How to avoid employee misclassification

Thanks to digitalization and the rise in remote work, companies nowadays have access to a global talent pool to build and grow their remote teams. Especially in the early stages of international business expansion, hiring a local team is a good first move to test a new market and gain valuable insights into local work culture and customer base. However, hiring abroad is far from being risk-free. Hiring in different countries means having to deal with different labour laws and regulations which turns out particularly difficult when it comes to classifying workers as either contractors or employees.

Employee misclassification, sometimes also referred to as contractor misclassification, is one of the major pitfalls of hiring abroad. But what exactly is employee misclassification? And what are the penalties for misclassifying employees as independent contractors? In this article, we will shed some light on the complicated legal issue that is worker misclassification and share some firsthand tips from Andrea Carlon, Head of Partnerships at Lano, on how to avoid it.

Employee misclassification describes the act of classifying workers as independent contractors although, for tax and legal purposes, they should be registered as employees. In most cases, the worker is hired as contractor or freelancer, with or without an appropriate service agreement. The judgement of whether or not it’s a case of misclassification is usually made by the authorities.

While some companies deliberately misclassify their workers to save on employment costs, independent contractor misclassification can also happen by mistake. For example, when hiring foreign talent without being sufficiently familiar with local employment laws and regulations, it’s easy to fall into this trap. 

Although almost every country adheres to the basic principle of distinguishing between independent contractors and employees, the concrete definition of what an independent contractor is and where the line is drawn between the two categories varies significantly between countries. In some countries, such as the US, rules even change from state to state.

For a quick overview of what distinguishes employees and contractors and which type of worker is more suitable for your business, check out our blog post Independent contractor vs full-time employee.

The main reason why governments and authorities care about the misclassification of employees as independent contractors is that it results in huge losses in tax revenue and contributions to the social security and welfare system. When an employee is misclassified as an independent contractor, this means that the employer - or rather the party that contracts the worker - doesn’t withhold any taxes nor do they pay any social security contributions for them. This is because independent contractors are responsible for paying their own tax and making their own social security contributions. 

Despite there being big differences between social security systems around the world, the most common contributions employers have to make for their employees are:

• health insurance

• unemployment insurance

• pension insurance

• disability insurance and other compensation funds

• contributions to special social security funds for family benefits etc.

For more information on payroll taxes per country, visit our global hiring guide. 

According to an article in Forbes, up to 30 percent of the total cost of an employee is benefits (information specific for the US). Put differently, this means that hiring an independent contractor allows a company to save almost 30 percent compared to hiring a full-time employee - no wonder some businesses decide to misclassify their workers on purpose. 

From the authorities’ perspective, these “savings” translate into billions of losses in tax revenue. The imbalance happens when workers who are being misclassified as independent contractors then need to be financially supported by the government like in the following case.

As a recent analysis of the Washington Post shows, tens of thousands of Uber and Lyft drivers received financial aid from the US government to help them through the pandemic. In total, the pandemic unemployment assistance payments reached a whopping $80 million. Needless to say that, if Uber and Lyft had classified their drivers as employees, unemployment benefits would have been funded by employer contributions. 

However, the consequences of contractor misclassification go deeper than just lost tax revenue. Misclassified workers miss out on a whole range of benefits and are exposed to a variety of risks. In contrast to company employees, they don’t enjoy any legal protection with regard to contract termination or minimum wage regulations and are deprived of employment benefits such as paid vacation days, sick leave, overtime pay or bonuses.

Given the dimensions of the impact employee misclassification has on tax revenue, social security systems and overall worker protection, it’s hardly surprising that governments all over the world are tightening their control mechanisms to detect false self-employment. In some cases, like in the US, the issue of independent contractor misclassification has been thrown into spotlight by prominent lawsuits involving high-profile companies such as Uber and Lyft, FedEx or Zenefits.

In other countries, government action has primarily been driven by the rise of the gig economy and the increasing number of independent contractors. For instance, Serbia launched a new independent contractor test in the beginning of last year. The UK introduced a similar set of rules for off-payroll working which is known as IR35. 

It is also worth noting that legislations across the globe use different notions to refer to the illegal practice of treating workers like full-time employees while simultaneously classifying them as independent contractors. While US legislation uses the term employee misclassification, the UK primarily refers to false or bogus self-employment. In Germany, the latter is called Scheinselbstständigkeit.ew hire.

No matter where you hire - i.e. abroad or within the boundaries of the same jurisdiction - it is your responsibility to make sure that the worker you are contracting for a specific project or task actually fulfills all the requirements to be considered as an independent contractor. While this can already be quite a challenge within your own country - in the US, for example, different rules for the classification of workers apply on state and federal level as well as between different government agencies - it gets even more complicated when companies start to grow their global team by hiring independent contractors abroad.

As rules and regulations for worker classification depend on each country, there is no easy one-size-fits-all test for employee misclassification. Also, different countries have different categories. The UK, for instance, acknowledges a separate category labeled “workers” which stands for a status between employee and contractor.

In response, courts in various jurisdictions all over the world have established comprehensive checklists for employee misclassification in the course of landmark settlements. One of them is the so-called ABC test which was first used as an official reference to distinguish independent contractors from employees by the Supreme Court of California in the 2018 Dynamex v. Superior Court case.

Despite the differences between the existing tests and checklists, it’s possible to say that, as a rule of thumb, independent contractors - just as their title suggests - are more independent in their way of working than traditional employees. In contrast, the more control a company exercises over a worker, the more likely it is for the authorities to classify the worker as an employee. Control, in this case, may refer to financial as well as behavioural control. 

“There’s a general consensus around the world about what a legitimate contractor classification is. So, if the person has set work hours, or receives certain employee benefits, or does things like performance evaluations, or even makes critical decisions for the business, then he or she is considered an employee”, summarizes Andrea Carlon, Head of Partnerships at Lano. 

Some possible questions which can help you determine whether you are at risk of misclassifying your employees as independent contractors are:

• Are they free in how they carry out the task given to them (work patterns, methods etc.)?

• Do they receive detailed instructions and/or training?

• Do they have full control over their working hours?

• Is their job activity different from the one carried out by your employees?

• Are they obligated to give periodic working reports?

• Can they freely choose their workplace?

• Are they in charge of their own marketing and do they have a business website?

• Are they involved in other projects for different clients as well?

• Are they only paid for their actual services or do they receive additional benefits such as holiday pay?

• Do they own and use their own equipment to fulfill the tasks given to them?

• How long will they be working for you?

If, after having answered these questions and applied one of the legal checklists mentioned before, you come to the decision that your foreign independent contractor should, legally speaking, be classified as an employee then you should immediately rectify the situation by changing their status. 

Read more about how to convert freelancers to full-time employees in our related blog article.

If the authorities find out that a business is wrongly classifying workers as independent contractors - be it because one of your contractors launches a lawsuit against you to claim employment rights or because of payment irregularities - the legal consequences can be very severe. The penalties for misclassifying employees vary from country to country but in most cases, they involve:

• Bad reputation for the company who misclassified its employees

• In case the worker is terminated and retroactively claims his or her rights as an employee: severance pay as well as other payments due upon employment termination

• Obligation to pay back social security and taxes for a duration of several years

• Financial penalties (fines calculated as percentage of the paid wages as well as a fixed criminal penalty for each worker)

“If tax authorities or social security agencies qualify a contractual arrangement as employment, both the freelancer and their contractual partner can face severe negative consequences. For instance, the company could be fined to pay Social Security contributions retroactively for up to four years. And there are also tax implications which could include repaying the VAT deducted previously from the invoices of the falsely self-employed person”, Carlon elaborates.

To give you an idea of the financial penalties we are actually talking about, let’s have a look at some of the high-profile lawsuits we mentioned earlier:

• In the Zenefits case, the company was sentenced to pay $3.4 million to their misclassified employees.

• To settle its employee misclassification lawsuit, FedEx had to pay no less than $2.4 million.

• Citigroup Technology had to consent to paying back wages equaling $1.8 million to 882 employees in Florida.

• In a settlement back in 2016, Uber ended up paying $100 million to its drivers in California and Massachusetts - that was to avoid having to change their status to full-time employees.

Furthermore, in a landmark ruling from November 2017, the European Court of Justice declared that workers misclassified as independent contractors had the right to claim back holiday pay going back as far as 1996. In some cases where the court rules that a company has intentionally misclassified employees as independent contractors to save on employment costs, the responsible person may even have to serve a prison sentence!

What’s more, misclassifying a foreign worker as an independent contractor also puts you at risk of so-called permanent establishment risk. This means that, when misclassification gets discovered, the local authorities may actually consider your company to have a legal and tax presence in the country. So in the end, you could end up having to pay back corporate tax on your company profits as well.

The best way to avoid employee misclassification penalties is to make sure the person you want to hire abroad really is an independent contractor. In order to do so, you can use a contractor checklist which your new hire has to fill out. Repeating the same test on a regular basis helps you detect any changes in your freelancer’s situation which may have repercussions on your contractual relationship with them.

Watertight contractor agreements are another important aspect to prevent independent contractor misclassification. This is where Lano can help you. Use the Lano platform to compliantly onboard international freelancers in over 170 countries. Got a foreign contractor you want to turn into an employee? With Lano’s Employer of Record solution you can hire the best talent all over the world without having to set up a local entity. From freelance to full-time, we’ve got you covered.