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10 min read

How to Identify and Avoid Employee Misclassification Risk

How to Identify and Avoid Employee Misclassification Risk in 2023

Employee misclassification is an issue that affects workers, businesses, and governments alike. It’s a complex topic with serious consequences for those involved. But what exactly is employee misclassification? Why does it happen, and how can businesses avoid the risks associated with it? In this blog post, we’ll delve into the intricacies of employee misclassification, explore its impact on workers, businesses, and governments, and provide valuable insights on how to identify, avoid, and correct employee misclassification.

Key Takeaways

  • Employee misclassification is an illegal practice that can lead to financial and legal consequences for businesses.
  • The IRS, Department of Labor, and ABC tests are used to determine worker classification.
  • Best practices include establishing explicit contracts, conducting audits/assessments, seeking professional consultation & correcting misclassifications promptly by paying back taxes & benefits.

Understanding Employee Misclassification

Misclassification of employees, also known as worker misclassification, is a situation where workers, who should be classified as employees, are wrongly labeled as independent contractors. This practice can lead to a myriad of legal and financial repercussions, as misclassified employees may be deprived of the rights and benefits they are entitled to under employment laws.

Reasons behind misclassification may include businesses trying to save money, avoid compliance requirements, or simply due to a lack of understanding of classification rules.

Employee misclassification is equally a risk when hiring contractors in the UK, and any other country that allows independent contracting, as it is in the US. 

Definition and common misconceptions

Employee misclassification, leading to legal and financial risks, occurs when workers are mistakenly classified as independent contractors rather than employees. This independent contractor misclassification can lead to common misconceptions, such as the belief that a written contract determines a worker’s status or that part-time workers are always independent contractors. These misconceptions can result in misclassification and potential investigations by federal and state agencies.

Reasons behind misclassification

Businesses may misclassify employees as independent contractors to reduce costs or circumvent compliance requirements, including federal, state, and local laws. In some cases, businesses might rely on the reasonable basis test, which permits the categorization of workers as independent contractors if there is a reasonable basis for such a determination.

This test considers how the Internal Revenue Service (IRS) views workers in similar circumstances rather than the precise relationship between the employer and the worker.

The Impact of Employee Misclassification

Employee misclassification has far-reaching consequences, impacting:

  • Misclassified workers, who may be denied rights and protections they are entitled to under labor and employment laws

  • Businesses, that face financial risks and legal liabilities

  • Governments, may lose out on tax revenue and face challenges in maintaining fair competition in the labor market.

We will explore further the effects of employee misclassification on each of these parties.

Effects on workers

Exploitation can occur when misclassified workers are deprived of their rightful employee rights and benefits. Workers who should be classified as employees may lose out on:

  • Minimum wage

  • Overtime compensation

  • Social Security and Medicare contributions

  • Workers compensation coverage

  • Unemployment insurance

They may also be denied access to critical benefits such as health insurance, retirement plans, and paid time off, and may be subject to an increased tax burden and denied the right to join a union.

Financial implications for businesses

Financial risks, such as fines, penalties, and back taxes, are faced by businesses due to employee misclassification. If found to have misclassified employees, businesses may be liable for unpaid taxes and required to pay back wages, overtime pay, and benefits to misclassified employees.

Indirect costs may involve increased tax liabilities, legal expenses, and potential lawsuits from misclassified employees seeking compensation for benefits and protections they were denied.

Government concerns

The issue of lost tax revenue and unfair competition makes governments concerned about employee misclassification. When a worker is misclassified as an independent contractor, it can lead to a loss of tax revenue for the government, as companies do not need to withhold earnings or pay certain taxes for independent contractors.

Misclassification occurs when an employer incorrectly categorizes a worker, which can also cause the underpayment of taxes by the worker. They may be liable for back taxes if their employer did not withhold the suitable amount.

Key Factors in Determining Employee vs. Independent Contractor Status

In order to correctly classify workers, businesses must consider key factors in determining whether a worker is an employee or an independent contractor. The Internal Revenue Service (IRS) generally evaluates the situation based on three criteria: behavioral control, financial control, and the nature of the relationship between the parties.

Each of these criteria will be examined in more detail.

Control over work

Worker classification significantly relies on control over work, including scheduling and decision-making. If a business has the authority to direct and manage what work is accomplished and how it is carried out, it implies an employer-employee relationship instead of an independent contractor relationship.

For example, if an employer retains authority over when, where, and how the work is conducted and issues instructions or directives that the employee must adhere to, it points towards an employee relationship.

Financial investment and risk

Worker status can be determined through financial investment and risk factors, such as expenses and profit/loss potential. Independent contractors typically have a substantial financial investment in their business and are responsible for potential profits or losses resulting from their business decisions.

In contrast, employees do not have a financial investment and are not accountable for the financial outcomes of the business.

Nature of the working relationship

Worker classification is influenced by the nature of the working relationship, including aspects of permanency and exclusivity, as well as employment status. For example, a permanent or indefinite relationship may suggest being classified as an employee, while the freedom to pursue other business opportunities may point towards an independent contractor status.

The character of the working relationship is essential in determining worker classification and can have a considerable effect on the classification of a worker.

Legal Tests and Guidelines for Classification

In addition to the key factors previously mentioned, businesses can use legal tests and guidelines to aid in worker classification. These include the IRS 20-factor test, the Department of Labor’s Economic Reality test, and the ABC test.

Familiarizing oneself with these tests can provide a better understanding of the classification process and help businesses avoid misclassification risks.

IRS 20-factor test

The IRS 20-factor test considers various aspects of the worker-employer relationship to determine classification. Although the IRS no longer employs this test, it is still a useful reference for businesses to understand the factors considered in worker classification.

The test encompasses factors such as the degree of instruction, control over the work, and the relationship between the worker and the company.

Department of Labor’s Economic Reality test

The Department of Labor’s Economic Reality test, developed by the Department of Labor, assesses a worker’s dependence on an employer for their livelihood. This test takes into account factors such as the type of work, the level of control exerted by the employer, and the worker’s potential for gain or loss.

The Fair Labor Standards Act, designed to ensure fair labor standards, guarantees that workers are appropriately classified and receive the applicable employment protections and benefits.

The ABC test

The ABC test uses three elements to determine independent contractor status. According to the test, a worker is deemed an employee unless the hiring entity fulfills all three of the following factors:

A) the worker is free from the control and direction of the hiring entity in relation to wage and hour matters,

B) the worker performs work that is outside the usual course of the hiring entity’s business, and

C) The worker as an independent is customarily engaged in an independently established trade, occupation, or business.

ABC Test

This test is applicable in several U.S. states and is widely adopted to determine worker classification.

Best Practices to Prevent Employee Misclassification

Implementing best practices like establishing explicit and comprehensive contracts, conducting routine audits and assessments, and seeking professional legal consultation can prevent employee misclassification in businesses.

By adhering to these best practices, businesses can ensure proper classification, avoid misclassification risks, and remain compliant with employment laws.

Clear and detailed contracts

Preventing employee misclassification requires the establishment of clear and detailed contracts that outline the worker’s status and responsibilities. Contracts should precisely delineate the roles and responsibilities of both parties, including:

  • The degree of control and oversight exercised by the employer

  • The terms of payment

  • Benefits

  • Any other pertinent factors that distinguish an employee from an independent contractor.

Consulting with legal professionals or employment law experts can ensure compliance with applicable laws and regulations.

Regular audits and assessments

Routine audits and assessments play a crucial role in ensuring proper worker classification. Businesses should perform internal audits to:

  • Assess whether their organization has misclassification errors

  • Review worker relationships

  • Understand the criteria for classification

  • Evaluate job classifications and payroll practices.

These audits should be conducted at least once annually to maintain compliance and reduce the risk of misclassification.

Legal consultation and expertise

Navigating complex classification rules and avoiding misclassification risks necessitate the seeking of legal consultation and expertise. Legal professionals can help businesses assess whether an individual is incorrectly classified as an independent contractor and provide counsel on the appropriate classification.

They can also assist in filing lawsuits for compensation and damages caused by misclassification, as well as help employers navigate the legal obligations and consequences of misclassification.

Video: Guide to Avoid Risks in Employee Misclassification

In this video of The Knowledge Group’s LIVE CLE Webcast on Employee Misclassification, employment law specialists Diane C. Mokriski (O’Connell, Attmore & Morris) and Edward Bierhanzl (Resolution Economics) offer vital insights for employers, highlighting ways to sidestep the pitfalls of incorrect employee classification.

How to Correct Employee Misclassification

Immediate action to rectify the situation and address its consequences is necessary if a business discovers that it has misclassified employees. This may involve paying back taxes and benefits, implementing proper classification procedures, and handling disputes and legal issues arising from misclassification.

Paying back taxes and benefits

Businesses must repay the following amounts to rectify misclassification:

  • Taxes

  • Benefits

  • FICA and income taxes

  • Social Security and unemployment insurance taxes

  • Other pertinent taxes and benefits

The process for paying back payroll taxes due to employee misclassification may vary depending on the jurisdiction, and it is advisable to seek counsel with a tax specialist or employment law expert to ensure compliance with specific regulations in your jurisdiction.

Implementing proper classification procedures

Preventing future misclassification requires the implementation of proper classification procedures. Businesses should:

  • Review and update job descriptions

  • Consult legal and HR experts

  • Establish precise criteria for classification

  • Steadfastly apply classification criteria.

Regular review and updates to classifications, as well as providing training and education, can help ensure ongoing compliance with classification regulations.

Handling disputes and legal issues

Disputes and legal issues arising from misclassification should be handled by businesses promptly and professionally. This may involve mediating disputes, engaging in voluntary negotiations, and seeking legal representation if necessary.

By addressing disputes and legal issues swiftly and effectively, businesses can minimize the potential damage and costs associated with misclassification.

Prominent Employee Misclassification Lawsuits

Notable employee misclassification lawsuits, like the FedEx case which led to a $228 million settlement, and the California lawsuits against Uber and Lyft, underscore the importance of proper worker classification. These cases demonstrate the significant legal and financial risks faced by businesses that fail to comply with classification regulations and emphasize the need for businesses to take employee misclassification seriously.

Employers must be aware of the potential consequences of misclassifying workers and take steps to prevent it.

International Perspectives on Misclassification

With laws and regulations varying across countries, misclassification is a global issue. In European countries, for example, governments are particularly proactive in pursuing misclassification claims and imposing penalties.

As businesses expand globally, understanding the international perspectives on misclassification becomes increasingly important to ensure compliance with labor laws and avoid costly legal disputes.

Case Study: Uber’s Driver Classification Conundrum

Founded in 2009, Uber has transformed traditional taxi services by providing a platform where passengers can connect with drivers using their own cars. From the outset, Uber classified its drivers as independent contractors rather than employees.

The issue

The central dispute revolves around whether Uber drivers should be classified as independent contractors or as employees. This distinction carries significant implications for labor rights, benefits, and costs:

  • Independent Contractors: Generally do not receive benefits such as health insurance, overtime pay, unemployment benefits, or the right to unionize. They also bear many of the costs associated with their work, such as car maintenance and fuel.
  • Employees: Entitled to the protections of labor laws, including minimum wage guarantees, overtime, and other benefits.

Uber maintained that it is a technology platform connecting riders with drivers, not a transportation company, and thus drivers are contractors who use the platform.

Legal Battles and Findings

Over the years, Uber faced numerous lawsuits challenging its classification of drivers as independent contractors:

  1. O’Connor v. Uber Technologies, Inc. (2015) – A class-action lawsuit filed in California. The plaintiffs argued that they should be classified as employees. The case almost reached a settlement in 2016, where Uber would pay $100 million to the plaintiffs but would not be required to reclassify drivers. However, the settlement was rejected by a judge for being insufficient.

  2. UK Ruling (2016): A landmark decision in the UK ruled that Uber drivers were workers, not self-employed. This meant they were entitled to certain rights, including the minimum wage.

  3. California’s Assembly Bill 5 (AB5, 2019): Introduced criteria to determine whether workers should be classified as employees or contractors. While not targeting Uber directly, the gig economy, including ride-share companies, was heavily impacted. In response to AB5, Uber, along with Lyft and DoorDash, sponsored a ballot measure called Proposition 22, which aimed to exempt app-based transportation and delivery companies from the law. In November 2020, California voters passed Proposition 22, allowing these companies to continue treating drivers as independent contractors while providing them with some benefits.

Implications and Repercussions

  1. Cost Implications: Had Uber been required to classify drivers as employees consistently, the company would bear additional costs, such as health benefits, unemployment insurance, and wage guarantees.

  2. Operational Changes: Some argue that reclassification might reduce the flexibility that attracts many drivers to the platform. Uber might have had to schedule drivers for shifts, rather than allowing them to log in and out of the app at will.

  3. Global Impacts: The rulings, especially in places like the UK, set precedents that could inspire similar legal challenges in other parts of the world.


The Uber case exemplifies the complexities of worker classification in the modern gig economy. It’s a testament to the changing nature of work and the need for legal systems to adapt to new business models. While Uber has managed to maintain its driver’s contractor status in many places, the debate underscores the need for a balance between business innovation and worker protection.


In conclusion, employee misclassification is a complex issue with significant consequences for workers, businesses, and governments. By understanding the key factors in determining employee vs. independent contractor status, implementing best practices, and staying informed on legal tests and guidelines, businesses can avoid the risks associated with misclassification. As we’ve seen through prominent lawsuits and international perspectives, proper worker classification is crucial to maintaining compliance, protecting workers’ rights, and safeguarding businesses from costly legal disputes and penalties.

Frequently Asked Questions

Employee misclassification is when an employer incorrectly classifies a full-time employee as an independent contractor in order to avoid providing benefits such as workers' compensation insurance coverage. This can have significant consequences for workers and businesses alike, and in some cases, criminal penalties may be sought by the Office of the Attorney General.

When an employee is misclassified as an independent contractor, they lose the legal right to minimum wage and overtime pay, potentially face fines, taxes, and penalties, and may need to pay back wages or benefits due to lost wages. Furthermore, employers are subject to criminal penalties, civil fines, and other forms of punishment.

When determining employee vs. independent contractor status, the primary considerations are behavioral control, financial control, and the nature of the working relationship.

Common misconceptions about employee misclassification include believing that the contract determines a worker's status, as well as assuming that part-time workers are always independent contractors.

Businesses can avoid employee misclassification by establishing clear contracts, conducting regular audits, and seeking legal expertise and advice.

At RemotePad, Lech draws on his professional experience to write about employment taxes and payroll (both remote, and in-office). Lech holds a Bachelors’ degree from the University of Kent, a Master of Arts (MA) from Kings College London, and professional payroll and tax qualifications. He has 20 years experience advising on all manner of tax and business planning matters.