Hiring employees in the United States is an effective way for companies to increase productivity while scaling operations and generating revenue internationally. The US is a desirable location for growing businesses because of its world-leading economy, sizable labor force of specialized workers, business-friendly regulatory environment, and proximity to other major North American markets.
However, despite the numerous advantages of hiring in this region, there are several challenges that employers may be subject to during the international expansion process. For example, misclassifying an employee relationship is a major risk that carries significant financial, legal, and operational penalties for companies.
In this article, we explain misclassification, the rights of independent contractors and employees, and strategies to avoid misclassification at all stages of the employment journey in America.
What is Employee Misclassification?
Employee misclassification is the incorrect classification of the employment status of a worker. In most cases, this occurs when the employer misclassifies a worker as an independent contractor instead of a regular employee. The differences between a contractor and an employee are significant and include tax obligations, rights, and social security contribution requirements. Misclassification can happen intentionally to reduce labor costs but frequently happens accidentally by failing to follow worker classification laws in the United States.
Misclassification is a common risk and happens across various industries, with an estimated 10-30% of US employers incorrectly classifying workers, according to the National Employment Law Project. Misclassification costs are also significant for employees, as some workers lose up to almost $17,000 per year in income and benefits.
As an example, an employer may classify a worker as an independent contractor and have the individual work more than the standard working week without being required to pay additional overtime premiums.
Occupations that are commonly misclassified include:
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Construction workers and landscapers
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Truck drivers and logistics workers
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Home health aides
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Janitors and housekeeping staff
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Nail salon workers
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Gig economy workers
Independent Contractor vs Employee
Knowing the differences between independent contractors and employees is important for companies to maintain compliance and avoid penalties.
What are Independent Contractors?
An independent contractor is a self-employed individual who performs work or provides services to a separate company, usually on a contract basis. In many cases, companies engage independent contractors for a predetermined period or to complete short-term projects. Organizations may also opt to partner with an independent contractor to gain access to specialized skills while avoiding the most substantial costs associated with hiring an employee in the United States.
Common positions for independent contractors include writers and other creative workers, software designers, tutors, virtual assistants, and more.
Workers under independent contractor status have certain rights and obligations. For example, contractors are responsible for filing and paying self-employment taxes and contributing to social security programs. In contrast to regular employees, contractors must file a 1099 form during tax season, which serves as a record for non-employment income earned by freelancers and other non-employees.
Employers have less control over the working relationship when engaging independent contractors. Contractors are free to set their schedules and have much more flexibility over where they work. Additionally, independent contractors can work for multiple clients simultaneously.
An independent contractor also takes on a higher degree of financial risk and can incur losses, while employees are not obligated to handle operating expenses.
What is an Employee?
An employee is a worker hired by a company to perform work on a long-term or permanent basis, under a contract of employment. In the United States, employees are also granted various rights and employment benefits, such as private insurance and paid leave.
The employer has various responsibilities and must remit taxes and deduct social security contributions from each employee’s paycheck. Additionally, employees receive taxation documents such as W-2 and W-4 forms instead of the 1099, which calculate the employee’s wages, federal and local taxes withheld, and Medicare or Social Security taxes paid.
Unlike independent contractors, employers have more control over the employer-employee relationship. For example, the employer sets the schedule and can stipulate the location of work, though flexible working arrangements are becoming more popular. Employers can also stipulate how work gets done, and the employee is typically restricted to working for a single client or company. While a contractor owns the equipment required to complete the job’s requirements, an employer will provide the employee with all the tools needed to accomplish work and handle maintenance fees.
Minimum Wage
Employees in the United States are entitled to a minimum wage for each hour worked. While the federal minimum wage in 2024 is $7.25, each state has its local laws regarding employee compensation. In different states, the minimum wage for employees ranges from as low as $5.15 per hour in states like Georgia and Wyoming, to $16 per hour or more in regions like California, Washington, and the District of Columbia. Additionally, states such as Minnesota have a progressive minimum wage based on how much the employer makes annually.
Each state also has its own laws governing overtime premiums, though the federal standard for a working week is 40 hours.
Leave Entitlements
Employees in the United States are also entitled to various forms of time off throughout the year. For example, the Family and Medical Leave Act ensures new parents can take up to 12 weeks of unpaid leave, though the actual requirements vary between states and industries, and there is no federal requirement for sick leave.
The US also does not have a federal requirement for statutory leave, but the average American worker gets 11 days of paid annual leave, which increases with the employee’s length of service.
Benefits
Employees in the United States are also entitled to various forms of benefits. For example, employers are responsible for contributing 1.45% towards social security programs such as Medicare, a form of public health insurance, and 6.2% towards Social Security insurance, which provides income support for loss of earnings from factors such as retirement, death, or disability.
The Federal Unemployment Tax Act (FUTA) is a program that provides financial relief to individuals who have lost their jobs and are currently seeking work. Employers are required to contribute 6% of an employee’s wage for the first $7,000 of compensation. Employees can also receive workers' compensation for any medical expenses or physical therapy costs.
Other acts, such as the Affordable Care Act (ACA), require large employers to offer affordable healthcare coverage to full-time employees and their dependents. Companies may also opt to offer various other benefits, such as home office or mental health allowances to recruit top talent more successfully.
What are the Penalties for Misclassification?
Misclassification does not only impact employees, but employers who are found at fault for incorrectly classifying employees are also subject to penalties and other punishments for non-compliance. These penalties vary between jurisdictions but businesses should carefully follow all guidelines to avoid the associated financial and legal risks of misclassification.
Penalties come in various forms, including:
Legal Risk and Ramifications
Employers who misclassify employees in the United States can face strict legal penalties. You may be subject to legal claims from employees for wages and benefits they were entitled to but did not receive.
Companies may also face class-action lawsuits if the organization has misclassified multiple workers. For example, Uber paid $8.4 million because of a class-action lawsuit regarding the misclassification of drivers in California where Uber regarded each worker as a contractor.
There are several other legal liabilities associated with employee misclassification. In some cases, employers may risk criminal penalties such as tax fraud and prison time. Companies that fail to follow the Fair Labor Standards Act may also face additional wage claim audits for as far back as three years.
Financial Consequences
In addition to facing severe potential legal penalties, companies that misclassify workers also face financial consequences. Financial hurdles are one of the most common reasons small businesses fail.
Companies facing misclassification may be required to provide back pay for any unpaid wages or benefits owed, which can be extensive for companies with a larger workforce. This also applies to any overtime pay that was not given to employees who worked more than the mandated working hours along with unpaid employment taxes.
Businesses also face penalties of up to $1,000 if the company has an otherwise clean record, a $50 fine for each W-2 form that should have been filed, along with up to 40% of the FICA taxes an employer should have contributed for each employee. Fines depend on the jurisdiction, but misclassification in California carries a civil penalty ranging from $5,000 to $25,000 depending on the severity of the case.
In 2016, FedEx incurred $240 million of financial consequences because of misclassifying drivers.
Other Penalties
Companies with misclassified workers may also be subject to various other penalties or sanctions from governing bodies, such as the Internal Revenue Service (IRS) and the Department of Labor. In New Jersey, employers can receive a stop work order, meaning the organization is unable to carry out core operations as a result of misclassification. In some cases, misclassification can also lead to the business losing important licenses, permits, or contracts.
Other ramifications include reputational damage, impacting recruitment efforts, decreasing employee morale, and influencing how a company is perceived by consumers.
Tips to Avoid Misclassification
Business leaders should implement strategies to mitigate risks when engaging an independent contractor versus an employee.
Understand Federal and State Laws
To avoid misclassification penalties, understand the federal and state laws that govern worker classification where your team resides. Draft employment contracts and independent contractor agreements that avoid any ambiguities and provide clear guidelines for the obligations of both parties.
For example, while federal labor laws may stipulate worker classification through various measures, individuals may be considered employees even if:
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The employer sends the worker a 1099 form
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The worker signs a contractor agreement
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The worker receives compensation in cash or through non-documented means
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The worker does not have a set office space or work location
Stay up-to-date with changing employment legislation to remain compliant with rules and regulations.
Implement Compliance Measures
Conducting routine regulatory audits helps companies identify areas of the employment process that can be improved by analyzing the nature of each employment relationship. This includes using clear language in any agreements, especially regarding working arrangements, to avoid potential ambiguities or complexities.
Additional measures such as reviewing job descriptions to avoid misinterpretations, developing clear and consistent policies for classification, and keeping accurate employment records are best practices. Governing bodies such as the IRS also provide resources to help employers follow all rules.
Seek Professional Guidance
Above all else, companies should seek guidance and expertise on classification laws. Professional guidance allows you to effectively navigate the challenges associated with scaling your team. This also ensures you follow all relevant local labor laws and regulations, which saves time, resources, money, and stress.
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Ensuring compliance with local labor laws
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Managing employment contracts
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With our help, your company avoids major risks, such as misclassifying employees as independent contractors. Contact us today to see how we enable businesses to legally hire American employees or engage independent contractors while complying with all local labor laws.
