How to Avoid Employee Misclassification (6 Key Tips)

Arise Virtual Solutions recently shelled out $3 million to settle an employee misclassification lawsuit. Could your business be next in line for a costly wake-up call?
Worker misclassification can cost your business millions in penalties. In 2024, the Office of the Attorney General for the District of Columbia ordered Arise to pay $2 million to its customer service workers who were misclassified as independent contractors instead of employees, plus another $1 million penalty to the District.

Even without the risk of hefty financial penalties, classifying workers correctly is critical. Everything from overtime to tax withholding varies depending on whether the worker is an employee or an independent contractor.

Read on to learn more about employee misclassification, what a misclassified employee could mean for your company, and how to correct employee misclassification using federal and state guidelines.

Employee Misclassification: Key Takeaways

Misclassifying employees and independent contractors hurts your company and the people who work for you in these critical ways:

While managing a complex workforce isn't always easy, having solid policies in place—and backing them up with a secure, user-friendly HRIS—can help lower common HR compliance risks for your company.

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What Is Employee Classification?

Employee classification is the process of determining whether a worker is an employee of the company or an independent contractor. This distinction determines your workers’ tax responsibilities, compensation, schedule, and other aspects of the job.

You’ll decide on employee classification when hiring a worker, so it’s important to have a process in place from the start to avoid any misclassifiation hiccups.

Businesses can hire employees and independent contractors across multiple categories to fulfill their needs, but the key is to make sure each worker is classified appropriately. Employee misclassification happens when an employer ties an employee to the wrong designation.

For example, if you accidentally hire an independent contractor but treat them like an employee—or vice versa—then you could be in violation of federal or state regulations.

There are several common employee types to consider:

Employees are also classified as exempt or non-exempt, which grants different legal rights under the Fair Labor Standards Act (FLSA). This classification is another significant one to consider, as it spells out whether employees need breaks (and what kinds, and for how long), whether they qualify for overtime pay, and a number of other employer benefits. Be sure to stay up to date with the relevant employment laws in your state.

Avoiding Employee Misclassification: The Difference Between Employees and Contractors

A worker is considered an employee if they’re hired by a business that controls what they do and how the work gets done. An independent contractor is considered self-employed. These workers are typically hired on a per-project basis through contractor agreements and are responsible for their own business expenses.

Employees vs. Independent Contractors

Key Factors
Employee
Independent Contractor
Employer Relationship
Employees are employed by a company.
Independent contractors are self-employed—meaning they work for themselves.
Work Circumstances
Employers dictate the schedule, role, and location.
Contractors are in control of when, where, and how they work.
Compensation
Employees receive hourly, weekly, or monthly wages.
Contractors are often paid per project.
Benefits
Typically, employees are eligible for benefits, like health insurance, PTO, and retirement.
They’re not entitled to the same benefits as employees.
Tax Responsibility
Employers withhold state and federal payroll taxes from each paycheck.
Contractors must pay their own income tax and self-employment tax.
Labor Law Protections
Employees are covered by labor laws, like the Fair Labor Standards Act (FLSA).
They’re usually not covered by the same protections as employees because self-employed.
Equipment/Resources
Employers provide equipment, tools, and materials.
Contractors are usually responsible for their own work equipment, tools, and materials.

How to Identify Employees vs. Independent Contractors

The federal government has a few ways to classify workers. The IRS uses the Common-Law Test, which includes three factors:

Similarly, the US Department of Labor uses the Economic Reality Test to determine if a worker is an employee or independent contractor under the FLSA, which considers several factors:

Many states also use their own methods for determining employee classification. For example, in California, the ABC Test states you're hiring an employee if you meet three conditions:

Some states have rules that only apply in certain situations (e.g., the construction industry), so consult your state government website for the most current classification criteria.

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The Risks of Worker Misclassification

Even if it was an honest mistake, misclassifying employees as independent contractors exposes companies to costly consequences. The repercussions depend on the severity of the violation and the laws in your jurisdiction, but you could face the following penalties.

Employee Lawsuits

Misclassification deprives your workers of several basic rights and labor protections, which can put your company in legal trouble. If you’re documenting employees as contractors but treating them as employees, you may be sued for several kinds of violations:

An employee misclassification lawsuit against your company could result in paying back wages, benefits, fines, civil penalties, and attorney fees. These employee misclassification penalties could add up to thousands or millions of dollars.

Reputation Damage

Misclassifying employees may also damage your company's reputation, even without a lawsuit. Plus, a lawsuit may result in increased scrutiny and an organization-wide audit, which can also be costly and time-consuming.

It may even lead to reputation damage: Workers may share their experience—either publicly or privately—and influence potential job candidates and business partners to avoid your company. Many customers care about your employer brand, so a history of worker classification mistakes could also affect your bottom line.

Tax Penalties

As an employer, you’re responsible for handling income tax, Federal Insurance Contributions Act (FICA) taxes (Social Security and Medicare), and unemployment tax for your employees through payroll.

However, misclassifying workers as independent contractors means you're not withholding the employee's share or paying employment taxes. This makes you responsible for those unpaid federal and state taxes along with any associated fines, interest, and employee misclassification penalties.

6 Key Tips to Avoid Misclassifying Employees

One way to avoid hiring issues is to create an employee classification policy. This policy creates a blueprint for your hiring team to follow, ensuring everyone understands the differences between classifications and the entitlements for each group.

Here are some other tips for avoiding employee misclassification:

Stay Up to Date

Keeping yourself informed of federal and state employment laws helps you maintain compliance not just when it comes to employee misclassification, but a whole host of other areas, like minimum wage, payroll taxes, and more.

Train Your Hiring Team

Remember, you have to get those classifications right from the get-go. Your trainers need to be clued in on how to do this, too. The key is to have your hiring and training teams well-equipped, well-informed, and working with a system that makes it easy to keep track of it all.

Establish Clear Company Guidelines

While it’s true your hiring team will need to understand the employee classification process, it has to start with clear and consistent company guidelines about how and why people are classified as employees or independent contractors, and FSLA exempt or non-exempt.

Your policy should also outline the steps for how to correct employee misclassification, so you can rectify the issue quickly. Taking ownership of the mistake, communicating the error to the employee, and resolving it with the authorities as soon as possible can help minimize the penalties against your company.

Tackle an Internal Audit

An audit might sound like another heavy-hitter to add to an already full to-do list, but it’s a great way to make sure your systems are squeaky-clean. Schedule HR compliance audits to ensure your workers are classified correctly. Plus, it’s a good idea to check every once in a while—you’d rather catch a big mistake yourself than face a lawsuit or other penalty.

Because the stakes are so high—and the penalties so hefty—don’t be afraid to ask for help. Reach out to your legal team if you have any questions.

Incorporate a Comprehensive Employee Record Platform

Having a comprehensive solution like BambooHR® to help track different active employee groups can make ensuring compliance much easier. Employee tracking is critical, and platforms like this help keep you ahead of the curve. When payroll, time tracking, and employee classification are all housed in one convenient platform, you’re able to focus on what matters most: your people.

Avoiding Worker Misclassification: The Benefits of Implementing an HRIS

A Human Resource Information System (HRIS) makes life easier in many ways—especially when it comes to HR compliance.

There are many other advantages of having an HRIS platform:

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https://www.bamboohr.com/blog/how-to-conduct-hr-investigation
https://www.bamboohr.com/blog/speed-up-your-hiring-process
https://www.bamboohr.com/blog/procedures-employees
https://www.bamboohr.com/blog/minimum-wage