Worker misclassification

How do authorities decide someone is an employee, not a contractor?

Authorities look at the substance of the working relationship, not what the contract says. Key factors include whether the business controls how and when the work is done, whether the person works mainly for one client and whether they bear real financial risk.

In the UK, HMRC uses an Employment Status Indicator and refers to case law on control, substitution and mutuality of obligation. In the US, the IRS uses a common-law behavioural and financial control test, supplemented by recent Revenue Ruling 2025-3.

What are the financial consequences of misclassification?

Consequences include back taxes, interest, penalties and the cost of any employment entitlements the worker should have received. In the US, unintentional misclassification triggers IRS Section 3509 reduced rates: 1.5% of wages for income tax withholding plus employer FICA obligations.

In the UK, HMRC pursues unpaid PAYE and employer NICs, and the misclassified worker can bring tribunal claims for unpaid holiday pay, minimum wage arrears and pension contributions. Settlement sums routinely reach five or six figures per individual where the engagement has been long-running.

Does IR35 change anything for UK businesses?

IR35 is the UK's specific rule for contractors working through their own personal service companies. It shifts the obligation to assess employment status onto the end client in most cases, meaning misclassification risk sits firmly with the business, not the contractor.

If HMRC determines that IR35 applies, the business must account for PAYE and NICs as though the contractor were an employee. The rules have applied to medium and large private-sector clients since April 2021.

Can you fix a misclassification before it becomes a formal investigation?

Yes, and acting early usually reduces the cost. In the US, the IRS Voluntary Classification Settlement Program (VCSP) lets businesses reclassify workers as employees and pay a reduced settlement covering only a portion of past tax liability.

In the UK, speaking to HMRC proactively before an enquiry opens generally results in lower penalties than waiting to be investigated. Teamed's employment-law team can help you assess current contractor arrangements and plan a compliant transition.

Frequently asked questions

• Does signing a contractor agreement protect my business from misclassification claims?+

  No. A contractor agreement records the parties' intention, but tax authorities and employment tribunals look at how the relationship actually works in practice. If the day-to-day reality looks like employment, the contract label will not protect you from back-tax assessments or worker claims.
• Who is liable when an Employer of Record (EOR) employs workers on your behalf?+

  When you engage workers through an EOR, the EOR is the legal employer and handles payroll tax withholding and employment compliance. Misclassification risk shifts because the workers are not contractors at all: they are formally employed. Your obligation is to ensure the arrangement is set up correctly from the start.
• Is worker misclassification treated the same way in every country?+

  No. Tests, penalties and enforcement intensity vary significantly. The UK uses employment status criteria developed through case law and HMRC guidance. The US applies IRS common-law and economic-reality tests. Countries such as France, Spain and Australia each have their own frameworks with different thresholds and penalty structures.
• What is the difference between worker misclassification and IR35?+

  Worker misclassification is the broad concept: treating any employed person as a contractor. IR35 is the UK's specific tax rule that targets contractors working through a personal service company where the underlying relationship would otherwise be employment. IR35 is one mechanism through which UK misclassification is caught and taxed.

Related terms

• IR35
• Independent contractor vs employee
• Employer of Record (EOR)
• Permanent establishment (PE) risk