To employ or not to employ: The importance of correct employee classification
Thanks to the rapid advancement of remote work, business leaders now have access to a diversified workforce of full-time, freelance, and contract employees. However, to break through your next growth stage or reach IPO, you still need to be diligent about how you categorise your full-time and contract employees.
Today’s diversified global workforce is far ahead of many of the tax and labour laws currently in place. So if you plan on hiring both FTEs (full-time employees) and freelancers, the miscategorisation of these employees could lead to a hefty tax fine and the possibility of a class-action lawsuit if you’re not careful.
In this article, we’ll show you how classifying your employees correctly can help you mitigate compliance risks and avoid unnecessary tax bills so you can scale without missing a beat.
Understanding the importance of employee classification
Business leaders across industries and verticals are feeling the pressure to do more with less. Given these circumstances, it makes sense that many companies continue to adopt a blend of FTEs and freelancers to scale their labour force up and down as needed.
But this approach may come with severe consequences if not handled correctly. Eurofound conducted a research report on fraudulent work contracting in 28 EU member states, including Norway. According to the report, 79 percent of the national correspondents reported a ‘significant’ fraudulent use of self-employment.
For example, global brands like Uber have dealt with the backlash of employee misclassification. In 2021, they lost a UK Supreme Court case after misclassifying their drivers as independent contractors rather than workers. While the precise damages cost is difficult to come by, it is generally accepted as running well over £1bn. Even more recently, it was reported that Nike may have misclassified thousands of temporary office workers and now faces potential tax fines of more than $530m.
While those numbers may seem like a drop in the bucket for internationally recognized brands, they could easily spell disaster for a rapidly growing company pursuing global expansion. A 2022 Economic Policy Institute (EPI) analysis of 11 commonly misclassified jobs helps explain why these penalties can be so severe.
According to the study, EPI estimated that a typical construction worker, for example, would lose out on as much as $16,729 per year in income and job benefits as a contractor compared with what they would have earned as an employee. By threatening companies with tax fines and legal action, governments can protect workers’ fundamental labour rights and economic security.
Now that you understand how misclassification affects workers at the employee level, let’s take a deeper look at the risks employers face.
Lawsuits, fines, and penalties: what are the risks?
Lawsuits, fines, and penalties based on worker misclassification don’t just apply to large corporations like Nike and Uber—companies across the growth spectrum can be held liable for holiday pay, sickness benefits, and pension contributions if they wrongly classify employees as freelancers.
How misclassification penalties are applied
In the United States, employee misclassification penalties can be applied to each W-2 — a US tax form used to report wages paid to employees and the taxes withheld — that an employer did not file because of improper classification. If an entire cohort of workers is found to be improperly classified, these penalties can multiply exponentially and create serious issues for employers.
As recently as 2022, a medical staffing company in Virginia of the United States was ordered by a federal judge to pay $7.2 million in back wages and damages to over 1,000 employees for willful misclassification. And in the UK, based on a court case from 2017, an employer was found guilty of having misclassified an independent contractor for a whopping 14 years — the company then had to provide him with 5.6 weeks of paid leave for each of the 14 years.
Simply put, the penalties for employee misclassification can be ruinous to employers.
As a result, the majority of respondents to a PwC survey cited compliance and regulatory risk as the greatest threat to their company’s ability to grow. And it doesn’t matter if this misclassification is willful or not — either way, it can still put you at risk for owing back taxes, benefits, and penalties for misclassified workers.
In response, governments are actively working to ensure the protection of worker’s rights. IR35 in the UK and The Fair Labor Standards Act (FLSA) in the US are both great examples of legislation written to ensure these protections. His Majesty’s Revenue and Customs (HMRC) in the UK will even publish a list of companies that failed to comply with the rules.
5 different employee misclassification penalties
While it’s clear that employers and governments are taking employee protections seriously, what do the penalties look like exactly? Here are a few of the fines and legal ramifications your company could face if you don't categorise your employees properly:
1. Tax and payroll fines:
Employee misclassification causes federal and local governments to lose out on tax and payroll revenue. In this instance, you may be held liable for paying state and federal payroll taxes, as well as Social Security and Medicare taxes for all employees found to be classified incorrectly. Fines from federal and state agencies can total to millions of dollars, and failure to make these payments may result in additional fines.
2. Legal and punitive damages:
The misclassification of employees can quickly lead to a class-action lawsuit — especially when it violates the labour rights of the workers involved. The legal fees, the time required from executives to gather relevant case documents, and the potential turnover of existing staff can all deal significant damage to an organisation.
3. Back payments to re-classified workers:
In the case of misclassification, your workers also get a chance to file a formal complaint with their state department of labour. Workers will then be entitled to employee benefits, including 401(k), severance, health and welfare coverage, stock purchase plans, and even overtime pay if these claims are validated.
4. Reputation damage:
The damage an employee misclassification lawsuit can deal to your business goes far beyond your company’s bottom line. It can tarnish your company’s reputation and make it difficult to attract top talent, industry partners, or — even worse — potential customers.
5. Willful or intentional misclassification
On top of the penalties and fines previously mentioned, the nature of the misclassification has a big impact on the consequences an organisation may face. Intentional misclassification may result in steeper fines and even jail time if an employer is trying to avoid paying the benefits that most employees are entitled to — health insurance, paid time off, and their side of payroll taxes, for example.
How an EOR helps you achieve compliance
Employee misclassification risks can feel pretty intimidating, especially when you understand the risks involved. But this shouldn’t stop you from leveraging outsourced talent to scale your business.
With an Employer of Record (EOR) solution, you can avoid employee misclassification and focus on hitting your business goals.
The rapidly-evolving nature of remote work makes it difficult to keep up with the constant changes in employment laws and regulations. However, an EOR solution like Atlas handles the hiring of employees and any legal and compliance responsibilities for you.
An EOR tool allows you to consolidate multiple entities under a single employer, which can be particularly useful for companies currently pursuing global expansion or with operations in multiple states or countries. Entity consolidation also ensures that all employees are properly classified and that you stay in compliance with all relevant laws and regulations.
Many EOR tools like Atlas provide local expertise by having a team of experts on-hand who are familiar with the employment laws and regulations in different states or countries. While indirect EORs use third parties from region to region, Atlas has entities on the ground in over 160 countries, so you don’t have to compromise quality control—regardless of where you decide to do business.
Employee classification is table stakes for achieving growth
As the workforce landscape evolves, proper employee classification should now be a strategic priority for senior execs — especially if your company has its sights set on global expansion. With an EOR solution like Atlas, you’ll be compliant in every territory you do business in and in every aspect — from working hours and parental leave to sick leave and terminations.
Ready to scale up your workforce and pursue global expansion? Get in touch with Atlas to see how you can stay compliant and avoid misclassification penalties.