Disguised Employment: Definition, Risks & How to Avoid It

Disguised employment is one of the most misunderstood and most risky workforce issues for modern businesses. It often starts with good intentions: hiring quickly, reducing costs, or working with flexible talent. But when an individual is labelled as a “contractor” while working like an employee, the consequences can be serious.

Governments and tax authorities across the world are paying closer attention to how companies classify workers. Misclassification penalties are rising, audits are becoming more common, and businesses are increasingly expected to prove that their workforce model is compliant.

This guide is designed to be a single source of truth on disguised employment. We’ll explain what it is, why it happens, how different countries define it, the risks involved, and most importantly, how your organisation can avoid it.

What is disguised employment?

Disguised employment occurs when a worker is formally engaged as an independent contractor but functionally treated as an employee.

While the contract may describe a freelance or consulting arrangement, authorities look at the reality of the working relationship. If the worker operates under employee-like conditions, the engagement may be reclassified.

Globally, regulators apply a “substance over form” principle, meaning that labels and contracts matter less than how the work actually happens day to day. Here are some of the key differences between an independent contractor/freelancer and a full-time employee:

Feature	Independent contractor	Employee
Control	Controls how and when work is done.	Directed by the employer on how and when to work.
Integration	Performs services outside the core business operation.	Integrated into the organisation's structure and operations.
Tools/Equipment	Provides their own tools and equipment.	Uses company-provided tools and workspace.
Financial risk	Bears their own financial risk of profit/loss.	Receives a fixed salary/wage regardless of profit.
Exclusivity	Free to offer services to multiple clients.	Generally works exclusively for one employer.

Signs of disguised employment (red flags)

Courts and tax authorities globally use various tests to determine the worker's true status. While the names of the tests differ (e.g., Common Law Test, Economic Realities Test, ABC Test), the underlying "red flags" are remarkably similar:

• High degree of control: The company dictates the worker's daily working hours, where they must perform the work, or the specific methods they must use.
• Integration into operations: The worker uses the company's email address, business cards, letterhead, or is listed in the internal directory.
• Provision of equipment: The company provides the main tools of the trade (e.g., a laptop, specialised software licenses, or a dedicated desk).
• Lack of business autonomy: The contractor is prevented from hiring their own help or substituting another person to complete the work.
• Exclusive relationship: The contractor is forbidden or strongly discouraged from working for other clients, making them economically dependent on the hiring company.
• Payment structure: The worker is paid a fixed salary or an hourly rate that mirrors a traditional employee, rather than being paid upon completion of specific, defined deliverables or projects.
• Permanent relationship: The contract is open-ended, continuous, or repeatedly renewed, indicating a permanent need for the service rather than a defined project.

Why disguised employment happens

Disguised employment rarely happens because an employer is trying to be malicious. It often stems from a desire for convenience or a misunderstanding of the legal requirements.

Common reasons

• Speed and flexibility: Contractors are faster to onboard.
• Cost considerations: Avoiding payroll taxes and benefits.
• Cross-border hiring: No local entity to employ workers.
• Misunderstanding the law: Assuming a contract alone defines status.
• Rapid scaling: Compliance deprioritised during growth phases.

Industries such as construction, logistics, and the gig economy are especially exposed. 

Common risks for employers and workers

The consequences of employee misclassification are severe and often retroactive, impacting the company's past dealings with the misclassified worker, and while often framed as an employer risk, misclassification also harms the worker in several ways

Financial exposure

• Backdated income tax and social security contributions
• Employer penalties, interest, and fines
• Retroactive benefits such as paid leave, pensions, or insurance

Studies show that misclassified workers, like a typical construction worker, can lose over $19,000 per year in wages and benefits, costs that may later be reclaimed from employers through enforcement actions.

Legal and reputational risks

• Employment claims (unfair dismissal, redundancy pay)
• Government audits and investigations
• Public enforcement actions and reputational damage
• Director or officer liability in some jurisdictions

Crucially, liability often rests with the employer - even if the worker agreed to contractor status.

Consequences for the worker

While often framed as an employer risk, misclassification also harms the worker:

• The worker loses access to core protections like minimum wage, overtime pay, and workplace safety regulations.
• They are ineligible for unemployment insurance if the contract ends and they lose access to employer-sponsored health and retirement plans.
• The contractor is responsible for paying the entire self-employment tax (both the employer and employee share).

How countries define disguised employment

There is no single global definition of disguised employment. Each country applies its own legal tests, but most focus on similar principles.

• The United States (US): Relies on multiple tests depending on the issue and agency.
  • IRS (Taxes): Uses the Common Law Test (20 factors of control).
  • Department of labour (Wages/Hours): Uses the Economic Realities Test, focusing on the worker’s dependence on the business.
  • State-level (e.g., California): Many states use the stringent ABC Test, which presumes a worker is an employee unless the company can prove three things:
    1. (A) The worker is free from the control and direction of the hiring entity.
    2. (B) The worker performs work that is outside the usual course of the hiring entity’s business.
    3. (C) The worker is customarily engaged in an independently established trade, occupation, or business.
• The United Kingdom (UK): Uses the "three-tier" approach: Employee, Worker (an intermediate category with some employment rights), and Self-Employed. The status is determined by Mutuality of Obligation (is the employer obliged to provide work and the worker obliged to accept it?) and Control. The UK's IR35 rules are designed specifically to combat disguised employment in the public and private sectors.
• The European Union (EU): While no single EU law exists, directives often emphasise the need for protection. Member states generally focus on factors like subordination, dependency, and organisational integration.

How to avoid disguised employment in your organisation

Protecting your business from disguised employment requires a proactive, company-wide commitment to compliance and a deliberate workforce design.

Best practices

• Select the correct engagement model from the start
• Structure contractor roles around defined projects
• Avoid long-term exclusivity arrangements
• Limit managerial control and internal integration
• Review worker status regularly as roles evolve

When uncertainty exists, choosing a compliant employment model is often safer than relying on contractor arrangements.

Assessing worker status: Practical checklist

Use this checklist for every new contractor relationship and regularly audit existing ones to identify risks early:

• Who controls how the work is performed?
• Can the worker refuse tasks?
• Can the worker substitute someone else?
• Does the worker serve multiple clients?
• Is the engagement time-based or outcome-based?
• Who provides equipment and tools?
• Is there an expectation of continuous work?

If most answers indicate control and dependency, the risk of disguised employment is high.

Tools for worker classification

Understanding the global rules of labour laws is often too complex for internal teams alone. Thankfully, specialised tools and services can help:

Common tools

• Worker classification assessment platforms
• Compliance questionnaires and scoring models
• Local legal and tax reviews
• Employer of Record (EOR) solutions like Native Teams
• Centralised workforce management systems
• Contractor of Record (CoR) solutions

These tools support better decisions, but should be paired with legal guidance.

Conclusion

Disguised employment is rarely intentional, but intent doesn’t matter when regulators assess risk. What matters is reality: if a worker operates like an employee, they are likely to be treated as one - regardless of what the contract says.

As this guide shows, the risk is not theoretical. From backdated taxes and penalties to worker claims and reputational damage, the consequences of getting worker classification wrong can be severe - and often far more expensive to fix retroactively than to prevent in the first place. 

The solution isn’t to avoid flexibility - it’s to apply it correctly. That means clear role design, limited control, regular status reviews, and a solid understanding of local rules go a long way in preventing disguised employment. When uncertainty exists, choosing a compliant employment model protects both the business and the worker.