Employee Misclassification: How It’s Costing Gig Economy Companies Millions Of Dollars In Penalties

Here’s how gig economy companies are risking lawsuits and hefty penalties from the IRS by misclassifying their employees as independent contractors.

Employees and independent contractors are different. That is established. However, when companies leverage on the hardworking efforts of their employees and then proceed to misclassify their employees as independent contractors for the momentary tax relaxations of hiring independent contractors, things do not look so good. 

In recent years, we have heard about companies like Uber, Lyft, Lime, and more that have misclassified their employees as independent contractors. But this is not the first time. Even companies like Microsoft have a history of misclassifying employees as independent contractors. While the employers argue that their reasons are just and in good faith, the IRS does not consider the non-substantial factors.

Today, the gig economy is on the rise with many companies leveraging the talent pool and resources available at large within the freelance economy. It’s nothing less than a goldmine for modern-day businesses.

The chances of a company hiring an employee and making them do the lot and sending them home only for the individuals to wake up to a 1099-NEC mailed to their addresses is pretty high.

But why does this continue to happen? Why do companies misclassify their hand-picked, hardworking employees? What factors play a role in this twisty maze of misclassification?

Let’s discuss. 

Employee misclassification: Why the temptation?

The lines are blurry when it comes to defining who is an employee and who is an independent contractor. Sure, there are state-vouched tests that help determine the case for the most part. But some business-contractor arrangements can be so complex that a one-size-for-all approach simply does not work. 

The modern-day business approach is very different from the market in the ‘30s, ‘70s, and ‘80s (the timeline around which the labor laws were established). Today, with the virtual dynamics and zero-footprint ecosystems, the same rules may not apply (at least to some extent).

Employers, in a rush, to hire resources (any type of resource) to get the work started, look for the cheapest labor available in the market. The gig economy, which flexes economically-priced, qualified talent pool at mass availability falls victim to this approach.

The companies that are hiring freelance brain talent are in their infancy or developing years. At this point, most businesses can’t afford a full-time employee and bear the additional expenses of having an employee.

If you’re recruiting an employee, you have to be prepared for some basic pay and expenses, such as salaries, wages, overtime pay, earned sick leave, family leave, insurance, unemployment benefits, and more. 

The gist is that you do not have to pay or worry about any of these when you hire an independent contractor. This is why most companies approach independent contractors. 

While some companies come across the misclassification lawsuits in their initial stages, some companies take the bigger hit of the misclassification just when a promising investor eyes them or when the turnover is at its highest – crashing down all the way when a lawsuit hits them. 

Because lawsuits don’t come alone; they come with hefty financial penalties, operational prohibitions, and even imprisonment if not addressed correctly.

What’s pushing the companies to misclassify?

When employers know that the consequences of misclassification are this drastic, why do they flirt with the idea of misclassification? 

It’s not that the employers are not educated or not smart enough to understand the consequences of employee misclassification. Every employer pretty much dreads hearing from the IRS.

 It’s just that the lines of classification are so blurry that the classification criterion changes for every resource – depending on the responsibilities. And the lines blur further when the approach of the business changes.

Look at the current work-from-home scenario. The freelancers and employees are both working from home. The employer is free to hire both an employee and an independent contractor. The dynamics are relatively similar.

Is the employer free to write off employees as independent contractors?

Probably, yes. 

But should the employer do it? 

Absolutely not.

Just because the nature of the work and the dynamics of the business arrangements have changed, doesn’t mean that the law changed.

The laws differentiate employees and independent contractors, and so should employers. 

You employ an employee but you hire an independent contractor.

That’s the difference.

What can be done to correctly classify employees/independent contractors?

While the legal and compliance work around classifying a worker as an independent contractor or an employee is complex, there are simple ways to determine and arrive at a legal classification.

Take a look at these tests for example. 

  • The common law test 
  • The ABC test 
  • The economic realities test 

You can use either or all three of these to determine and classify your workers.

The common law test

The common law test is used by most state agencies to determine the classification of the worker in most cases. There are three fundamental factors here that are used to classify the worker and the degree of control an employer has over their workers. 

Behavioral control: This factor is used to understand what the worker does and how the worker does their job. 

Financial control: This factor is used to understand the following. 

  • How the worker gets paid;
  • If the expenses of the worker are reimbursed;
  • And who provides the supplies

Relationship of parties: This factor is used to determine if there are any written contracts between the parties and if there are any employee-type benefits. Further, this also helps understand the longevity of the business arrangement and determine if the work performed is a key aspect of the business. 

The above criterion can be used to classify a worker as an independent contractor or employee.

The ABC test 

The ABC test, similar to the common law test, focuses on three fundamental factors to determine and classify the worker. 

This is as follows. 

A: The worker is free from control or direction of the performance of work (under contract and in fact). 

B: The required service is not in the usual course of the business. Or the work is performed outside of all the places of business of the enterprise.

C: The worker is primarily engaged in an independently established trade, occupation, profession, or business.

The economic realities test 

The economic realities test helps you define if the worker is classified as an employee or an independent contractor per the following factors. 

  • It is integral for the employer’s business to monitor or measure the extent to which the work is performed
  • The managerial skills of the worker define the opportunity for profit or loss 
  • It is crucial to determine the relative investment of both the worker and the employer 
  • Determine if the work that needs to be performed requires any special skills and initiative 
  • The stability and longevity of the relationship or business arrangement
  • The extent to which the employer exercises or retains their control on the worker

You can use N number of tests to determine and define your relationship with your workers. Sometimes, you can even use a combination of the above tests to classify your workers. However, it is essential to note that you cannot get worked up with the tests.

From the words of Michael Masterson; a fish lives inside the water all its life. If you tell the fish “Look! There’s water all around you!” and the fish will respond with “what water?” 

Sometimes, employers get too worked up with the terminologies that they sometimes forget to look at the picture at large. This could be an honest mistake. Sometimes, the answer is right in front of us and we just can’t bring ourselves to see it. 

So, be sure to look at the legal framework and the compliance protocols before you define someone as an independent contractor and ensure that the business arrangement you have with your contractors is enough to get the work done and safe enough to keep you in the green zone.

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