The costly consequences of misclassifying your independent contractors

The odds are high that you’ve either done some freelance 1099 work yourself or know somebody who has. The number of independent contractors increased to 60 million Americans in 2022—the highest it’s ever been. In the tech industry alone, the percentage of job postings for contract roles jumped from roughly 6% in 2021 to 20% in 2022. The number of contractors is only expected to increase with Statista expecting 90 million freelancers in America by 2028. 

It’s easy to see why businesses are eager to work with independent contractors. A variable workforce model allows companies to grow and scale sustainably without the many financial obligations inherent in a more fixed, full-time W-2 workforce—including employment benefits, administrative overhead, and FICA taxes.

In a global economy defined by its frenetic pace and unpredictable nature, a nimble and distributed workforce gives businesses the ability to adapt seemingly overnight to new ideas, technologies, and opportunities. 

The perilous pitfall? Worker misclassification. The National Employment Law Project estimates that 10% to 30% of US employers are misclassifying their workers as independent contractors based on the organization’s analysis of state labor reports. 

Source: National Employment Law Project

To protect workers and maximize tax revenue, the government fines companies seriously for misclassifying full-time employees as independent contractors. In California, businesses pay anywhere from $5,000 and $15,000 per violation and an additional $10,000 to $25,000 for repeated willful misclassification.

Simply put, independent contractor misclassification can be dangerous for companies, especially those that heavily rely on contractors to generate revenue and service their customers. 

What are the dangers of misclassifying employees?

Whether or not misclassification is intentional, it comes with serious consequences for businesses. Both government agencies and employees can take legal action against your company, resulting in massive fines, significant reputational damage, and more. 

FLSA violations

The Department of Labor (DOL)’s Fair Labor Standards Act (FLSA) is a federal law aimed at protecting both full-time and part-time workers against unfair labor practices. It sets standards for minimum pay, record keeping, overtime compensation, and youth employment.

Under the Act, organizations must classify their workers as either "exempt" or "non-exempt" from the FLSA's provisions. Workers classified as independent contractors are exempt from FLSA coverage—which deprives them of labor protections, such as minimum wage guarantees and entitlement to overtime pay.

Misclassifying employees as exempt under the FLSA can lead to serious fines and even criminal prosecution. The Department of Labor will fine companies up to $1,000 for each FLSA violation to compensate employees for back wages and liquidated damages. If convicted for the second time, the employer may face imprisonment.

IRS tax penalties

One of the primary consequences of misclassification is lower tax revenue due to IRS fines. 

An employer is responsible for withholding and paying Federal Insurance Contributions Act (FICA) taxes on behalf of the employee—including federal Social Security taxes, Medicare taxes, and unemployment taxes.When found guilty of misclassification—and therefore, of withholding FICA taxes—the employer can be required to pay:

• A $50 fine for every W-2 Form the company failed to file for a misclassified worker
• A penalty of 1.5% of the wages paid
• 40% of the FICA taxes the employee didn’t pay and 100% of the matching FICA taxes the employer failed to pay
• 100% of the FICA and income taxes not previously withheld from the employee in case of deliberate misclassification
• Compensation for Social Security and Medicare tax a misclassified employee has been paying out-of-pocket as a self-employed professional

These fines can add up, especially if you engage hundreds or thousands of contractors. Just consider the ride-sharing app Uber.  In September 2022, the company and its subsidiary, Rasier LLC, paid $100 million in unpaid state payroll taxes and penalties to the New Jersey Office of Administrative Law after being convicted of misclassifying nearly 300,000 drivers as gig workers between 2014 and 2018.

State labor violations

Along with following IRS and FLSA regulations, some states also have their own laws to supplement these rules. These state-level misclassification laws vary from state to state.

In California, the scooter company Lime faced fines due to violating the state’s misclassification laws. Lime classified its workers who took care of the company’s scooters as independent contractors, but plaintiffs argued that under California law, these workers should be considered employees. 

The lawsuit, filed under California's Private Attorney General Act (PAGA), alleged violations of California's Labor Code, including minimum wage and reimbursement provisions. The court has approved an $8.5 million settlement for the case.

Reputational damage

When contractors come forward to demand fair treatment, they often get wide exposure on social media and media outlets that can potentially hurt employers’ images. 

Meta’s content moderator contractors in Austin, for example, took action in 2019 to expose their poor working conditions. They used Meta Workplace, the company's internal communication system, to share their grievances—including getting paid 14 percent of the median Meta salary, few opportunities for raises, psychological trauma from reviewing graphic posts, and restricted breaks. 

After the Washington Post picked up the story and detailed contractors’ grievances, Meta found itself in the public eye, labeled as a tech giant that treated its contractors as “second-class citizens. The company didn't help its cause 3 years later  in 2022 when there were allegations about the mistreatment of African contractors by Meta in 2022.

What constitutes misclassification of workers?

To avoid misclassification penalties, companies need to follow federal and state guidelines for determining the appropriate worker classification. Use these guidelines to determine whether workers are independent contractors or employees. 

To keep reading, download our brand new ebook: "2024 Edition: The Ultimate Guide To Worker Classification."