Contractor or Employee? The Risks of Misclassification

💡 TL;DR

Misclassifying workers as independent contractors instead of employees can lead to significant legal and financial consequences. This guide details the dangers of misclassification, how to determine proper worker classification, and steps to ensure compliance.

What Is Worker Misclassification?

Worker misclassification happens when an employer incorrectly categorizes an employee as an independent contractor. As a result, the worker may be denied important benefits and labor protections guaranteed under laws like the Fair Labor Standards Act (FLSA). Misclassification also exposes the employer to serious risks, including fines, penalties, audits, and substantial legal liabilities. To help organizations make the right determination, various federal, state, and international agencies have published specific guidelines for properly classifying workers.

General Differences Between Employees and Independent Contractors

How to Determine Proper Classification

To correctly classify workers, consider the following factors:

1. Behavioral Control: Does the company control or have the right to control what the worker does and how the worker does their job?

2. Financial Control: Are the business aspects of the worker’s job controlled by the payer? (e.g., how the worker is paid, whether expenses are reimbursed, who provides tools/supplies)

3. Type of Relationship: Are there written contracts or employee-type benefits (e.g., pension plan, insurance, vacation pay)? Will the relationship continue, and is the work performed a key aspect of the business?

Consequences of Misclassification

• Legal Consequences: Misclassifying workers can expose businesses to serious legal risks. Potential consequences include lawsuits for wrongful termination, unpaid wages, denied overtime, and missing benefits. In addition, businesses may face claims under labor laws and anti-discrimination statutes. When multiple workers are affected, these issues can escalate into costly class action lawsuits.

• Financial Penalties: Worker misclassification can lead to substantial financial repercussions. Businesses found in violation may be required to pay back taxes, unpaid wages, and accrued interest. Additionally, government agencies such as the IRS or Department of Labor may impose steep fines and penalties. These costs can quickly escalate—especially if the misclassification affects multiple workers or spans an extended period of time.

• Operational Disruptions: Misclassification claims can lead to audits, investigations, and legal actions that drain resources, disrupt operations, and distract leadership. Employee morale may suffer, and in some states, violations can trigger stop-work orders—forcing a temporary shutdown until compliance is achieved. Audit findings often necessitate an overhaul of policy and processes. 

Steps to Ensure Compliance

• Build Compliance into New Vendor Onboarding: Integrate worker classification checks into the new vendor process to ensure proper vetting before work begins. Strategic sourcing, Accounts Payable and Procurement are often the gatekeepers here and can help align the process for bringing in new vendors.

• Self Audit to Evaluate Your Current State:  Once you’ve resolved the problem with new vendor onboards, you can breathe easy, the problem is no longer growing. It’s time to evaluate the current state by self-auditing, and putting together the necessary action plan based on your findings.  Worksuite can help with a comprehensive plan, and consult on best practices for self-evaluation and identification of your embedded base of contractors.

• Use Clear Contracts: Define the nature of the working relationship explicitly to ensure the scope of work is well-defined, project-specific, and includes clear acceptance criteria. This not only helps mitigate misclassification risk but ensures alignment on objectives. This reduces the potential for future disputes–especially when contracts are stored in a central repository for easy access..

• Educate Management: Companies should educate hiring managers on their worker classification process and policy to ensure consistent, compliant decision-making during recruitment and engagement. Informed managers are less likely to make missteps that could lead to legal, financial, or reputational risks related to misclassification.Ensure those involved in hiring understand classification criteria.

• Partner with Industry Experts for Peace of Mind: Protect Yourself: Worker classification laws are complex and constantly evolving—making mistakes can be costly. Partnering with an industry expert like Worksuite helps ensure your processes are correct from the start. Our platform automates onboarding, integrates compliance checks, and provides a central repository for contracts. Most importantly, we back up the classifications with indemnification, giving your business added protection and peace of mind.buy our indemnification product or Companies like Worksuite have resources that help you protect yourself from misclassification. We can automate onboarding, create clear templated contracts, and indemnify you against errors to ensure you are always in compliance with federal and local laws.

Proper worker classification is essential to avoid legal issues and maintain business integrity. By understanding the differences between employees and independent contractors and taking proactive steps to ensure compliance, businesses can mitigate risks associated with misclassification.

Frequently Asked Questions

Q: What triggers a misclassification audit?

A: Common triggers include worker complaints, unemployment and worker’s compensation claims, tax discrepancies, wage and hour violations,  routine tax audits and industry-targeted sweeps.

Q: Can a contract alone determine worker status?

A:  No, a contract alone does not determine a worker’s classification. While it's an important component, auditors and regulators focus on the actual working relationship—not just what’s written on paper. They will evaluate factors such as control, independence, and how work is performed to assess whether the classification aligns with legal standards.

Q: Are there tools to help with classification?

A:  Yes—platforms like Worksuite provide automated tools to streamline onboarding, embed compliance checks, and centralize contracts. Most importantly, we offer indemnification, giving your business added protection and peace of mind.

Need assistance with worker classification? Schedule a demo with Worksuite to learn how our platform can help ensure compliance and streamline your workforce management.