Independent contractor misclassification: What it is, real-world examples, and best practices to avoid it in 2025

The rise of independent work is transforming how businesses scale. From agile startups to global enterprises, companies are increasingly relying on 1099 talent to grow quickly, remain flexible, and expand across borders. And why not? Compared to traditional hiring, the independent contractor vs employees model offers access to specialized skills without the long-term costs and obligations of full-time staff.

However, in 2025, a growing compliance problem emerges that businesses can’t ignore: independent contractor misclassification.

At a glance, it might seem harmless. However, misclassifying someone who should be legally treated as an employee can lead to serious legal, financial, and reputational damage. In this guide, we’ll break down what independent contractor misclassification means, what’s changed this year, and what you can do to stay compliant without slowing down your hiring strategy.

What is independent contractor misclassification?

Simply put, independent contractor misclassification occurs when a business treats someone as an independent contractor (issuing them a 1099 form) when they should legally be classified as a W-2 employee.

This distinction is critical, not only for tax purposes, but also for ensuring legal compliance. If you’ve ever Googled what a W2 form is, it refers to the IRS tax form used to report wages paid to employees and the taxes withheld. It serves as a clear marker of employment status.

The independent contractor vs employees distinction goes beyond paperwork. It determines who qualifies for benefits, who’s protected under labor laws, and who bears tax responsibilities.

Here’s a quick look at how the two compare:

This independent contractor misclassification doesn’t just affect the business; it can have a direct financial and legal impact on the worker as well.

Why independent contractor misclassification matters more than ever in 2025

As we head deeper into 2025, regulators are cracking down on the misclassification of employees as independent contractors. In the U.S., the Department of Labour’s Final Rule has shifted the classification landscape by emphasizing a six-factor economic realities test, making it harder for businesses to justify contractor status. California continues to enforce the strict ABC test under AB5, and the IRS is ramping up audits and cross-agency data sharing.

Globally, the UK’s IR35 legislation, the EU Platform Work Directive, and Asia-Pacific frameworks in Australia and Singapore are all tightening definitions. For remote-first teams hiring across borders, the compliance complexity is growing.

Even well-meaning companies can get caught off guard. In recent years, multiple companies across industries, including SaaS startups and global logistics firms, have faced regulatory delays during audits and funding rounds due to confusion surrounding independent contractor vs employee classification. These weren’t bad actors; they were simply businesses that were moving quickly and struggling to keep up with the evolving labor rules. Reclassifying misclassified workers after the fact isn’t just a legal fix; it can slow down hiring, trigger back payments, and complicate investor relations.

Real-world examples of independent contractor misclassification risks

Independent contractor misclassification isn’t theoretical. Large companies have already paid the price. Microsoft settled a $97 million lawsuit after misclassifying temporary workers. The company had to overhaul its contractor management processes and implement stricter internal audits. Similarly, FedEx was forced to pay out $228 million after misclassifying delivery drivers as independent contractors, leading to years of legal disputes and restructuring.

These are cautionary tales. However, they also demonstrate the benefits of acting early. The businesses that course-correct quickly are often better off in the long run — less legal risk, smoother operations, and more investor confidence.

These examples underscore how independent contractor misclassification can escalate from oversight to crisis if not addressed early.

Why does misclassification happen?

From what we’ve seen, independent contractor misclassification often starts with good intentions and a lack of clarity. Founders and HR leaders are typically trying to move fast, stay lean, and minimize unnecessary overhead. When you’re unsure whether a hire will be long-term, calling them a contractor seems easier.

There are a few recurring themes:

• Cost savings: No need to cover payroll taxes, benefits, or insurance.
• Administrative ease: Contractors don’t require onboarding into HR systems.
• Ambiguity in law: Classification rules vary between countries and even within the U.S. states.

Sometimes, companies hire global talent without fully understanding local labor laws, and that’s where problems begin. Take Portugal, for example. According to recent guidance, Portuguese labor law presumes an employment relationship if a worker maintains a set schedule, operates under direct supervision, and receives consistent payments, even if they’ve signed a contractor agreement. In other words, it’s not the contract title that matters — it’s the working conditions. Misclassifying such workers as independent contractors can quickly invite independent contractor misclassification penalties and scrutiny from local authorities.

Legal and financial risks of misclassifying employees as independent contractors

The penalties for misclassifying employees as independent contractors have never been higher. In the U.S., companies can face:

• Up to $25,000 per misclassified worker in California alone
• Retroactive payroll taxes, including Social Security and Medicare
• Wage reimbursements and unpaid overtime
• Class action lawsuits from misclassified workers
• Public reputational damage, which can hurt hiring and fundraising

And in countries like the UK and across the EU, regulators can go further, demanding reclassification and levying back taxes even if a worker was hired through an overseas entity.

How to identify if you are misclassifying contractors

You don’t need to be a legal expert to spot misclassification red flags. We have developed a quick checklist based on key triggers auditors look for to detect the misclassification of employees as independent contractors:

• Does the person work regular, fixed hours?
• Are they using your company’s internal systems (email, project tools)?
• Are you reviewing their performance like you would a full-time employee?
• Have they worked with you for more than 6 months without a break?
• Are they prohibited from working with other clients?

If you answered “yes” to more than a couple of these, you may be misclassifying that person.

Best practices to avoid independent contractor misclassification in 2025

We have seen that the best strategy is to be proactive. Don’t wait for an audit or a lawsuit to re-evaluate your hiring practices. Start with these steps:

• Use role-specific, legally sound contracts: Define the scope of work, IP ownership, payment structure, and independent status clearly.
• Schedule regular classification reviews: As roles evolve, so should classifications.
• Stay informed: Bookmark resources from the U.S. Department of Labor (DOL) or trusted compliance blogs, such as Sanford Tatum and Rise.
• Reclassify when needed: If a contractor is now integral to your operations, it’s time to convert them to a W-2 employee.

AOR and EOR: simplifying compliance with workforce solutions

If all this sounds complex, there’s good news. You don’t need to build an international HR team from scratch.

Instead, platforms like Multiplier can act as either an:

• Agent of Record (AOR) for managing true contractors compliantly
  An AOR handles onboarding, contracts, and payments for freelancers, ensuring they meet local legal definitions of independent contractors. This reduces the risk of accidental misclassification while giving your contractors autonomy.
• Employer of Record (EOR) for reclassifying long-term contractors into legal employees
  An EOR becomes the legal employer, handling benefits, taxes, and labor law compliance in the worker’s country. It’s a safe way to convert critical contractors into full-time employees without setting up foreign entities.

This means they handle the legal contracting, payroll (in local currency or crypto if needed), and compliance reporting, giving you peace of mind and more time to focus on scaling your business.

The cost-benefit of getting classification right

Investing in proper classification isn’t just about avoiding fines; it’s a smart business decision. Companies that prioritize compliance often find that it leads to smoother operations, reduced legal exposure, and greater trust from stakeholders and investors.

Consider this: issues related to misclassification of employees as independent contractors are frequently flagged during due diligence. If a company has long-term contractors who meet employee criteria, it can trigger delays, raise legal concerns, or even jeopardize a funding round. On the other side, having clear independent contractor misclassification policies and working with a reputed platform like Multiplier shows you’ve thought through your global workforce strategy and mitigated compliance risk.

Whether you are preparing for an audit, a financing event, or scaling into new markets, getting this right upfront can save months of clean-up and costly legal backtracking later.

Final thoughts: don’t wait for an audit

Independent contractor misclassification is a significant concern, not merely a legal technicality — it’s a real business risk that can derail growth, scare off investors, and damage your brand. In 2025, tackling this issue early is one of the most effective ways to future-proof your hiring strategy.

The good news? It’s entirely manageable. A classification audit is a smart first step toward minimizing risk. And with a global employment platform like Multiplier, you get the tools and support to avoid independent contractor misclassification — even as your team grows across borders.

Ready to get it right from the start? Book a demo with Multiplier today.