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.

Misclassification of employees: key takeaways

Misclassification of employees and independent contractors hurts your company and workforce by:

• Denying people basic labor protections
• Creating tax liabilities
• Leaving your business vulnerable to costly legal issues.

Having solid policies in place—and backing them up with a secure, user-friendly HRIS—can help lower common HR compliance risks.

What is employee classification?

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

• Eligibility for benefits
• Job security and termination rights
• Access to training or development
• Reporting and performance reviews.

You’ll decide on employee classification when hiring a worker. It’s important to have a process in place from the start to prevent misclassification.

Businesses can hire employees and independent contractors across multiple categories to fulfil 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:

• Full-time employee: 35–40 hours a week
• Part-time employee: Less than 35 hours a week
• Temporary employee: Works for a set period
• Independent contractor: Employed on a contract basis to perform a specific task.

What’s the difference between exempt or non-exempt?

Exempt employees have a salary and aren’t eligible for overtime, while non-exempt employees are normally paid hourly and must be paid for overtime hours.

Employee classification (exempt or non-exempt) is crucial because it defines their rights under the Fair Labor Standards Act (FLSA). This classification affects breaks, overtime, and other benefits. Keep track of employment laws specific to your state as well as national laws.

Avoiding employee misclassification: The difference between employees and contractors

To avoid employee misclassification, it’s important to know 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. They’re responsible for their own business expenses.

Employees vs. Independent Contractors

How to identify employees vs. independent contractors

It’s important to understand the importance of classification. And remember, different states and organizations have varying rules, so one size doesn’t fit all.

The federal government uses different tests to classify workers. They are:

Common-Law Test:

The three factors of the IRS Common-Law Test are:

• Behavioral control: Do you control how the work is done (for example, through detailed instructions or training)?
• Financial control: Do you control the financial aspects of the work (for example, payment methods, expense reimbursement, profit/loss potential)?
• Working relationship: How do you and the worker perceive your relationship (for example, benefits, contracts, duration of the relationship)?

Economic Reality Test

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:

• Opportunity for profit or loss depending on managerial skill
• Investments by the worker and the employer
• Permanence of the work relationship
• Nature and degree of control
• Whether the work performed is integral to the employer's business
• Skill and initiative

State-Specific Tests:

Many states also use their own methods for determining employee classification. For example, in California, the ABC Test stipulates that you need to meet all of the following three conditions to classify a worker as an independent contractor.

• The worker is free from the hiring entity's control and direction
• The work is outside the hiring entity's usual business
• The worker is independently established in that trade or business

Some states have rules that only apply in certain situations or industries. Consult your state government website for the most current classification criteria.

Common causes of employee misclassification

It’s important to stamp out misclassification of employees right from the root. Knowing what to look out for can help you avoid doing it in the first place. Some of the causes of misclassification are:

• Lack of clear policies: Keep policies clear—avoid vagueness and ambiguity
• Misunderstanding contractor laws: Ensure you comprehend federal and state contractor laws well, and comply fully with them
• Rushed hiring processes: Take your time with recruitment to screen high-quality candidates. Things can be made much easier with an effective applicant tracking system
• Poor record keeping: Store your records in an easy-to-use system, ensuring staff are trained properly to use them. Streamline your record management to stay ahead.
• Misinterpreting exempt vs. non-exempt job duties: Don’t assume that salary alone determines someone’s exemption. It comes down to their duties and understanding them well.

Even if it was an honest mistake, misclassification of 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 that 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:

• Denying employer-sponsored retirement benefits, unemployment insurance, expense reimbursements, or workers' comp
• Scheduling overtime without appropriate pay
• Refusing job-protected leave under the Family and Medical Leave Act (FMLA)
• Failing to give the required notice during mass layoffs per the WARN Act.

An employee misclassification lawsuit against your company could result in paying back wages, benefits, fines, civil penalties, and attorney fees.

Reputation damage

It’s not how you comply with the law, but how you’re perceived by stakeholders that could take a hit if any misclassification occurs. Some things to consider are:

• Misclassifying employees may also damage your company's reputation, even without a lawsuit
• A lawsuit may result in increased scrutiny and an organization-wide audit. This 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)
• Unemployment tax for your employees through payroll

However, misclassification of employees as independent contractors means you're not withholding the employee's share or paying employment taxes. This makes you responsible for:

• Unpaid federal taxes
• Unpaid state taxes
• Associated fines
• Interest
• Employee misclassification penalties

Unpaid wages and benefits

Misclassification can lead to your business being held liable for paying back wages and retroactive payments. One such example was when Louisiana Landscaping Company paid back $319k in back wages for 49 workers who were misclassified as independent contractors.

It can also prevent workers from accessing employee benefits. This is because they’re usually tied to employee status. Some examples are:

• Health insurance
• Retirement contributions
• Paid leave
• Increasing their personal tax burden.

6 key tips to avoid misclassifying employees

Knowing how to avoid employee misclassification is almost half the battle. Below are some tips you should consider so that it doesn’t happen at your organization.

Create an employee classification policy

Avoid hiring issues by creating an employee classification policy. This acts as a blueprint for your hiring team to follow. It also ensures everyone understands the differences between classifications and the entitlements for each group. Having strict rules around categorizing employees sets boundaries. Knowing where everyone stands can reduce misclassification of employees.

Stay up to date

Keeping yourself informed of federal and state employment laws helps you maintain compliance. It may also apply to things like minimum wage, payroll taxes, and more. Essentially, you’re killing a few birds with one stone. Also, knowing your organization is in alignment with these laws can give you peace of mind.

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

It all starts with clear and consistent company guidelines about how and why people are classified as employees or independent contractors, and FLSA 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. It acts as a safety net. Schedule HR compliance audits to ensure your workers are classified correctly. Plus, it’s a good idea to check occasionally. Better to catch a big mistake yourself than face a lawsuit or other penalty.

Consult your legal team

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. It’s better to be safe than sorry. Remember, prevention is better than a cure. Avoiding it altogether is better than resolving it afterwards.

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) can help make misclassification of exempt or non-exempt employees something your organization avoids. They’re invaluable tools that make HR compliance easy.

Some of the benefits of using an HR platform are:

• Applicant tracking system (ATS): Makes collaboration easy for your hiring team. It helps everyone stay on the same page about which worker types your company needs for each open position
• Employee records: Acts as an electronic filing cabinet, eliminating piles of paperwork and centralizing your employee data for easy review
• HR reporting and analytics: Analyzes your workforce needs, spots possible issues, and makes data-driven decisions
• HR automation: Reduces the risk of human error (and the compliance issues that follow)
• Employee onboarding: Helps manage new-hire paperwork quickly and accurately, creating a more organized process that minimizes errors
• Employee self-service: Aids employees in reviewing and updating their own information. This makes it even easier for HR to manage compliance.

Employee misclassification FAQs

Want to know more about employee misclassification? We’ve covered some popular questions here:

Is misclassification of employees illegal?

Yes, misclassification of employees is illegal because it violates federal and state laws by denying workers their rights, benefits, and protections. It’s important your organization makes the utmost attempts to prevent it from happening. It also helps to know how to deal with it if it does occur.

What triggers a misclassification audit?

A misclassification audit can come about due to:

• Formal complaint or inquiry from an employee
• A regulatory agency like the IRS
• Internal audit

An audit can also be triggered if your organization has:

• Lots of independent contractors
• High-cost benefits
• Unpaid taxes
• Changing or unclear laws

What happens if you misclassify an employee as exempt?

If you misclassify an employee as exempt, you risk hefty lawsuits. Also, you’re likely to be given high financial penalties, which can include paying back overtime wages. And if there were any unpaid taxes, you might be responsible for those, too. In extreme scenarios, you could face criminal charges.