Employee misclassification: Lawsuits, penalties, legal risks, and how to avoid them

Employee misclassification — treating someone like an employee while labeling them a contractor — can cost businesses millions.

Hiring independent contractors unlocks speed and agility, especially in the global hiring race. But there’s a catch: if you get the classification wrong, you’re looking at lawsuits, regulatory audits, and six-figure penalties.

With remote work on the rise and cross-border teams becoming the norm, the risk of misclassifying workers, whether due to oversight or ambiguity, has never been higher.

According to the US Department of Labor (DOL), misclassification has resulted in billions of dollars in unpaid taxes and denied benefits. For example, Uber alone agreed to pay New Jersey  $100 million in back taxes and penalties from misclassification investigations in 2022.

That’s where compliance tools like Multiplier’s Contractor of Record, also known as Agent of Record (AOR), come in — helping businesses accurately classify and manage contractors across borders while reducing legal risk.

In this guide, we’ll explore the legal implications of misclassification, real lawsuits that made headlines, and how your company can avoid becoming the next cautionary tale.

To start, let’s define exactly what employee misclassification means in the modern workforce.

What is employee misclassification?

Employee misclassification happens when a company labels a worker as an “independent contractor” while treating them like a regular employee.

In practice, this might look like:

• Setting fixed work hours
• Requiring exclusivity
• Providing company-owned equipment
• Assigning tasks under tight supervision

These behaviors contradict the autonomy that independent contractors must retain under the law.

Intentional vs. unintentional misclassification

Some companies knowingly misclassify workers to cut costs on taxes, insurance, and benefits. Others may do so unintentionally due to complex or unclear classification rules. Regardless of intent, both forms can lead to legal penalties, fines, and back payments.

Regardless of why it happens, misclassification carries serious consequences for companies of any size.

Why employee misclassification matters

Beyond compliance, misclassification affects your employer brand, finances, and global expansion strategy. Governments are aggressively pursuing cases to protect worker rights and recover lost tax revenue.

Understanding these risks begins with a clear grasp of the legal frameworks that dictate worker classification in various jurisdictions.

The legal landscape: Laws governing classification

Before you classify a worker as a contractor, you must understand how the law views that relationship.

Federal regulations

• Fair Labor Standards Act (FLSA): Establishes minimum wage and overtime rights.
• Internal Revenue Service (IRS): Uses a 3-factor control test: behavioral, financial, and relationship control.
• National Labor Relations Act (NLRA): Protects collective bargaining rights — contractors aren’t covered.

State-specific laws

Some states apply even stricter tests. For example:

• California’s ABC test: Workers are presumed employees unless the company proves:
  • The worker is free from control
  • The work is outside the usual course of business
  • The worker is independently established

Regional classification standards and key legislation (Global comparison)

Employee classification is regulated differently across regions, creating complex compliance challenges for global companies.

These frameworks vary, but the takeaway is consistent, i.e., if you treat someone like an employee, the law likely will too.

Severe consequences: Lawsuits, penalties, and risks

Misclassification isn’t just a technical error; it can unravel your business operations.

Financial penalties and back wages

Misclassifying workers can lead to severe financial consequences across multiple categories, from tax violations to unpaid benefits. Here’s a breakdown of potential liabilities:

1. Tax violation fines

• Up to 3% of total wages paid to misclassified workers
• 100% of unpaid FICA taxes
• Up to 40% of employer-side taxes not withheld
• $50 per unfiled W-2 form

2. Federal law violation fines

• Civil penalties up to $1,000 per misclassified employee
• Retroactive payment of employee benefits

3. Back pay and overtime

• Repayment of unpaid overtime, severance, bonuses, and even healthcare contributions

4. US penalty structure breakdown

Misclassification often results in underpaid taxes and social contributions. Governments may require employers to pay retroactively.

• Income tax withholdings and social security contributions
• Employer-side payroll taxes and insurance premiums
• Unpaid benefits including paid leave, bonuses, and pension contributions
• Interest and  penalties on overdue amounts

To avoid costly mistakes, consider using Multiplier’s misclassification assessment tool.

Here’s a closer look at common violations and the penalties they may trigger:

Legal actions and litigation

Misclassified workers and government agencies can take legal action, leading to costly lawsuits and reputational damage.

Common types of legal actions include:

1. Individual lawsuits

Workers may sue for unpaid wages, denied benefits, and damages.

2. Class-action lawsuits

One misclassification can lead to dozens of retroactive claims.

3. Government eEnforcement

Agencies like the IRS and DOL conduct audits often triggered by whistleblowers or tax discrepancies.

In 2021, DoorDash settled a misclassification lawsuit worth over $ 100 million, with more than $16 million going directly to misclassified contractors. The court determined drivers were managed like employees but denied the associated benefits.

Criminal penalties

Intentional misclassification can carry criminal consequences, including imprisonment for up to one year in some jurisdictions.

Reputational damage

Besides fines, lawsuits damage your brand, hinder hiring, and may affect investor confidence.

Regulatory scrutiny and audit defense (What regulators examine)

When facing investigation or litigation, authorities scrutinize these critical factors:

Classification assessment matrix

Use the matrix below to identify key factors that distinguish contractors from employees — and understand the compliance risk each carries:

Defense strategy considerations

If answers indicate employee-style control, companies may still face liability, regardless of contractual language. Successful defense requires:

• Comprehensive documentation of business relationship
• Evidence of contractor’s independent business operations
• Proof of arm’s length commercial arrangements
• Demonstration of industry-standard practices

Why companies get misclassification wrong: Common triggers

Even well-intentioned companies misclassify contractors due to the common misclassification triggers mentioned in detail below.

How to avoid misclassification: Best practices for compliance

Preventing misclassification begins with understanding legal tests, maintaining proper documentation, and adhering to clear operational boundaries. Here’s how to stay compliant:

Understanding the tests

Use the IRS’s 3-prong test (behavioral, financial, and relationship control) or the ABC test where applicable.

Clear documentation and agreements

Contracts should define:

• Scope of work
• Autonomy
• Tax responsibilities
• No eligibility for benefits

Operational best practices

Don’ts:

• Set working hours
• Provide equipment
• Restrict other contracts

Dos:

• Pay per project/milestone
• Use contractor’s own tools
• Let them work independently

Seeking expert legal counsel and compliance solutions

Engage labor law attorneys and tools like Multiplier’s COR solution to avoid slip-ups.

Even with best practices, managing contractors globally can be complex — this is where a COR solution helps.

When to use a Contractor of Record solution

A COR can help you stay compliant when managing independent contractors globally. Use cases typically involve high compliance risk or operational complexity:

Ideal COR use cases

Consider a Contractor of Record when: