractors all have certain rights.

  • Van Dusen et al v. Swift Transportation: This case, which lasted more than nine years, eventually saw Knight-Swift transportation pay out more than $100 million in damages to around 20,000 workers who were found to be misclassified as owner-operators. Businesses must consider the financial harm that can arise from a decade-long court case and a nine-figure settlement before treating classification concerns lightly.

Even if these lawsuits occurred in a different country or state, employers should heed their warnings. Laws can change quickly, and employers found to be in violation cannot continue to operate outside the law once the rules change.

An overview of independent contractor taxes and forms

In the United States, the forms to file related to independent contractor taxes have changed recently. Here are a few of the forms companies need to know:

  • Form W-9: This form collects information from the contractor, including name and tax identification number (TIN).

  • Form W8-BEN: This form determines the foreign status of non-resident aliens for the purposes of taxation.

  • Form 1096: This form acts as a cover sheet for forms pertaining to contractors that are physically mailed to the IRS. You do not need to file Form 1096 when filing digitally.

  • Form 1099: While employers of U.S. contractors previously had to file Form 1099-MISC, today those companies file a 1099-NEC instead. Short for “non-employee compensation,” Form 1099-NEC reports payments made to individuals not employed by the company.

Every country has its own unique requirements related to contractor classification and tax forms. Be sure to consult with a local legal expert in the countries where your contractors operate to ensure you file all taxes properly.

What are the complexities of managing contractors globally?

Although you may have a good grasp on your own country’s laws and statutes, it can be difficult to manage risk across multiple countries without the support of local labor experts. You must consider how:

  • Laws vary from country to country.

  • Laws change over time.

  • Laws can be subject to interpretation.

  • The nature of your relationship with a worker may change over time.

Complexities come into play when you work with global contractors. For example, you may be required to make payments in a local currency from an approved bank, as is the case with employees in Mexico.

Filing the appropriate tax forms also depends on accurate classification. In the United States, businesses report contractor payments via Form 1099-NEC, while full employees fill out Form W-2.

In addition to whatever penalties are associated with misclassification, you could also face penalties for failure to file forms. In the U.S., penalties start at $50 per form and rise with time and the seriousness of the offense.

Further complexities arise if you have difficulty designing an attractive compensation package because you don’t fully understand the local economy. Without that understanding, your business will struggle to stay compliant and to compete for the best local talent.

With so many factors making global contractor management a challenge, you may want to enlist some expert help.

What’s the best way to manage compliance for a globally distributed team?

You have two primary options to manage compliance for your global contractors and employees.

Invest in a local entity and develop a network of local partners

If your company has lots of cash and time, you can establish a local legal entity and an HR presence in each country in which you operate. In that case, you’ll be able to hire your own local specialists who understand classification; who are legally empowered to employ and pay workers; and who are deeply knowledgeable about all local laws and regulations. In addition, you will want to create partnerships with local lawyers, payroll companies, and benefits administrators.

Typically, only large enterprises consider this option. Unless you plan to expand aggressively into a single country, it might not make sense to spend tens of thousands of dollars and wait several months (or longer) to open your own foreign entity.

Work with an employer of record

Most companies hiring employees in other countries choose to work with an employer of record. Your employer of record employs workers in other countries on your behalf, handling payroll, benefits, taxes, and compliance for your international team members.

As the most trusted employer of record in the industry, Remote provides the security and expertise you need to expand your global workforce. We only offer services in countries where we own our own local legal entities, which means we can guarantee local expertise wherever you hire — a guarantee no other employer of record can match. Because we own all our own entities, we are also able to provide you with fully transparent pricing and no hidden fees.

If you are concerned about contractor misclassification at home or abroad, don’t let doubt stop you from growing your business. Sign up for today and let our employment experts help you manage your contractors, onboard your employees with ease, and provide your company with the global HR services you need.

Use our Contractor Compliance Checklist to avoid misclassification

Work through this checklist to help determine if a new hire should have a contractor or employee relationship.

A tablet with the title contractor compliance checklist.

Subscribe to receive the latest
Remote blog posts and updates in your inbox.