Employee or Contractor? Understanding the Risks of Misclassification

In today’s fast-evolving workforce landscape, businesses are increasingly relying on a mix of employees and independent contractors. While this flexibility can benefit businesses, the stakes are high when it comes to properly classifying workers. Misclassifying an employee as a contractor — whether accidentally or intentionally — leads to significant legal, financial, and reputational consequences. For companies operating in the U.S. and on an international scale, the risks vary by jurisdiction but share a common theme: compliance is key.

This blog explores the risks of employee misclassification in both U.S. and international contexts and highlights how Justworks has PEO and global EOR capabilities that can help businesses navigate these complexities.

Understanding Employee vs. Contractor Classifications

Before diving into the risks of misclassification, it’s essential to understand the fundamental differences between employees and independent contractors. 

Employees typically:

• Work under the control and direction of an employer.

• Follow set schedules defined by that business.

• Rely on the employer for tools and resources.

• Receive benefits such as health insurance, paid time off, and retirement/pension plans.

Contractors, on the other hand, typically:

• Are self-employed individuals who retain control over how and when they perform their work.

• Use their own equipment and tools.

• Work for multiple clients instead of exclusively for one organization.

• Operate independently without relying on an employer for resources or benefits.

• Have to deduct and pay their own taxes. 

Missteps in classification can lead to severe consequences like backpayments of benefits and fines depending on where you’re hiring employees and contractors. 

The U.S. Perspective: Navigating Complex Classification Rules

In the U.S., worker classification hinges on guidelines from the Internal Revenue Service (IRS), the Department of Labor (DOL), and sometimes state laws, which can have stricter criteria. The primary distinction lies in the level of control the business has over the worker’s tasks, schedule, and methods.

Risks of Misclassification in the U.S.

Financial Penalties

Companies may face back taxes, unpaid Social Security contributions, and fines for failing to withhold and pay proper payroll taxes. The IRS charges penalties based on the extent of misclassification, which can add up quickly.

Lawsuits and Legal Actions

Misclassified workers can sue for unpaid wages, overtime, and benefits they should have received as employees. High-profile lawsuits in recent years have resulted in multimillion-dollar settlements.

Reputational Damage

Being publicly called out for worker exploitation, even if it was not on purpose, usually leaves a trail, and a bad reputation for a company’s culture and brand, making it more difficult to retain and attract talent. 

U.S. Compliance Challenges

Each state adds its own layer of complexity. For instance, California’s stringent ABC Test under AB5 assumes all workers are employees unless businesses prove otherwise. Other states, like Texas, have different laws regarding employee classification, making it critical to understand local laws.

Justworks Understands U.S. Classification Laws

Justworks simplifies worker classification by:

• Offering guidance on U.S. labor laws.

• Managing payroll in compliance with state and federal requirements.

• Providing tools to document and track contractor relationships, reducing the risk of audits.

The International Perspective: A Global Compliance Puzzle

When businesses expand globally, worker classification becomes even more complex because it will vary by country. Each country has unique labor laws, tax systems, and employment protections that define employees and contractors. 

Risks of Misclassification Internationally

Severe Fines and Tax Liabilities

Many countries impose steep penalties for failing to classify workers correctly. For example, in countries throughout the European Union like Spain and Portugal, misclassification can result in backdated social contributions, hefty fines, and even criminal charges in extreme cases.

Employment Rights Violations

Contractors in countries like France and Germany may claim employee benefits if misclassified, including paid leave, health insurance, and severance payments.

Immigration and Work Permit Issues

If misclassified contractors are working on visas that require employee status, businesses risk violating immigration laws resulting in deportation or bans on future hiring.

Key Global Classification Challenges

Inconsistent Definitions

What qualifies as a contractor in one country might not meet the same criteria elsewhere. For instance, Canada and Mexico have stricter definitions compared to the U.S. 

Cultural Expectations

In many regions, such as Latin America, there’s a cultural assumption that most workers will be full-time employees, leaving contractor relationships up to more scrutiny from local labor boards.

Justworks Experts Understand Global Classification Laws

Justworks International EOR supports global businesses by:

• Acting as the employer of record, ensuring compliance with local labor laws.

• Providing localized expertise to navigate classification standards in various countries.

• Taking care of payroll, benefits, and reducing other HR administrative burdens.

Best Practices for Avoiding Misclassification Risks

Whether in the U.S. or abroad, businesses can take proactive steps to reduce the risk of misclassifying workers:

• Understand Local Laws:

  • Regularly review federal, state, and international labor regulations that apply to your workforce.

• Conduct Regular Audits:

  • Periodically evaluate your contractor relationships to ensure compliance.

• Use Written Agreements:

  • Draft clear contracts outlining the scope of work, timelines, and independence expected from contractors.

• Leverage Technology:

  • Use platforms like Justworks to assist you in tracking compliance and managing payroll.

• Consult Experts:

  • Engage legal or HR experts with experience in international employment hiring and compliance.

Safeguard Your Business with Justworks

Worker misclassification is a growing risk that small businesses may not always have the resources to understand or combat when compliance problems arise. Navigating these complexities can overwhelm even the most well-prepared HR teams. That’s where Justworks comes in.

Whether you’re a U.S.-based business managing contractors across states, or a global enterprise expanding into new markets, Justworks provides simplified compliance support, and helps you stay focused on growth.

Ready to reduce your compliance risks? Get started with Justworks.