Consequences of Freelancer Misclassification
Freelancer misclassification can be costly, time-consuming, and damage your reputation.
While there are many benefits to working with freelancers instead of hiring employees, the consequences of misclassifying freelancers can be costly, time-consuming, and could cause significant damage to your brand.
What is freelancer misclassification?
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Freelancer misclassification occurs when companies classify workers as 1099 independent contractors when they should be classified as W-2 employees. Businesses are required to ensure that workers are properly classified. When workers are improperly classified, it reduces federal and state revenue collections and leads to improperly classified workers to be deprived of various rights and protections guaranteed to W-2 employees.
Freelancer misclassification can be costly.
Federal criminal penalties of up to $1,000 per misclassified worker and one year in prison can be imposed if you and your company are found to have misclassified employees. Moreover, the person responsible for withholding taxes could also be held personally liable for any uncollected tax. In addition, many individual states also impose additional penalties for misclassification — for example, California penalties for willful misclassification are between $5,000 and $25,000 per violation.
Download Liquid’s Employee (W2) versus Independent Contractor (1099) Compliance Checklist as a handy reference when evaluating your relationships with freelancers.
Here are some specific cases of class action lawsuits or U.S. Department of Labor investigations that resulted in costly settlements for the employer:
- In May 2014, Paul Johnson Drywall Inc. of Phoenix, Arizona, paid $600,000 in back wages, damages, and penalties to 445 current and former misclassified employees as a result of a U.S. Department of Labor investigation.
- In 2016, FedEx agreed to pay $240 million to settle a class-action lawsuit filed by drivers in 20 states who alleged they had been misclassified as independent contractors.
- Mittl v Lowe’s Home Centers LLC. In 2017, Lowe’s agreed to pay up to $2.9 million to 450 New Jersey installers to settle this class action lawsuit alleging it had misclassified workers as independent contractors.
- Venegas v. Global Aircraft Service, Inc. In 2017, this aircraft maintenance company agreed to a settlement to pay more than $1 million to a group of 33 workers who had filed a class action lawsuit.
- In 2018, direct mail company RPG Enterprise LLC (dba Planet Direct Mail) paid more than $750,000 in back wages, damages, and penalties to 73 employees as a result of a U.S. Department of Labor investigation into misclassification, recordkeeping, and overtime issues.
As you can see, fines and damages for freelancer misclassification can total millions of dollars. IRS penalties for misclassifying workers as independent contractors can range from 22% to 43% of all freelancers’ earnings retroactive to the initial engagement. According to ADP, more than one-third of midsize businesses have been fined or penalized for misclassification issues.
Freelancer misclassification can be time-consuming.
If you end up being investigated by the U.S. Department of Labor, IRS, or state authorities, you will be subjected to a lengthy audit. You will be required to provide and submit paperwork proving that you have classified your workers properly. In addition, you will likely have to engage legal counsel to ensure the best outcomes for your business. This is why most lawyers in California and New York insist that their clients separate their independent contractor contracts and payments from W-2 employee payroll and processes.
Freelancer misclassification can damage your brand.
In 2019, Conde Nast experienced damage to their brand after two freelance journalists made accusations on Twitter that Conde Nast was misclassifying employees as independent contractors to avoid paying benefits. As a result, the New York Department of Labor investigated Conde Nast’s freelancer hiring practices. In addition, the story was picked up by many media outlets, and Conde Nast was subjected to intense scrutiny and negative press.
This kind of brand damage can lead both to impacts on your revenue but also on your reputation, making it potentially harder to compete for top talent — whether independent contractors or employees.
Properly classifying freelancers with Liquid.
There are clear benefits to working with freelancers. The cost of hiring an independent contractor is approximately 30% less than the cost of hiring an employee, and working with freelancers allows you to be agile and pay only for the on-demand project-based work you need. The key is to do it properly. When you use Liquid, you get features made for businesses working with freelancers — making it easier to stay compliant with independent contractor compliance regulations.
Ready to improve your freelancer compliance processes and reduce your risk? Try Liquid today.
Updated: January 13, 2021
Quick note: This is not to be taken as tax advice or legal advice or payroll advice. Since tax rules and laws change over time and can vary by location and industry, consult a CPA / tax advisor and/or attorney for specific guidance.