Contractor Models aren’t a Good Fit

When Payroll and Contractor Models aren’t a Good Fit. Introducing EOR

Table of contents

Key Takeaways

  1. There is no one size fits all employment model
  2. Contractor misuse can open a company up to charges of misclassification
  3. An Employer of Record can provide a good middle ground between opening an entity and using contractors
  4. Opening an entity often makes sense once a critical mass of 10-15 employees has been reached

When it comes to employment models, there is no ‘one size fits all’ solution. While payroll is the most stable and far-reaching choice, it also has the most risk and liability associated with it. In contrast, a contractor model has the least administrative overhead attached, but you’ll need a smart contractor management solution to scale up, and you also need to stay on top of misclassification risk.

Finding What Works for Your Business

This decision often comes to a head when organizations are considering onboarding staff in a new country. Setting up an entity in a new place is a legal prerequisite for using the payroll model, but this can be costly and time-consuming, especially if you’re only looking to hire one or two new people, or you aren’t sure how long you’re going to be sticking around in the new location. If you decide not to keep a presence in the location long-term, you might also need to continue to pay tax while you dissolve the entity, which can’t happen overnight.

One answer is to use a contractor model. However, this has its own challenges. especially when it comes to understanding misclassification, an issue that is becoming increasingly complicated.

Contractor Complexity

In the US for example, the ABC test, expanding the way that organizations need to define an employee, is already active in California, Virginia and New Jersey. among other states. In California, as just one example, employers that misclassify contractors according to this definition can be liable for between $5,000 and $15,000 in fines for each individual offence, with the cost rising to as much as $25,000 for repeat offences. If the PRO act was to pass into law as it currently stands, the ABC test would become a national requirement, and similar penalties would apply across the country.

Under the ABC definition, a person providing labor or services is automatically an employee, and therefore needs to be managed using the payroll model, unless three things apply.

  1. The hiring entity demonstrates that the person is free from the control and direction of the hiring entity in connection with the performance of the work.
  2. The person performs work that is outside the usual course of the hiring entity’s business.
  3. The person is customarily engaged in an independently established trade, occupation, or business.

While the ABC test is a US-only issue, compliance laws for using independent contractors vary hugely from one place to another. Here are just a few more examples that show how compliantly using a contractor model is not as simple as it might seem:

India: No company can supervise or control independent contractors, and each freelancer needs a PAN, or Permanent Account Number to ensure taxes are paid. These are payable by both the contractor and the client, and freelancer agreements are usually limited to 240 days.

See our India payroll guide for more information.

Brazil: Any contractor project that seems to be indefinite or exceeds 90 days, automatically turns a freelance arrangement into a formal employment relationship. Contractor agreements therefore need to be project-based, and for a limited amount of time.

See our Brazil payroll guide for more information.

Germany: Germany is much more active about going after misclassified employees than many other countries. If found to be guilty of misclassification unawares, employers may need to pay 4 years worth of SS arrears, with 12% interest. If your activity was found to be intentional, this can jump to 30 years.
See our German payroll guide for more information

So, If setting up an entity feels premature, but contracting doesn’t fit the bill either, what can organizations do? 

Simplifying the Decision with an Employer of Record

EOR (Employer of Record) is sometimes known as global PEO (professional employment organization), and is a unique model that provides quick time to value when hiring abroad. Rather than incorporate internationally in a new location, or using the global contractor model, an EOR can take on the employment on your behalf.

Examples where this model is perfect, include:

  • Great candidate in a new location: Found the best talent for a role, in a new location? EOR lets you onboard them in a compliant way, without setting up an entity.
  • Testing a local market: Not sure if a country will be a good long-term fit? Think of EOR as a low-risk, ‘try before you buy’.
  • Short-term engagement: Want to work with a particular candidate for a short amount of time? Sidestep the admin of opening an entity by using EOR instead.
  • Handling an interim solution: Entity on the way, but want to start working faster? EOR is a great way to fill the gap while you get all your ducks in a row.

From the employee perspective, EOR will feel identical to being on payroll, with tax and social security contributions being taken from their monthly paycheck, and the same benefits as any other employee. But for the employer, it eliminates the admin headache and liability. The company can simply engage in a contract with the EOR, and the EOR will outsource the employment to a local partner in the same location as the employee. This local partner also handles HR such as working hours, vacation days, sick leave, and more, reducing operational costs and administrative overhead.

Finding the Break Point

For many companies, choosing an EOR solution will be something that works for the short-term in a specific location, before setting up an entity and moving over to a payroll model. This is particularly important to consider in countries where there is an enforced limit on how long you can use EOR, such as Germany that caps it at 18 months.

The exact transition point in determining when to move from PEO/EOR to payroll will vary from company to company, but generally speaking, it’s usually at around 10-15 employees. At this point, the costs of maintaining a EOR model for that many employees may start to challenge the savings of not having to set up a foreign subsidiary. For less than 10 employees, and considering that an entity needs management and reporting, maintenance, bookkeeping and accounting, and incurs associated legal and compliance costs, the EOR model is a great choice, and for many organizations, a much less risky way of testing the waters.

However, once that critical mass of 10-15 employees has been reached, it’s safe to say that your organization is setting down roots in this new location, and the costs of setting up an entity begin to seem more worthwhile.

Making the Right Future-focused Decisions

This transition can be complex for organizations to navigate, and this is one of the key ways that Papaya Global differentiates itself against the competition. As the only solution for all types of employees and workforces, we can work with you for the long term. We can support your enterprise in creating a EOR model in a new location where necessary, and also provide equal expertise and know-how in incorporating and managing payroll, if and when you’re ready to shift your business model in that direction.

With no specific dog in the race, Papaya is best placed to provide genuine and impartial advice to your business on the right employment model for your needs. Once you’ve chosen what works for you, we can support a hybrid model of payment processing, the simplest way to handle complex employee payroll, globally.

Don’t we all need some impartial advice from time to time? If you’d like some expert advice on which model is right for your business, let’s talk.