How to Avoid Misclassifying Contractors

Alex Margolin
August 01, 2019

As work continues to evolve on a global scale, an increasing number of people are opting out of regular employment and joining the “gig economy.” Instead of taking regular, full-time positions at companies, more workers are choosing freedom over stability through short-term contract work.

While certain fields such as writing or graphic design have always had a large number of freelancers, the gig economy and the telecommunications revolution that has made it possible, brought contract work to virtually any field. A large number of office jobs can be done from remote locations, anywhere in the world with an Internet connection. More people are choosing to live as “digital nomads,” doing skilled, white collar jobs through the Internet while travelling the world.

In addition, new technology-based companies like taxi service Uber or bicycle delivery company Foodora have created entire business models by offering work in small “gigs” for people to work when they want.

The gig economy has also opened up opportunities for people across the world, creating a truly global community. Experts estimate that as much as 40% of the world’s workers are part of this global economy.

And the numbers are only going up. In the US alone, 56.7 million people worked as freelancers in the past year; 3.7 million people joined the gig economy in over the past four years; and 64% of them found work online. Once they start, most say there is no going back – a full 51% said they wouldn’t take a traditional job for any amount of money.

Employers in the Gig Economy – The Risk of Misclassification

For the most part, employers are happy to go along with global workforce evolution. Since contract workers are self-employed, employers are exempt from many obligations they have to regular workers. There are no employee taxes, no social security payments, and no benefits like health insurance or pensions. Independent contractors are not entitled to the standard labor protection regular workers enjoy, including minimum wage requirements and extra pay for overtime.

Employers make their payments in lump sums with no need to withhold taxes from worker paychecks. That responsibility belongs to the contractor. Payroll is easier to administer, and without the extra costs of perks and benefits, employers can offer higher hourly pay and compete for the best talent on the market.

Done right, the arrangement is a boon for both sides. For businesses, that often means combining a permanent workforce with a pool of contractors. Freelancing platform, Upward, for example, maintains a workforce of 450 full-time employees as well as 1,100 freelance workers. That type of arrangement allows companies to ensure continuity of operations while maintaining maximum flexibility.

However, there is also a looming risk when it comes to contract workers. Worker misclassification – labeling workers as contractors when they actually qualify as regular workers – carries significant fines. Employers need to know what constitutes a regular worker compared to a contract worker so that they don’t misclassify them in error – and wind up paying the price.

Contractors vs. Regular Workers

Misclassification hurts workers because it allows companies to avoid providing health insurance, pensions, paid time off, and other benefits workers are typically entitled to receive. It also decreases the amount of taxes collected by governments because the employers don’t pay employee taxes or Social Security.

In the US, government agencies are serious about cracking down, both to collect unpaid taxes and to protect workers whose rights may be violated by unscrupulous employers.

But even companies with the highest integrity can accidentally fall victim to misclassification error if they are not careful. The IRS has outlined specific terms that distinguish contractors from regular workers.

Clearly, errors in classification are easier than they would appear. According to the IRS, a contract stating the status of the worker as either an employee or a contract worker is not enough to determine the status of the work in and of itself.

If the company exerts substantial control over the worker, the worker is entitled to legal rights that go with it. While standards vary from country to country, the following criteria serves as test in the US to determine whether the worker should be classified as an employee or a contract worker. The difference in the classification is reflected in three primary areas:

Behavior Control

If an employer has the right to direct and control how work is performed or where it is performed, such as by providing office space to the worker, the worker may be an employee, not a contractor.

Employee: Employer controls finished product and directs worker on how and where to do it.
Contractor: Employer only controls finished product, not how it is done.

Financial Control

The more financial control an employer exerts over a worker, the more likely the worker is to be classified as an employee. Employees are paid in regular intervals, receive reimbursements for expenses, and if they require specialized equipment, it is provided by the employer. Contract workers are paid in one lump sum, do not receive reimbursements, and invest in their own equipment.

Employee: Receive regular paycheck monthly or bi-weekly and have taxes withheld from salaries.
Contractor: Receive lump-sum payment for full job with no taxes withheld.

Nature of Relationship

If a worker is providing a service that is vital to the business on a regular basis, and especially when the relationship is viewed as permanent between the worker and the company, the probability is high that the worker should be classified as an employee. Receiving benefits is seen as part of building an employee-employer relationship.

Employee: Provides service on a permanent basis with expectation that relations will continue.
Contractor: Provides short term service with no expectation of future employment.

Avoiding Classification Errors

Because misclassification can result in fines, damage to a company’s reputation, a possible limitation on a company’s ability to hire contract workers, and even the right to operate in certain regions, companies must be proactive in ensuring they are in full compliance.

Taking the following steps can help ensure that workers are classified appropriately. Laws vary from country to country. The only way to be sure that you are working within the laws of any particular region is to consult a legal expert in that region.

1. Learn the specific laws governing employee classification in your country and any other country where your company employs contract workers. Maintain ties with a legal expert in every country so that you always maintain compliance.

2. Conduct a review of each contract worker to ensure that you are not directing the worker in how to do the job, only the result; you are not maintaining financial control of the worker; and the worker is not providing vital services on a regular basis with the expectation that the work will continue on a permanent basis. The standard test may be different in some areas, but the element of control, financial dependence, and relationship are a good starting point.

3. Maintain channels of communication with each contract worker to allow the worker to express concerns that the relationship is shifting to a degree that the line between employee and contractor may begin being blurred. Make sure the worker contacts you in cases of doubt rather than having no option but to file a legal grievance and exposing your company to an audit. In some cases, contractors should be reclassified as regular workers when their role at the company chances.

4. Create company policy to ensure that anyone empowered to hire or oversee contract workers in your company receives training on the different classifications and ensure that standards are consistently applied in classification.

5. Put the relationship in writing through a contract. Although a contract is not enough on its own to determine status of a worker, a carefully delineated set of expectations for both sides can help ensure that everyone is on the same page and serve as a guideline for procedures, minimizing the risk of misclassification.

Payapa Provides Payroll and Compliance

Papaya can help you ensure proper classification of your entire work force. Our network of local experts covers more than 100 countries worldwide and our dedicated CSM team us always available to assist on questions of workforce management.

Papaya can manage the payroll for any number of workforce options, including full-time workers, contractors, and workers paid through Global PEO/Employer of Record model. Let our experts keep your payroll from of worker misclassification or any other workforce management issue you might encounter.

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