Misclassification and wage theft are significant issues affecting most organizations, HR teams, and employees. 10% to 30% of U.S. employers are misclassifying workers, resulting in billions in lost taxes for the authorities, as well as wages & benefits for employees.
Governments and authorities are raining hard on non-compliant companies, fining them hefty penalties and, in some cases, prison time. Misclassification often leads to wage theft for employees, affecting their livelihood and their family’s lifestyle.
Here’s what you need to know about misclassification and wage theft and how to avoid it.
What is Misclassification?
Misclassification pertains to employers inaccurately categorizing their employees or workers. This situation often arises when workers are mistakenly labeled as independent contractors or assigned other non-employee designations, as well as mistakenly classified as exempt or non-exempt. Not only does this take away wages & benefits for the employee, but it can also cause heavy legal and financial consequences for the employer.
In many jurisdictions, employees are entitled to certain rights and benefits that independent contractors or other non-employee classifications may not receive. These rights and benefits can include minimum wage, overtime pay, workers’ compensation, unemployment insurance, health and safety protections, paid leave, and more.
Exempt vs Non-Exempt
The classification of employees as exempt or non-exempt is crucial as it determines factors like pay structure, benefits eligibility, and adherence to labor regulations. Accurate classification is essential to ensure compliance with employment laws and prevent legal issues related to compensation and working hours.
Exempt Employees
Exempt employees are typically salaried and are excluded from certain provisions of labor laws, such as overtime pay. They’re often employees in managerial, professional, or executive roles. Their compensation isn’t tied to the number of hours worked per week, and they’re expected to fulfill their job responsibilities regardless of the hours required.
Non-Exempt Employees
Non-exempt employees, on the other hand, are usually paid on an hourly basis and are entitled to overtime pay according to labor laws. These employees are covered by wage and hour regulations, and they receive additional compensation for hours worked beyond the standard 40-hour workweek.
Employment Types
In addition to the broad spectrum of exempt vs. non-exempt, there are numerous employment types that HR needs to be aware of. These employment types have their own set of laws and regulations. The most common types are full-time, part-time, independent contractors, seasonal, and temporary employment.
Full-Time Employment
Full-time employees maintain a consistent weekly schedule, frequently around 40 hours, and typically receive compensation in the form of a fixed salary or hourly wages. Additionally, full-time employees receive company-provided benefits such as health insurance and paid leave as part of their compensation.
Part-Time Employment
Part-time employees typically work a reduced number of weekly hours and are compensated based on an hourly rate. Part-time employees are often defined as “non-exempt,” allowing their entitlement to overtime pay and specific benefits (including minimum wage and regulations related to youth employment) as outlined by the FLSA.
Independent Contractor
Each state has its unique definition of an independent contractor. Therefore, it is the responsibility of the HR team or employer to prove that a worker is an independent contractor and not a taxed employee.
To determine whether a worker is an employee or independent contractor under the federal Fair Labor Standards Act (FLSA), employers must analyze two core factors worker’s control over the individual’s work, and the person’s opportunity for profit or loss.
Employers may also look at three guidepost factors:
- The amount of specialized skill required for the work that the potential employer does not provide
- The degree of permanence of the working relationship, focusing on the continuity and duration of the relationship and weighing toward independent contractor status if the relationship is definite in duration or sporadic
- Whether the work performed is part of an integrated unit of production.
Seasonal vs. Temporary Employment
Seasonal staff members are recruited for specific periods when a company experiences heightened workloads, such as during holidays or tourist peaks. They typically work for a predefined duration, their employment concluding once the busy phase subsides.
Conversely, temporary employees are brought in for shorter intervals to cover brief absences, like when a staff member takes leave or for specialized projects with definite end dates. These temporary employees are often sourced through staffing agencies, with the possibility of transitioning to permanent roles if both the employee and the company find the arrangement favorable.
Seasonal and temporary personnel afford employers the flexibility to address evolving demands without the commitment associated with full-time hiring.
Why Are Authorities Concerned About Misclassification?
The following are crucial factors that make authorities concerned and act on employee misclassification by employers or HR teams.
No Tax Withholding
Employee misclassification usually deprives governments of taxes they’re entitled to take under the law. In most countries, employers withhold income tax before distributing wages and salaries to employees.
On the other hand, independent contractors are mandated to submit their taxes.
If an employee is wrongly classified as an independent contractor, the government earns a lower total tax, making it more difficult to monitor income tax compliance with independent contractors.
Employers can save up to 30% of labor costs by misclassifying employees as independent contractors.
Benefits Deprivation
Misclassification leads to workers being deprived of benefits they may be entitled to from the company. This could take away overtime pay from a non-exempt employee or deny health insurance benefits to an employee.
Incorrect Expense Deduction
Independent contractors are often entitled to deduct certain expenses from their gross income that employees cannot submit as part of their expense deductions. These include office equipment, transport, retirement contributions, and private health insurance.
Lack of Employee Protection
Most companies in the US provide a range of employee protections, such as minimum wage, maternity leave, sick leave, and fair treatment. Misclassification can rid workers of these essential protections.
Lawsuit Examples of Misclassification
One of the most substantial misclassification cases was in June 2015 with FedEx. FedEx ended up paying out $228 million to over 2,300 California Ground Package drivers who were misclassified as independent contractors. This settlement is one of the largest settlements for employment wage and hour.
In December 2000, Microsoft paid out 96.6 million dollars for misclassifying 8,000-12,000 employees as independent contractors instead of classifying them as temporary employees. This robbed them of certain benefits that a temporary employee would be entitled to.
Uber paid out 8.4 million dollars to about 1,330 California drivers because they classified them as contractors instead of employees. This was not the first time they had been sued for misclassifying their employees. In 2019, they had to pay out $20 million to over 15,000 drivers in California and Massachusetts.
Time Warner, Inc., found itself obligated to disburse a settlement of $5.5 million to the Department of Labor (DOL) as a result of the misclassification of workers who were improperly excluded from pension plans.
These instances are merely a handful of lawsuits stemming from misclassification, yet companies face legal action frequently in relation to this matter. This emphasizes the paramount importance of upholding compliance when categorizing employees and workers.
How Misclassification Leads to Wage Theft
Unlike an employee, an independent contractor pays self-employment taxes and does not receive employer matches for their FICA and Medicare. This can be a significant burden for the worker, especially if they’re unfamiliar with self-employment provisions and regulations at the state and federal levels.
Therefore, if workers underpay their taxes at the end of the year, they may receive fines from the IRS and other tax authorities, resulting in lost wages. Also, if independent contractors are misclassified, they do not receive benefits and other forms of compensation an employee is entitled to. If misclassified as exempt instead of non-exempt, the employee can lose out on overtime payments, too.
The Risks of Employee Misclassification
If a business misclassified its workers, it’s at risk of the following:
Substantial Back-Taxes
Tax authorities can back-tax a business determined to have misclassified its workers. The tax authority will often back-tax payroll and income taxes for the misclassification period. This can be a sizable sum, damaging the business’s financial position.
Financial Penalties
Apart from imposing back taxes, tax authorities and government regulators can fine or penalize the guilty business. This often happens if it’s legally determined that the company misclassified the worker.
Legal Action
Misclassified workers can file for legal action against your business under the law. If found guilty, your company can be liable to compensate the affected employees for lost wages and benefits under that period, in addition to fines and attorney fees.
The court may also impose additional exemplary/punitive damages for flagrant misconduct.
How to Avoid Misclassification
Here are a few things you can do to avoid misclassification:
Know and Understand the Differences Between Exempt & Non-Exempt Employees
Understanding the distinctions between exempt and non-exempt employees is crucial for businesses to navigate labor regulations effectively.
Exempt employees, often occupying managerial or professional roles, receive a fixed salary and are exempt from certain wage and hour provisions. On the other hand, non-exempt employees, frequently paid on an hourly basis, are entitled to overtime pay and other wage-related protections.
Accurate classification is vital to ensure compliance with employment laws and prevent legal liabilities.
Review Classifications Regularly
State and country laws change regularly. Therefore, you need to review the classifications of an employee and independent contractor often to ensure you remain compliant. Having a third-party compliance expert help you with this will yield better results.
Talk to a Compliance Expert
Misclassification and wage theft are serious offenses that carry severe consequences for organizations. Talk with a compliance expert to discover how technology can streamline the process of conducting classification audits and help you maintain compliance effortlessly.
