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Labor and Employment

Employee Misclassification: Navigating the Legal Landscape

Written by

Zoe Aharon

October 20, 2024

Businesses must comply with a wide range of state and federal labor laws when hiring employees, one of the most critical being employee classification laws. These regulations ensure that workers are properly classified as either employees or independent contractors, protecting their rights to benefits such as expense reimbursements, overtime pay, health insurance, and retirement contributions.

While federal laws like the Fair Labor Standards Act (FLSA) provide some guidance, many employers exploit ambiguities in the classification rules to avoid financial liabilities such as taxes and benefits. This issue has led courts and regulators to implement stricter guidelines, such as the “economic reality test” or state-specific laws like California’s AB-5, to help clarify the difference and protect workers' rights.

What is employee misclassification?

Employee misclassification, also referred to as job misclassification, occurs when businesses falsely classify contracted full or part-time employees as contracted employees. And unfortunately, this practice isn’t so uncommon. According to the National Employment Law Project, between 10% and 30% of U.S. employers misclassify their workers as independent contractors, creating significant financial and legal implications.

This illegal practice denies these employees rights and benefits, such as health insurance, overtime pay, unemployment benefits, and workers' compensation that they would otherwise be entitled to under the Fair Labor Standards Act (FLSA).

But how does the FLSA differentiate between employees and independent contractors? Well, it’s not so clear. And here is where the problem lies. The distinction is murky, and employers may try to use this ambiguity to pass off a worker as an independent contractor for their own financial and tax benefits.

However, the FLSA does loosely define the terms employer, employee, and employ as the following:

Employer: Any person acting directly or indirectly in the interest of an employer in relation to an employee.
Employee: Any individual employed by an employer.
Employ: To suffer or permit to work.

Therefore, to make it easier for employers and the courts to distinguish between employees and independent contractors, both state and federal courts have taken action.

Protecting employee rights: Federal legislation to combat employee misclassification

On January 10, 2024, The Wage and Hour Division of the Department of Labor modified the Employee or Independent Contractor Classification Under the Fair Labor Standards Act

(29 CFR Parts 780, 788, and 795 of the FLSA) and implemented what’s referred to as the Final Rule.

Effective on March 11, 2024, this rule amended its previous 2021 guidance and clarified how courts should differentiate between employees and independent contractors.

The proposed rule builds on judicial precedent and introduces a more structured approach using the "economic reality test" to assess a worker's level of independence or economic dependence on the employer.

In the past, the Department of Labor and most courts have traditionally used a “dependence-for-work” test, which looks at whether a worker relies on the employer for their job or operates independently through their own business. However, some courts have applied a “dependence-for-income” approach instead, in which they focus on whether or not a worker has other income sources or is financially dependent on their employer.

But, according to the Final Rule, “economic dependence is the ultimate inquiry, and that an employee is someone who, as a matter of economic reality, is economically dependent on an employer for work—not for income.”

The economic reality test

Unlike states such as California, Illinois, Pennsylvania, Washington, and Nebraska, that apply a separate “ABC test,” the economic reality test is the federal standard for determining a worker’s standing and provides six factors that must be considered:

The extent to which the work performed is an integral part of the employer's business.
The worker's opportunity for profit or loss depending on their managerial skill.
The extent of the relative investments of the employer and the worker.
Whether the work performed requires special skills and initiative.
The permanency of the relationship.
The degree of control exercised or retained by the employer.

The economic reality test focuses on the actual nature of the relationship between employers and their workers, rather than just the terms of any written agreement, making it harder to misclassify them.

Penalties for misclassifying workers as independent contractors

There are a myriad of penalties for misclassifying workers as independent contractors. Employes may even face criminal penalties if they are found to have willfully misclassified workers.

Employers may be required to pay:

Reimbursement expenses: This refers to compensation owed for any out-of-pocket costs that should have been covered as business expenses, such as mileage, supplies, or equipment, restoring the financial support these employees were entitled to receive.
Back wages and overtime pay: Employers may be required to pay back wages for unpaid minimum wages and overtime. Under the FLSA, non-exempt employees are entitled to minimum wage and overtime pay at 1.5 times their regular rate for hours worked over 40 in a week. Misclassified workers may be owed these wages.
Liquidated damages: Employers may be forced to pay workers an additional amount equal to their back wages as liquidated damages as compensation for the delay in back wage payment.
Benefits: Employers may be responsible for paying employees the value of benefits owed, such as health insurance, retirement plans, and paid leave.
Interest: Employers might need to pay interest on unpaid wages and taxes.
Legal fees: If the case goes to court, employers may be responsible for covering both their own legal fees and the employee's.

Have employee misclassification lawsuits been successful in the past?

Absolutely. The unlawful act of misclassifying workers is seen across all industries. But over the past decade, it’s been particularly prevalent amongst gig-economy roles, such as ride-share drivers, where the lines between employee and contractor can become hazy. At Darrow, it’s no different–we’ve seen a number of employee classification cases that fall in this category.

This is because gig-workers often have flexibility in choosing when and how they work, yet the platforms they rely on maintain significant control over factors like rates and performance. This creates a mix of independence and management that blurs classification. Also, many gig roles are project-based, resembling independent contracting, but workers' financial dependence on a single platform can make their situation more like traditional employment.

Are there other regulations against employee misclassification besides the FLSA?

The FLSA legislation against employee misclassification is the primary federal regulation, but there are several others that exist in the U.S., including:

The IRS

The IRS regulation that addresses worker misclassification is primarily enforced through the Internal Revenue Code (IRC). The IRS uses a series of guidelines, sometimes referred to as the Common Law Test, to determine whether a worker is classified correctly as an independent contractor or employee.

If a worker is misclassified, the employer may face penalties for failing to withhold taxes, such as Social Security and Medicare contributions, and for not paying unemployment taxes.

National Labor Relations Act (NLRA)

Enforced by the National Labor Relations Board (NLRB), the NLRA protects workers’ rights to unionize, collectively bargain, and engage in other protected activities. When employees are misclassified as independent contractors, they lose these protections, which is a violation of the NLRA. The NLRB can investigate and penalize employers for such misclassification.

State employment laws

Several states have enacted their own employment laws to address the issue of employee misclassification, providing protections that go beyond federal regulations. These laws often impose stricter standards than federal law to prevent employers from wrongly labeling workers as contractors to avoid paying taxes or benefits.

For example:

California’s AB-5 Law: The ABC Test: California adopted the ABC test through Assembly Bill 5 (AB-5), which places strict criteria on classifying workers as independent contractors. Under this law, a worker is considered an employee unless the employer can prove that the worker is free from control, performs work outside the usual course of the business, and is engaged in an independently established trade.
Right to Control Test: Another commonly used test, the Right to Control Test examines the extent to which an employer has control over a worker's tasks and processes. It looks at how much direction an employer provides in terms of how, when, and where the work is done. According to the Right to Control Test, the more control an employer has over the details of how work is completed, the more likely a worker is considered an employee.
New Jersey’s Worker Misclassification Law: New Jersey implemented legislation that not only strengthens the ABC test but also includes heavy penalties for employers who misclassify workers. The state can issue stop-work orders, impose fines, and hold employers responsible for unpaid wages, benefits, and taxes.

Using technology to detect employee misclassification cases

Technology and AI-powered research applications can dramatically accelerate legal research and help lawyers discover cases faster, leaving them more time to litigate and fight for justice.

At Darrow, we’ve developed our own in-house intelligence infrastructure, driven by generative AI, that goes beyond traditional legal analysis to evaluate the merits of potential employee misclassification cases.

Using our own technology, we recently investigated and sold an employee misclassification case to a leading law firm against a large US-based package delivery company. The case has an estimated six thousand plaintiffs and a value of $13.5 million in damages.

But how did we do this?

Using anomaly detection algorithms, we developed an AI-powered Justice Intelligence Platform that processes hundreds of thousands of publicly available documents, including job review sites, to identify potential employee misclassification violations.

With this data, our team of in-house lawyers were able to successfully detect a string of offenses, claiming that the company violated the FLSA and the economic reality test on many occasions.

Interested in working with us to find your next case? Talk to one of our legal experts.

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