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.
In this guide, we look in depth at the difference between employees and independent contractors, and set out steps you can take to mitigate the risk of misclassification.
Key Takeaways
1. It is becoming increasingly common to hire independent contractors or freelancers instead of employees.
2. There are pros and cons to hiring employees and independent contractors, respectively. The appropriate choice depends on the specific needs of the individual business.
3. The key difference between employees and independent contractors is the degree of control exercised over the workers.
4. Businesses need to manage their contractors carefully to avoid the risk of misclassifying workers.
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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.
To confuse matters, in the US, independent contractors often go by the popular name ‘1099 employees‘.
While the hiring of independent contractors may have become more popular, the difference between employees and independent contractors seems to be 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.
In spite of these legal developments, as long as there is a difference within the law between employees and independent contractors, businesses will need to consider carefully how they can manage the compliance risk posed by independent contractors (more on this below).
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 different 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:
- Cost
- Contractors do not have full employee benefits. This means that your business is not liable for administering a range of benefits that it would otherwise be required to hand out. These compulsory benefits may include insurance and pension contributions and paid time off.
- Flexibility
- In general, contractors can be terminated more easily than employees. This makes it easier to scale up and down the size of your workforce depending on the needs of the business at a particular time. For this reason, independent contractors are often considered the core component of the contingent workforce.
- Compliance ease
- While the compliance obligations towards contractors are increasing in recent years (see the note above in relation to California), in general, businesses have far fewer legal and compliance obligations towards contractors than they do towards employees.
To find out more about the difference benefits of engaging independent contractors in an international context, 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. The UK Government recently introduced off-payroll working laws (IR35) to deal with the issue. We explain misclassification in further detail below.
How Do Authorities Establish the Difference Between Employees and Independent Contractors?
The test that is applied in the United States is based on three key questions:
- Behavioral Control
- Is the business able to direct and control the worker, even if that right is not exercised? Behavioral control could be demonstrated through the type of instructions given, the degree of instruction (more instruction is indicative of employment), and training procedures or methods (the presence of training is more indicative of an employee).
- Financial Control
- Is the business able to direct or control the financial and business aspects of the worker’s job? Relevant factors include the method of payment (regular payments with pay stubs or payslips will generally be indicative of employment), whether the worker is free to seek work elsewhere (more likely to be a contractor), and whether their expenses are generally reimbursed (if not, they are less likely to be an employee).
- Relationship
- How do the worker and business perceive their interaction with one another? Relevant information will include how any written contract describes the relationship that is to be created, the existence of benefits, and the degree of permanence of the relationship.
Many other countries make identify a similar difference between employees and independent contractors, including the United Kingdom and Australia.
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 employee misclassification, we recommend that you:
- Develop a Human Resources (HR) strategy
- Your enterprise should have a plan in place for the organization to determine the appropriate proportion of contractors and employees. For example, Upwork, a major international contracting/freelancing platform, has found that around 450 full-time employees to 1,100 contractors, is the right mix for its business needs. Being intentional about the workforce reduces the chance of engaging a worker as a contractor when they should have been employed.
- Consider also, as part of this strategy, whether direct sourcing could be a useful alternative to recruiting wholly new employees and contractors.
- Consider outsourcing non-essential functions
- By outsourcing functions (such as payroll, human resources, or benefits administration), a company can minimize the overall number of workers that need to be hired.
- Regularly review worker status
- The relationship between a worker and a business is dynamic and changes over time. Roles should be regularly reviewed to ensure that workers are still correctly classified.
- An independent contractor agreement should specify the conditions and pay that apply to independent contractors.
- Depending on the outcome of this review, the individual may need to be transferred from an independent contractor agreement to an indefinite employment contract. If you offer full-time employment to a candidate, consider whether to offer a conditional offer or an unconditional offer.
- Consider a Professional Employer Organization (PEO)
- A PEO becomes the ’employer of record’ for your workforce. This means that the PEO takes on compliance and tax obligations for your employees. Note, depending on the country of operation, this might be a ‘co-employment’ arrangement, where your company still retains some responsibility for the employees.
- Consider Contractor Management Outsourcing (CMO)
- Contractor management outsourcing means engaging a third party to conduct all administration and payments for independent contractors. Read more about this expansion solution here.
- Consider Setting Up a Foreign Subsidiary
- By setting up a foreign subsidiary or company in the target country, majority owned by your business as the ‘parent company’, you will be in a position to directly hire employees in a foreign country.
Conclusion
When making strategic human resources decisions the balance or mix of employees and independent contractors that might be the best choice for their business. This means having an in-depth understanding of the difference between employees and independent contractors. Where expanding internationally, Horizons can provide advice on the best options for your business, which may include contractor management outsourcing or a global PEO solution.
Frequently asked questions
The short answer is that employers have a much higher degree of control over employees than a client does over independent contractors. The long answer is that tax authorities (such as the IRS) apply a lengthy list of questions to determine whether or not an individual is an employee or an independent contractor.
This depends entirely on the priorities of the individual. Employees usually have longer engagements, greater payment protections and a legal right to various benefits (such as pension schemes and paid sick leave).
Independent contractors, on the other hand, often earn more than their employee counterparts and have greater day-to-day freedom in how they carry out their tasks.
