Adam DeSanges May 25, 2022 10:06:36 AM 10 min read

What Is Employee Misclassification And What Are The Risks

Today you will learn why employee classification is a hot topic at both country level and state level and what can happen if you get it wrong. 

What Is Employee Classification? 

If you’ve spent any time browsing the business news section of Google, you’ll have noticed a common theme lately, employee classification and the problems surrounding it.  

Over the past few years, businesses like Uber, Deliveroo, and Amazon have come under intense scrutiny over the classification of their employees. Partly because of the gig economy, and partly because of the economic situation and how it moves employers to find alternative means of staffing. Either way, governments across the globe and their auditing teams are taking an increasing interest in the classification of your workers.  

In the U.S. alone, state, and federal regulators are furiously trying to navigate an increasingly complex workforce situation. The IRS and Labor Department are conducting audits with the explicit task of uprooting worker misclassification, leading to fines and even more serious penalties.  

In Britain, HMRC are going the same route. With more and more firms hiring contractors instead of regular employees in this “new economy”. 

So why is this happening? Why are the IRS, Inland Revenue, and other government bodies so intensely worried about whether your workers are contractors or employees?  

Tax revenue. 

According to Mindy Mayo, a managing director with KPMG LLP, governments around the world have figured out there are billions of tax dollars hiding between the cracks. The IRS and Labor Department have taken an intense interest in collecting lost tax revenue and fines related to employee classification violations.  


“I believe we’ll see more audits coming,” Mayo said.  


The main reason is that employers are likely to look for independent contractors during an economic downturn. While we agree that a business must do what needs to be done to survive, it’s wise to get one step ahead of the auditors before hefty fines are handed out.  


Summary: Lost tax revenue is the main reason governments across the globe are auditing businesses for signs of employee misclassification. The world of tech and SaaS are particularly interesting to the IRS/HMRC, since the business models can sometimes lend themselves to gig work.  


What Are The Red Flags? 

According to Mayo, the easy opportunity for the IRS is simply looking into company forms. Any employee who receives a Form 1099-NEC (the form used for paying contractors) and Form W-2 (used to report wages) will send up a red flag.  


Also, anyone receiving Form 1099 showing a Social Security number instead of another form of taxpayer identification will cause problems during an audit. These are usually signs that an employee is also running an independent business.  


And the federal government will audit retrospectively for up to 3 years. How can you be sure where your contractor is in 3 years’ time if the IRS comes knocking? They might have pivoted into some other line of work.  


Evidence is key.  


Mayo also mentions that federal and state level tax audits usually rest on the IRS’s 20-factor test. Although in practical terms there are three main red flags the IRS are interested in.  


In the U.K. the Fair Labor Standards Act and the minimum wage/overtime sections of that act, were introduced to eliminate the risk of an employee being classified incorrectly. 


Brexit and economic uncertainty have definitely impacted the hiring decisions in the U.K. Firms are looking for contingent workforce and contractors over regular employees. This might look great short-term, but in the long run, HMRC (Her Majesty’s Revenue & Customs) are following the U.S. in this regard. Looking closer at company structure, issuing fines for employee misclassification and issuing annual audit notices for repeat offenders. 


Summary: The form your business or your employee/contractor send to the IRS/HMRC are the usual methods of employee misclassification detection. The government understands that mistakes happen, but repeat offenders will pay a hefty price. You can eliminate these traps by engaging Emerald as your Employer Of Record.


What Are The Three Key Indicators?

As mentioned above, Mayo notes the IRS has a 20-factor test designed to discover the status of your employees, but for efficiency, they tend to look at three initially.  


Behavior Control  

Did you train the worker?  


  • A contractor usually comes to the business with a set of skills ready to go. If you had to train the employee, it might be a sign that you do not have a contractor, but an employee.  


  • Normally, an employee is given behavioral instructions. Do you, as an employer, have complete control over how, where, and when the employee delivers the work? Even if no explicit instructions are given, it might be deemed behavioral control if the employer controls how the employees’ results are achieved.  


Financial Control 

Does the worker have a significant investment in the tools or facilities required to undertake the work?  


  • Contractors tend to own the tools needed to complete said work.  


  • What is the employee’s exposure to profit/loss? A contractor can lose money on a project, most employees have no exposure to loss/profit apart from sales commission.  


  • Does the worker have expenses? Some employees have expenses but they’re usually billable and only occur when work is being done. Does the employee have to pay for something even when work isn’t being done? Like a truck or equipment that’s hired.  


Relationship Control 

  • Do you provide benefits, health insurance, sick pay, vacation pay, pensions? This is usually the sign of an employee.  


  • Do they have a written contract?  Especially one that defines the intended relationship between the business and the worker.  


It’s worth mentioning that these three factors are just watered-down versions of the original 20-factor rules, and the IRS will happily dig deeper if they find an anomaly. 


Summary: At a glance, the government will do a simple 3-point test, if anything looks unusual they will dig deeper.  


What Happens If We Get Caught? 

The IRS have a Volunteer Classification Settlement Program, this was started by the government to allow companies time to settle the outstanding tax debt and only pay 10% of the total. 


Along with a promise to classify future workers correctly, of course. We can assume the IRS is also looking at your business a little closer in the future since you’ve now proven unreliable when it comes to worker classification.  


It’s worth pointing out the federal tax inspectors across the globe aren’t the big bad wolf we might expect. They’re simply following orders to find lost tax revenue in an ever-changing employer/employee landscape.  


Intent is also a thing. A couple of employees misclassified as contractors differs from an entire business model that requires mis-classified workers to make a profit.  


From a financial point of view, the business should at least have enough money on the books to cover whatever fine is levied. It might affect the company’s financial position, but this is the government we are talking about. They can shut you down any time they want.  


No company should take risks with employee misclassification, it can cause massive amounts of red tape and paperwork and ultimately this is why CEOs and CFOs wind up looking for another job.  


What Should I Do Next?

Hiring contractors or temporary workers can be daunting, but in this new economy it’s how businesses are able to grow, expand internationally and still have some flexibility along the way.


The better choice is to engage with an EoR (Employer of Record), like Emerald. Hiring new staff through Emerald, still allows you access to the same pool of talent globally but it comes risk free. Since we are legally the employer of your staff, all of the risk is passed on to us and you can simply get on with growing your business.


It’s the best of both worlds.

If you already have staff on your books that could fall foul of employee misclassification laws, we can still help. Emerald can help you transition to a safe, compliant, legal workforce with minimum fuss. 


Worried about the status of your staff members? Talk to us. 


Our team are ready to build your team.

We provide a full global payroll solution

To find out more about how we can help your company expand globally, contact Emerald Technology. 

Adam DeSanges

Part of Emerald since 2006, Adam has personally developed an Executive Search process that has been incorporated throughout the entire Emerald Technology business and has enabled our team to offer an unrivalled, collaborative service to our clients. As one of our Company Directors, he is responsible for leading, training and mentoring this methodology.