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This Is Why It's Critical to Avoid Employee Misclassifications

Oversights stemming from gray areas can lead to major legal repercussions.

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There has been a major shift in the U.S. workforce since the onset of the pandemic: the rise of freelancing and remote work. More than two million adults in the U.S joined the freelance workforce since 2019, and that number is projected to hit 86.5 million by 2027. The income of freelancers increased by 22% from 2019 to a stunning $1.2 trillion, fueled in part by an influx of younger, highly skilled professionals seeking flexible alternatives to traditional employment.

The trend started a few years ago, but has been accelerated by the pandemic. The main reason is both the fact that skilled workers lost their jobs and opted to take on freelancing, and that when one out of four Americans are working remotely, the distinguishing factors between employees and freelancers becomes reduced significantly.

The booming freelance economy has gained the attention of governments, which worry that companies are defining their employees as freelancers or contractors in order not to pay taxes and social benefits. In addition to that, freelancers can make business deductions that employees cannot, leading to large amounts of public revenue being lost. Contractors are also not subject to legal protections that the law provides, such as minimum wage, paid leave or worker’s compensation, which protects both the employer and employee.

Related: When Is Hiring Freelancers a Good Idea?

According to a whitepaper by Stoke Talent, a freelancer-management system, freelancers on average cost about 35% less than employees, which is significant for companies. It can result in an unfair market environment, where companies are incentivized to hire contractors rather than employees to avoid additional costs.

Legal repercussions

This has led several states to legislate “freelancer” laws and the IRS to increase penalties for misclassifications that can currently reach up to $3 million. State and federal penalties can include administrative fines for noncompliance, paying back pay with interest, civil lawsuits and even jail time for intentional misclassifications. 

It is important to note that this is not only a U.S concern. The U.K. has legislated the “off payroll” law, the HMIS has increased penalties, and Germany is currently going through a similar situation.

Related: Think Twice Because Your Freelancer Might Legally Be an Employee

Classification tests

So how do organizations differentiate between independent contractors and employees? 

The U.S. Department of Labor (DoL) under the Fair Labor Standards Act (FLSA) does not use the same test as the IRS, making the waters muddy when it comes to understanding contractors versus employees. The IRS utilizes a 20-factor system broken down into three sections, where they look at how much control the employer has over the person, how the person gets paid and the type of relationship they have. The FLSA uses the Economic Reality test, in which the DoL considers if the person is financially dependent on the organization or if he or she is self-employed. 

Even states use other tests to classify, with the ABC test being born out of California. It consists of three parts: The worker is free from the control and direction of the company that hired him or her while he or she performs his or her work, the worker is performing work that falls outside of the organization’s usual business, and the worker is consistently engaged in work of the same nature. The test is extremely strict in that the worker must meet all three qualifications in order to be classified as a freelancer. It was a major win for Uber and Lyft drivers to be classified as employees; however, the second item heavily restricted the freelance industry. Freelance workers such as writers were no longer being hired by media companies, as per the new law, they had to be hired as employees, which is not the nature of the industry. The bill has since been modified to include exemptions.

Related: Uber, Lyft Drivers Are Employees, According to California Regulator

The employer-employee relationship is bound by laws that explicitly define employee compensation and social benefits. On the other hand, the terms of the organization-contractor relationship are defined by the two entities.

The problem is that even with the best of intentions, ensuring your non-payroll workers (freelancers, contractors and consultants) aren't misclassified isn’t easy. The Stoke Talent whitepaper states that most CFOs underestimate the number of freelancers they hire by more than 70%. With such high penalties, it is becoming increasingly more important for companies to clarify their work relationships, and it is in their best interest to be extremely mindful from the moment they onboard new team members and contractors to avoid any oversights. 

Farhana Rahman

Written By

Entrepreneur Leadership Network Contributor

Farhana Rahman has represented tech startups for over 10 years as a PR and digital marketing professional. She's passionate about individuals, companies and trends that are well on their way towards disrupting industries, and offers approachable actionable insights on how to stay ahead of the curve.