Misclassifying Workers as Independent Contractors: 3 Steps to Avoid Lawsuits

Growing a team for your online business can present amazing growth opportunities. You can secure the best talent from a pool of nationwide applicants and maintain flexibility within your business operations. However, growing a team presents new challenges you’ll have to navigate before making your next hire. 

One of the most costly mistakes business owners make is misclassifying workers. You may not have thought much about this before now. It’s easy to overlook when you’re mainly hiring VA’s and other contractors for small projects. But if you’re looking to hire for larger, more long-term roles to scale your business, understanding how workers are classified is a MUST. 

Whether you intentionally or unintentionally misclassify workers, doesn’t matter. You can face tax penalties through the IRS along with fines from each state (and potential lawsuits from workers). 

In this blog post, I’ll share 3 steps you should follow to avoid tax penalties and lawsuits for misclassifying your workers.  

Step 1: Analyze the working relationship

Let me start by saying that the misclassification of workers pertains to misclassifying employees. If you are planning to hire someone who will function as an employee in your business but treat them as an independent contractor, you have legally misclassified them. This conduct is what opens you up to tax penalties and potential lawsuits. 

If I had a penny for every business owner that asked me to draft contracts for a new independent contractor that actually functions (or will function) as an employee in their business…. I’d be a very rich woman…. (and likely sitting on the beach drinking a margarita instead of writing this blog post!).  

Just because you want someone to be a contractor to avoid payroll taxes, social security taxes, unemployment taxes, and other expenses doesn’t mean they are a contractor under legal standards. Whether a worker is deemed a contractor or an employee depends on the working relationship. 

Here are the 3 factors states and the IRS use to determine whether a worker is a contractor or an employee:

1. Behavioral control − Does the company control or have the right to control what the worker does, who they work with, or how the worker does the job?

2. Financial control − Does the business direct or control the financial and business aspects of the worker’s job? Are the business aspects of the worker’s job controlled by the payer? Things like how the worker is paid, are expenses reimbursed, who provides tools/supplies, etc.

3. Relationship of the parties − Are there written contracts or employee type benefits such as pension plan, insurance, vacation pay? Will the relationship continue and is the work performed a key aspect of the business?

In analyzing these 3 factors, two major tests are used in the United States: Common Law Test and ABC Test.

Under the Common Law Test, states that follow this model presume that workers are employees. Whereas under the ABC Test, workers are presumed to be contractors. 

Understanding which states use which tests will help you in your analysis. Which brings me to step #2.  

Step 2: Look at the laws in each worker’s state

Whether a worker is deemed an employee or an independent contractor will ultimately depend on the laws in their state. While every state will follow some version of the tests outlined in step #1, this can be tricky for online businesses that are hiring workers nationwide. 

For some online entrepreneurs, making the decision to avoid hiring workers in states like California, can be a way to safeguard against hefty fines for misclassification. (In California, penalties range from $5,000 – $15,000 for intentional misclassification. If there is a pattern of willful misclassification, the courts can fine employers an additional $10,000 to $25,000. (Source: https://www.romerolaw.com/blog/2022/05/what-are-the-penalties-for-misclassifying-employees-in-california/))

Wherever you decide to hire, make sure you’re familiar with their laws on worker status and utilize written agreements to clearly state the worker’s status. 

Step 3: Get help!

If you’re not sure, or you’re concerned that you may have misclassified some workers, get help! Every situation and business is different, so it’s important to gain clarity for your specific situation. 

• Contact a Lawyer – My law firm doesn’t specialize in employment law, however, we’ve worked with numerous online entrepreneurs through our Legal Audit Intensives in making these determinations. 
• Get HR support – I’ve worked with Jumpstart HR over the years, and love how helpful and practical their advice is for small business owners. They have vast experience in supporting online businesses who hire workers nationwide. 
• Check with the IRS – I know that reaching out to the IRS is probably the last thing you want to do. However, they offer a number of resources to help answer questions so that you aren’t misclassifying your workers.

Hopefully this helps you gain a better understanding of the tax and legal implications of misclassifying your workers. By following these steps, you can stay on the right track in growing your business and avoiding this costly mistake!