How should you arrange your workforce? Engaging independent contractors (sometimes called ‘freelancers‘, ‘contract workers’, or just ‘contractors’), can save your business in costs, time, and energy. However, it also comes with a significant risk of ‘misclassification’: This occurs where a business has treated a worker as a contractor when they should have treated them as an employee. Misclassification can result in a substantial tax bill, penalties, and amounts owing to employees.
Read all about independent contractor agreements at What is an Independent Contractor Agreement?
In this guide, we explain what the difference is between independent contractors and employees, and set out steps you can take to mitigate the risk of misclassification.
The Rise of Independent Contractors
There has been significant growth in the use of independent contractors, rather than employees, over the last few years. Upwork’s 2019 ‘Freelancing in America’ study indicated that 35% of the United States workers are currently freelancers, an increase of 4 million since 2014. Perhaps more striking was the increase in freelancers who worked full-time, from 17 to 28 percentage points over that period. There is every sign that COVID-19 is accelerating the existing trend to hire independent contractors over permanent employees.
While the practice has become more popular, the difference between an employee and contractor is narrowing: For example, law reforms put in place in California and New York state, place many of the same obligations on businesses, whether they are engaging contractors or employees.
Nevertheless, while the distinction between contractors and employees remains, businesses will need to manage the risk of misclassification.
What is an Independent Contractor?
Contracts are the key legal tool for a business to protect its rights. A business may enter into contracts to lease or purchase goods or property. A business can also enter into contracts for services from individuals. We call the individuals engaged through this contract an ‘independent’ contractor, as they work ‘at arm’s length’ from the company. By contrast, the work of an employee is more closely connected to the operations of the enterprise itself. This is a loose way of describing the difference between the two types of workers. But as we shall explain below, there is no conclusive test as to whether an individual is an employee or a contractor – it requires weighing up a range of different considerations. We explain this in further detail below.
‘Independent contractor’ is usually not a distinct business structure according to the tax and regulatory systems that operate within a country. Rather, an independent contractor can operate through various business structures such as sole proprietor, limited liability company (LLC) or trading trusts.
Independent contractors are sometimes confused with staff hired through a contract staffing agency. Those staff are not usually directly contracted with the client company, and instead are engaged indirectly via the staffing agency’s contract. These workers are not ‘independent’, as they operate only through a third party.
What Are the Benefits of Engaging Independent Contractors?
There are quite a few benefits to engaging independent contractors. These include:
To find out more about the advantages and disadvantages of hiring contractors and employees see What Are the Advantages and Disadvantages of Using International Contractors?
What Is the Risk of Misclassifying Workers?
The benefits of engaging independent contractors mean that many businesses have a preference for hiring contractors, rather than employees. This presents a risk, however. The risk is that businesses may ‘misclassify’ workers as contractors where they are, or should be treated as, employees. The concern of regulators is that businesses are depriving workers of the benefits that they are entitled to (such as insurance, pension contributions, and paid time off).
There is also a concern from tax agencies that this reduces the overall tax take (as contractors are responsible for paying their own taxes).
As a result, in various countries, regulators are cracking down on businesses that misclassify. We explain classification in further detail below.
To read more about the different tax obligations that apply to businesses hiring employees and businesses hiring independent contractors see What is Payroll Tax?
How do you Determine Whether a Worker is a Contractor or an Employee?
The test that is applied in the United States is based on three key questions:
Note, the considerations above are not legal criteria: No one factor or set of factors must be present for an individual to be classified as a contractor rather than an employee. It is a matter of weighing up the factors in each individual case to come to an overall judgment.
How Can You Best Manage Misclassification Risk?
In order to best manage the risk of misclassifying a worker as a contractor, we recommend that you:
When making strategic human resources decisions, enterprises need to consider carefully whether independent contractors or employees or a mix of the two, are the best choice for their business. This means having an in-depth understanding of the difference between a contractor and an employee. Where expanding internationally, New Horizons Global Partners can provide advice on the best options for your business, which may include outsourcing or a global PEO solution.