Last updated: 13 Jan 2025 09:00 Posted in: AIA
Catherine Chidyausiku explains the risks that can occur when misclassifying workers, and how businesses can avoid worker misclassification findings and the fines and penalties which come with them.
Large companies need to have proper classification of employees as a key part of their onboarding and retention strategies. Increased hiring resources and role creation for temporary workers and freelancers can be key to growth for many large enterprises. If this is not properly managed, however, the business could be at risk of breaching employment regulations and face financial consequences. From construction and logistics to healthcare and retail, all industries are affected by misclassification regulations.
What are the risks that can occur when misclassifying workers and how can businesses avoid falling foul of potential fines?
Financial and ethical consequences
Incorrectly classifying workers in the company directory can lead to an array of financial implications, which can damage the cash flow of the firm. These include delayed wages, overtime and benefit payments; backdated tax and National Insurance payments; fines issued by regulators; and legal fees following action taken by underpaid staff.
Other consequences outside the financial implications include lost wages, damaged staff morale, loss of talent and unfair competition when it comes to cutting costs. With many industries proving more competitive than ever amidst growing technological innovations, misclassifying workers is not worth these risks. Regulators across the world are cracking down on worker misclassification, staff exploitation and the tax avoidance involved.
United States
In the United States, enterprises need to adhere to the state and federal laws and guidelines (including multiple different tests applied by different agencies) around classifying contingent workers who would like to provide their services as independent contractors. These are intended to ensure that necessary distinctions are made between employees on payroll and independent contractors.
In March 2024, the US Department of Labor began enforcing new legislation ordering companies to apply the appropriate benefits and protections to each worker. These include minimum wage, overtime, tax withholding and benefits.
The main factors that need to be taken into account when enforcing the Fair Labor Standards Act are:
Data from by the IRS reveals that firms have managed to hire independent contractors for around 30% less cost compared to permanent staff. While this may be financially beneficial in the long term, it is very likely that legal risks and expenses will come back to bite the firm down the line if they haven’t made sure that the independent contractors are truly independent.
US Department of Labor research reveals that around 10% to 30% of employers across the country have listed staff incorrectly since the 2000s. Misclassification is particularly prevalent within labour-intensive industries, which are largely made up of female workers and staff of colour including Black, Latinx, and Asian American/ Pacific Islander backgrounds.
In the United States, corporations including FedEx and Microsoft have been found liable for having misclassified staff over the last 25 years, and have had to pay settlements in the millions of dollars – $97 million for Microsoft following an eight-year legal battle in 2000; and $500 million in the case of FedEx in a 2015 lawsuit.
United Kingdom
In the UK, penalties enforced by HMRC for liability over a lack of withholding tax can make up 100% of the amounts due, depending on the severity of the infringement. Navigating the regulations on employment status and employments rights in the UK to understand the risks associated with staff and independent contractor misclassification is no easy feat. Once this is conquered, achieving and maintaining compliance becomes yet another prominent challenge.
The IR35 regulation for UK freelance workers was introduced in 2020 to help prevent business tax evasion occurring as a result of misclassification. This legislation orders contractors who work like employees to pay the same amount of income tax and National Insurance as an employee, regardless of whether they are providing services through a personal service company.
Breaching the regulation can lead to millions of pounds in fines being ordered. Notably, a government body was recently fined £36 million for misclassifying staff, resulting in backdated taxes.
However, a recent report from the Public Accounts Committee (PAC) – responsible for overseeing government expenditures – has accused the rulings of being too complex, stating that businesses are finding hiring freelancers too risky from a compliance standpoint:
‘Since the IR35 reforms, employers have moved between 150,000 and 200,000 workers from contractor status onto their own payroll. However, we are concerned that a lack of confidence in how to apply the rules, together with HMRC’s tough approach when taxpayers make mistakes, is deterring companies from using contractors unnecessarily.’
The report also concluded that the regulation was not sufficiently deterring misclassification.
European Union
In the European Union, the EU Court of Justice has issued several rulings that have reinforced the criteria for distinguishing between independent contractors and employees. These rulings emphasise the importance of factors such as control, integration into the business and economic dependence in determining the correct classification.
The resulting fines and penalties for misclassification have been extensive, reaching £1.73 billion in minimum wage, paid holidays and other benefits in a ruling against Uber in the UK in 2021; and €20 million against Tesco Ireland in 2020.
Australia
In Australia, the High Court of Australia oversaw a 2022 ruling declaring that the documented terms of all contracts would from then on be the primary factor in determining misclassification.
In 2023, the Fair Work Legislation Amendment (Closing Loopholes No. 2) Act 2023 clarified the definition of ‘employment’ and made it clear that regardless of what the written contract states, the definition of employment is defined by the practical reality and true nature of the relationship between the individual and the party who may be deemed to be an employer.
To determine the true nature of the relationship, a multi-factor test was instituted which undertakes to evaluate the totality of the relationship. This new method for independent contractor classification became effective August 2024.
How to overcome the pitfalls
Incorrectly classifying workers in the company directory can lead to an array of financial and other implications. These include:
Other consequences outside financial implications include brand damage when the misclassification suits and findings are publicised. Additionally, there are extensive information sharing arrangements between different agencies interested in worker classification, so that one audit with a negative finding can cause a snowball effect with other agencies joining in for their piece of the pie.
To ensure that your business stays compliant with worker classification legislation and mitigate risks, you must do the following:
Seeking expertise from a globally operating workforce solution and compliance provider can keep your business leaders clearly informed about legal developments pertaining to worker classification, both in the UK and further afield.
Employee of Record (EOR) and Agent of Record (AOR) services provide a framework for properly determining how each member of staff should be classified in the system, and how to engage accordingly.
Taking this proactive step can keep you properly informed, as well as reducing strain on hiring and retention processes, leaving you free to focus better on core business activities that bolster your bottom line - rather than damage it.
Author bio
Catherine Chidyausiku is Chief Legal Officer for North America at People2.0 and is a seasoned legal expert with over two decades of experience in workforce solutions.