Worker Misclassification with Independent Contractors (ICs) – Worth the Risk?

By: Don Catino, Principal

Employer misclassification of their employees as independent contractors is a pervasive issue and a major concern in the United States today. The Internal Revenue Service (IRS) estimates that employers have misclassified millions of workers nationally as independent contractors creating a ‘tax gap’ of over $400B each year.  This causes substantial losses to the federal and state governments and further contributes to the underfunding of state unemployment insurance and workers’ compensation funds.

While some employers misclassify their workers as independent contractors in error, often employers misclassify their employees intentionally in order to reduce labor costs and avoid paying state and federal taxes.

Misclassified employees are often denied access to the critical benefits and protections they are entitled to by law. These can include: minimum wage, overtime compensation, family and medical leave, unemployment insurance and even a safe workplace.

The IRS, Department of Labor (DOL), individual states and many agencies within the states –  all discourage the utilization of independent contractors (ICs) in order to facilitate easier tax collection and better protect workers’ rights.

As a result, many initial Independent Contractor designations made by employers are being ‘reclassified’ to Employee status in audits with government agencies and through class action lawsuits brought by the ICs who feel they are due more rights as employees.

Clearly bad actor employers who are forcing their workers into IC status in order avoid their own financial obligations to them is wrong and needs to be stopped.  Similarly, ICs who are not reporting or under reporting their income and / or overstating their expenses is not fair to the rest of the taxpaying public and also needs to be stopped … but that is easier said than done.

Hence, current laws and enforcement efforts lean largely toward simply classifying all independent workers as employees.  In fact, in today’s legal landscape, while it is still possible to be a legitimate IC – the law is not in favor of that status and does not make it easy to comply.

The IRS favors W2 employee status because it is easier for them when an employer withholds taxes directly from their W2 employees’ payroll vs. the IRS having to collect those same taxes from the ICs’ individual corporate and personal tax filings.

The DOL favors W2 status based on their belief that ‘employee status’ is the common preference of ‘all workers’ and that all workers wish to have the employer-provided protections and entitlements that the DOL has worked so hard to implement.

Penalties & Awards:

Government audits and class action lawsuits alleging that workers paid on a Form 1099 basis should actually be paid on a Form W2 basis may be able to recover back pay and other benefits for misclassified workers. These workers are found in virtually every sector of the economy, but tend to be concentrated in transportation, technology, car services, staffing, and the sharing or “gig” economy.1099 or W2 penalties

Employers could be subjected to penalties that include 20% of all of the wages paid (50% in California) – PLUS – 100% of both the employee’s and the employer’s share FICA taxes (equal to 12.2%).  Not to mention criminal penalties of up to $1,000 per misclassified worker and one year in prison!

Misclassification awards include:

  • Microsoft agreed to pay $96.6 million to temporary workers who claimed they should have been entitled to benefits under Microsoft benefit plans.
  • A judge approved a $27 million class action settlement brought against Lyft on behalf of California drivers who claimed the ride-hailing company misclassified them as ICs
  • FedEx agreed to pay delivery drivers in 20 states $240 million to settle allegations that the company misclassified drivers as ICs.
  • Hiring agency Arise Virtual Solution for AT&T and Apple accounts agreed to a $1.24 million settlement to resolve allegations that their customer service representatives were misclassified as ICs
  • A $2 million settlement was reached between oil field workers claiming to be wrongly misclassified as ICs and J&A Services LLC.
  • A nationwide class action lawsuit filed by dancers for the Spearmint Rhino adult nightclub resulted in a settlement worth nearly $13 million.
  • Lowe’s agreed to pay $6.5 million plus legal fees to settle a class action lawsuit with workers who claimed they were misclassified as ICs and denied overtime wages and other employee benefits.

The take away:

Independent contractor misclassification and compliance issues are in virtually every industry, regardless of company size or location.  Businesses that use ICs have exposure to a variety of laws and regulations that pose significant liability and/or legal expense to them – especially if they are seen as forcing workers into an unwanted IC status.

So, what’s the problem?

There is a flaw in the DOL’s current approach in assuming all independent contractors wish to be employees and in the IRS’s default belief that ICs are not going to pay their fair share of taxes – And this is a disservice to those individuals who choose to be ICs and conduct themselves according to the rules.

Some of the best and brightest minds in IT & Engineering prefer working for themselves as independent contractors (ICs).  There are many reasons for this, and the tax advantage of a ‘pass-through business’ status is just the latest.  Outside of tax advantages, ICs also enjoy the entrepreneurial spirit of running their own business and solving complex problems for a host of companies in varying industries … all without the office politics involved of the traditional employment ladder.  Perhaps most importantly, highly talented (and confident) workers prefer the IC status because they feel they can perform their craft in a more satisfying and profitable way under this arrangement.

Effectively barring these ‘self-elected’ and law-abiding ICs from the marketplace with overly complicated and often conflicting rules is also a disservice to the clients these ICs serve.  ICs are a considerable and valuable part of the knowledge economy and they can frequently offer clients with less expensive and more flexible offerings compared with their larger business competitors.  But if those clients are too worried about the penalties of misclassification – neither party is able to benefit from the other – and that is wrong.

Who’s who?

How do employers tell if their worker is an IC or a regular W2 employee?  It’s complicated and that is another huge part of the problem.

The IRS, when hunting for lost tax revenue, replaced the old 20 factor test with a more modern Three Factor Test that is centrally focused on who is in control:

  1. Behavioral: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. (If the worker gets training, uses employer tools and supplies or is told when, where and how the work is to be done – that worker is less likely an IC)
  2. Financial: Does the business have a right to direct or control the financial and business aspects of the worker’s job? (If the worker has compensation dictated by the employer, gets expenses reimbursed, cannot work for other employers or can’t incur a financial loss – that worker is less likely an IC)
  3. Type of Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. (If a worker gets employee type benefits, is working under an ‘offer letter’ vs a work order (or SOW or PO) and follows an ongoing Job Description vs a project specific business outcome – that worker is less likely an IC)

In its simplest form – for the IRS – if the employer controls the services that the worker does – then the worker is not an IC.

The DOL, when protecting workers under the Fair Labor Standards Act (FLSA) uses a Seven Factor “Economic Reality’ Test

  1. Is the work performed for the business part of its principal business (if the worker is doing the exact same kind of work as regular employees – that worker is less likely an IC)
  2. Permanency of the relationship (if there is not a specific outcome, result or end date – that worker is less likely an IC)
  3. The worker’s investment in their own equipment (if the worker is on site using the business tools and supplies provided – that worker is less likely an IC)
  4. Control of the worker by the business (if the business says when, where and how the work is done – that worker is less likely an IC)
  5. Worker’s opportunity for profit or loss (if the worker has no downside when the result of their work is not achieved – that worker is less likely an IC)
  6. The amount of open market competition (if the worker was not part of a competitive bid process – the worker is less likely an IC)
  7. The degree of independent business organization and operation (If the worker does not have a Company name, EIN, GL Insurance, Workers Comp insurance, website, offices, other employees and multiple customers – the worker is less likely an IC)

For the DOL – Employees have only one employer and are ‘financially dependent’ upon that employer.  ICs on the other hand are in business for themselves – they invest in their own business operations – can make profit or incur loss and have a broad base of customers.

In addition to DOL and IRS – there is also the EEOC and unique guidelines in each state based on their individual workplace laws.


The Gig Economy has spoken and it seems clear that an ever increasing and desirable portion of the talent pool wishes to be engaged as independent contractors.

Empowering your company to engage the IC community opens the door to some of the brightest minds in the IT & Engineering industry.  They can typically be engaged with more flexible terms and at drastically reduced rates compared to what large consultancies would charge for similar talent.

At the end of the day – the DOL is looking to help reluctant ICs – those working in IC status because the business gave them no other option.  And the IRS just wants to make sure that it is being paid the money it is owed.

When working with reputable tax paying ICs who have happily self-elected this mode of engagement it can be a major win for the ICs and the clients they serve.

See also: Best Practices for IC Engagement.

See also: So you think you want to be an Independent Contractor?

Start working with a recruiting agency that fully understands worker misclassification with Independent Contractors today!

An experienced recruiting agency can be a valuable resource for companies trying to mitigate the risks of engaging independent contractors. Contact one of our IT staffing specialists today!

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