Employee Misclassification: What You Need To Know

Employee misclassification is one of the costliest compliance mistakes global companies make. In the U.S., 10–30% of employers have misclassified at least one worker and the consequences can escalate quickly when international hiring is involved. For instance, Nike had to pay a $530M fine for misclassification.

Governments are tightening enforcement, expanding audits, and increasing cross-border data sharing. If you’re building global teams, you need to get this right—legally and operationally.

This guide breaks down:

• What counts as misclassification (and why it happens)
• Global employee misclassification penalties by country
• How to fix existing employee misclassification issues
• Tips to avoid employee misclassification lawsuits 
• How EOR like Tarmack helps you mitigate exposure proactively

Let’s begin with the basics.

What is Employee Misclassification?

Employee misclassification happens when someone legally qualifying as an employee is hired or treated as an independent contractor.

This distinction matters because employees are entitled to protections like minimum wage, paid leave, social security, severance, and collective bargaining. Contractors are not.

Misclassification may be:

• Intentional, to avoid taxes or benefits
• Accidental, due to global legal complexity or unclear job scopes

Either way, regulators won’t care. The liability is yours.

Legal tests by country: who’s an employee?

There’s no universal rule. Every country applies its own test to determine whether someone counts as an employee. Here’s how the standards vary:

Why Employees Get Misclassified

Sometimes it’s intentional (to save on taxes or avoid benefits). More often, it’s because:

Global growth moves faster than HR

Startups entering new markets often default to contractors. It’s fast. No local entity, no payroll setup. Just onboard and go. But in countries with large informal workforces, say 61% globally, governments crack down hard, especially if the worker is full-time or central to operations.

The rules keep shifting

In March 2024, the U.S. Department of Labor made contractor classification stricter. And internationally, things get even more complex. In France, control over hours or tools can trigger employee status. In Germany, economic dependence is enough.

Compliance gets deprioritized

It’s common to think: “We’ll fix it later.” But that delay can cost you. Misclassification issues have paused expansions, triggered audits, and even blocked fundraising rounds.

If you’re hiring across borders, these global expansion complexities are the operational risks with real financial impact.

It feels cheaper

Contractors seem like a budget win. U.S. businesses save an average of $3,710 per worker each year by avoiding benefits and taxes. But if the classification doesn’t hold up, that short-term gain can spiral into back pay, fines, and reputational risk.

Penalties for Employee Misclassification

For misclassification, you may have to face: payroll tax liabilities, contract nullification, blocked expansions, or reputational risk. These risks vary country to country, such as:

Risk Insight: Even one misclassified hire can trigger a full-company audit in some jurisdictions.

How to Fix Existing Misclassification Issues

Start by auditing your current workflows across all countries, entities, and employment types. Follow these steps to do it right:

First 7 Days: Triage Mode

Start by isolating the high-risk cases.

• Stop all problematic hiring patterns. Pause current global hiring for roles where classification is unclear. This avoids adding to your risk exposure while you assess the existing ones. 

Learn how to pay international employees.

• Identify the gray-zone workers. Use your compliance audit or decision tree to flag workers where control, financial dependence, or integration points suggest employee status.

Step-by-Step Audit Checklist

• Do we have clear contracts and classification criteria for every worker?
• Are we applying the same classification standards across countries?
• Has a legal review of our worker types in each jurisdiction?
• Are any contractors managing people, using company tools, or working full-time hours?
• Are we treating freelancers and employees differently in practice (benefits, performance reviews, etc.)?
• Do we have documentation in place for how each classification decision was made?

Export this into a formal audit template for legal or HR leadership to review.

• Start estimating financial exposure. This includes unpaid benefits, overtime, paid time off, and tax liabilities, especially if the worker has been classified as a contractor but behaves like an employee.
  
• Loop in external counsel. You’re dealing with cross-border tax and labor law. A local employment attorney or global compliance firm should validate every classification decision and correction step.

Pro Tip: Internal legal teams often focus on risk mitigation, not employee sentiment. Pair them with HR for a more balanced implementation strategy.

Month 1: Address the Clearest Cases

Once legal risk is triaged, start executing on what’s clear.

• Reclassify the obvious cases. Prioritize workers who perform employee-like duties under company-set schedules or tools. Re-issue offer letters or contracts with the correct classification.
  
• Issue retroactive pay adjustments. Where legally required, offer back pay for benefits, overtime, or holiday pay. Document this clearly to demonstrate good-faith remediation.
  
• Clean up contracts and records. Misclassification often stems from outdated or vague scopes of work. Ensure contracts, payment terms, and role descriptions reflect the reclassification.
  
• Communicate proactively. Don’t wait for workers to hear about reclassification through rumors or email threads. Use a tailored communication template to explain what’s changing, why, and how it benefits them.

Months 2–3: Resolve the Complex Cases

Tackle the gray areas and build guardrails to avoid future problems.

• Bring in multi-country legal expertise. A contractor in France may have a different threshold for employment status than one in Singapore. Context matters.

• Implement stronger classification protocols. That means using a consistent decision matrix or tool (some EORs offer this) at the time of hiring. (Find out the best EOR providers)
  
• Train hiring managers and budget owners. Most misclassification risks begin with team leads who don’t understand legal boundaries. One training session can prevent dozens of future compliance issues.
  
• Introduce internal audit checkpoints. Add a classification review step in onboarding workflows, payment approvals, and vendor procurement.

🚩 Red Flag Indicators Table

Cultural & Geographic Considerations

Misclassification is not interpreted the same way across borders. Misclassified workers might’ve been excluded from team benefits, ignored in culture initiatives, or left out of key communications. That damage doesn’t disappear with a reclassification form.

• Acknowledge the issue directly. Don’t spin it as “just a compliance update.” Be transparent.
  
• Offer support during the transition. Think: onboarding materials, new team introduction, benefits walkthrough, and a clear point of contact.
  
• Monitor morale post-reclassification. The shift may create friction with managers or peers, especially if expectations shift or salary bands are adjusted.

When to Consult Legal (Again)

You should bring in legal experts:

• When you have multi-country exposure
• When making back pay offers
• Before sending communication to affected workers
• When calculating penalties or correcting tax filings

How to Classify Workers Correctly Moving Ahead

Most misclassification problems come down to one thing: mistaking labels for legal reality. Here’s how to get it right:

1. Look at how the work is done

Does the person control their hours? Bring their own tools? Make independent decisions? If they’re reporting to your managers and working fixed shifts, you’re likely looking at an employee, even if the contract says “freelancer.”

2. Use the right legal test for each country

Classification rules aren’t global. The UK looks at supervision and substitution rights. Brazil focuses on subordination and habitual service. In the U.S., you might deal with IRS 20-factor tests, FLSA, or ABC laws depending on the state. You’ll need localized assessments, not general frameworks.

3. Make this a cross-functional decision

Classification decisions affect more than legal. HR, finance, and compliance all carry downstream risk: from payroll tax errors to equity misallocations. This isn’t a task to pass around in isolation.

4. Bring in infrastructure that’s built for this

If you don’t have in-house counsel in every region, an EOR gives you the legal infrastructure to engage talent without running afoul of misclassification rules. At Tarmack, we’ve helped companies de-risk their international hiring by using localized frameworks.

5. Keep a record. Recheck when roles evolve

Regulators won’t care what you intended. They’ll look at what’s on record. Keep a clear audit trail of how you classified each worker, why, and when it was last reviewed. And revisit them when responsibilities shift.

Monitor for “Employee-Like” Signals

Red flags include:

• Fixed work hours
• Core team Slack access
• Email IDs under your domain
• Task management in company tools
• Recurring monthly invoices for same scope

💡 Tip: When in doubt, classify conservatively or use an Employer of Record (EOR).

Tarmack Handles Classification the Right Way, From Day One

Classification risks aren’t isolated to contracts. They show up in how you onboard, pay, manage, and renew. Tarmack builds guardrails into every part of that process.

You get:

• Country-specific logic baked into every classification decision
• Contractor and employee agreements that reflect actual working terms
• Alerts when worker setup drifts from compliant thresholds
• Audit-ready records without scrambling before a deadline

And if you’re already mid-scale, we’ll help you review your current setup, flag missteps, and clean up the backend without disrupting operations.

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