28 May Navigating the Complexities of Global Talent Classification

When hiring global talent, proper employee classification quickly becomes complicated. Engaging a diverse workforce of remote workers, distributed employees, and international contractors while adhering to various country laws and payroll regulations is a significant challenge. 

Misclassifying an employee as a contractor can seriously violate labor laws and employee rights, denying them pay, benefits, tax withholdings, and other legal protections. Companies must ensure compliant employee classification or face severe penalties, including fines, back pay, tax and labor violations, legal disputes, loss of intellectual property, and reputational damage.

This guide, some of which were lifted from Velocity Global, discusses employee misclassification penalties and how businesses can avoid them.

Five misclassification penalties to avoid:

Misclassification negatively impacts both the employer and the worker. Employers risk severe legal, financial, and operational penalties. Misclassification penalties depend on several factors, such as the severity of the misclassification, company size, and the duration of unpaid employment benefits and taxes. Misclassification laws vary worldwide, with each country having its own regulations and subsequent penalties.

1. Tax violations and fines

In most countries, employers withhold and pay taxes for national programs like social security. For example, in the US, the Internal Revenue Service (IRS) requires employers with W-2 employees to withhold and pay Social Security and Medicare taxes, pay unemployment taxes, and withhold and remit employee income taxes. 

Meanwhile, businesses engaging 1099 workers, also called contractors, do not withhold or pay taxes on behalf of their contractors; contractors are responsible for their own taxes. If an employer misclassifies an employee as a contractor, they must pay back taxes with accrued interest and may face additional fines and penalties if the misclassification was intentional. Legal fees and court costs can also arise from misclassification disputes, and employers may lose certain tax benefits, deductions, and credits.

2. Wage and labor law violations

Employees are entitled to wage rights and labor law protections, such as overtime pay, minimum wage, worker’s compensation, retirement, medical insurance, vacation, and sick pay. Misclassification denies these entitlements, and employers must retroactively pay any unpaid wages or overtime and provide any owed benefits.

3. Legal disputes and costs

Misclassification can lead to class-action lawsuits seeking punitive and special damages. These disputes incur additional costs, attorney fees, resources, and time, and increase the likelihood of wage claim audits and further scrutiny of tax practices.

4. Loss of intellectual property

Misclassification can create issues with intellectual property. If misclassification severs an employment relationship, the worker could claim ownership of their work and the company’s intellectual property. Proper classifications and protections in employment contracts are essential, especially for contractors and remote workers in other countries.

5. Damaged business reputation

Employers risk a negative standing among industry peers, customers, and prospective talent. A company violating labor laws may cause employees to leave or deter potential talent. High-profile misclassification cases can also damage the company’s reputation with investors and industry peers.

Avoiding employee misclassification penalties

Despite the severity of penalties, companies can avoid them with due diligence:

• Understand workforce differences: Employers must understand the difference between contractors and employees as regulated by local laws.
• Draft compliant employment agreements: Establish transparent contractor agreements that define the working relationship, adhere to tax requirements, and follow local regulations.
• Seek expert legal counsel: Consult legal counsel or an employer of record (EOR) to review agreements, navigate regulations, and ensure proper classification and compliance.
• Convert contractors to employees: Consider converting contractors to employees to ensure compliance, protect intellectual property, and retain top talent.

Employee misclassification: why authorities care

Governments worldwide are concerned about preventing misclassification to maintain a fair and equitable labor market. US agencies like the IRS and the Department of Labor (DOL) play critical roles in enforcing employment regulations and educating employers about proper worker classification. Key reasons include:

• Tax revenue: Proper classification ensures appropriate tax withholding, contributing to government revenue.
• Government programs and benefits: Misclassification undermines funding for programs like Social Security and Medicare.
• Worker protections: Proper classification ensures employees receive protections like minimum wage, overtime pay, and workers’ compensation.
• Unemployment insurance: Ensures workers access benefits during job loss or economic downturns.
• Health and safety regulations: Misclassified workers may miss out on regulations ensuring workplace safety.
• Employment discrimination laws: Misclassification can inadvertently remove protections against discrimination.
• Fair competition: Proper classification ensures a level playing field among businesses.

The proper ideal employee classification

Recent updates to the US Department of Labor (DOL) regulations provide clearer guidelines. The new rule effective March 11, 2024, adopts a multifactor, totality-of-the-circumstances analysis, emphasizing the economic reality test. This approach evaluates six factors to determine if a worker is economically dependent on the employer or in business for themselves.

Employers must review classification practices, update contracts to reflect true working relationships, and consult HR professionals or legal counsel to ensure compliance.