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How to Avoid the Risks of Independent Contractor Misclassification

By December 22, 2022January 20th, 2023No Comments
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Hiring contractors overseas has many benefits and offers more flexibility in global expansion. Employers can engage contractors for specialized projects, save time and money that would otherwise go toward hiring full-time employees, and test a new workforce in an international market.

However, hiring contractors comes with misclassification risks. Contractor misclassification leads to fines, employee entitlement back pay, and legal headaches. Plus, because employment regulations vary globally, the risks significantly increase when engaging international talent.

In this guide, learn the differences between contractors and employees and how to avoid the risks of independent contractor misclassification.

What Is Independent Contractor Misclassification?

Independent contractor misclassification refers to the illegal practice of categorizing employees as contractors, which denies them their entitlement to benefits and other legal protections. Classification depends on factors such as the worker’s financial relationship with the company and the degree of control over their work.

Contractor misclassification is often an employer’s attempt to avoid paying taxes. If caught, the employer is liable for unpaid taxes, employee back pay, and other legal fines. Even if an employer unintentionally misclassifies their workers, they still face similar consequences.

Independent Contractor vs. Employee: Key Differences

Infographic comparing the key differences between an employee and an independent contractor

Unlike employees, contractors are self-employed and are not on the company payroll. Additionally, employers hire contractors for short-term work while they invest in a long-term working relationship with their employees.

Explore more key differences between contractors and employees below.

Benefits and Taxation

Employees are entitled to statutory benefits, such as health insurance, pension, and paid time off. Conversely, contractors do not receive benefits from their clients and must pay for them independently.

An employer withholds the appropriate taxes from their employees’ salaries while contractors pay their own taxes. Additionally, international contractors working for U.S. clients must fill out a W-8BEN form to certify their non-U.S. residency and avoid double taxation. The client is responsible for providing the W-8BEN form, and the contractor is responsible for filling it out and submitting it to the client.

Payment Method

Employees are on the company payroll and paid an hourly wage or salary. Contractors are not on the payroll and may receive payment in various ways, including by the hour, upfront, or when the project is complete. The employer and contractor should outline payment terms in a contractor agreement.

Work Autonomy

Employees are typically subject to a fixed schedule and specific obligations set forth by their employer. By contrast, contractors have more autonomy over their work. For example, they can choose their own schedule, location, hours, and project scope.

Depending on the contractor agreement, contractors may be required to meet specific deadlines or risk not getting paid. Contractors may also choose to work for several clients at the same time.

Training and Career Development

Employees receive onboarding and training from their employer to understand job responsibilities, team roles, and company goals. Employees may also receive development opportunities that help them grow professionally.

However, contractors come to the job already trained in their responsibilities. They focus only on the specific tasks required by their client per the contractor agreement and only receive information related to their contractual duties.

Read more: Should You Hire a Contractor or a Full-Time Employee?

What Are the Risks and Penalties for Misclassifying Employees?

Employers may face several risks and penalties for misclassifying employees as contractors, including:

  • Back taxes. Employers are liable for paying back national, state, and local taxes.
  • Back benefits. Employers must pay for benefits owed to the employee, such as worker’s compensation, medical insurance, vacation, and sick pay.
  • Legal fines. Employers may incur costs from liquidated damages and attorney fees. Misclassification can also lead to class action lawsuits.
  • Reputational damage. On top of financial impacts and legal headaches, employers risk negative standing among peers and prospective talent.

How to Avoid Independent Contractor Misclassification Risks

Despite the severity of misclassification risks, compliance is possible with due diligence. The following steps help employers avoid independent contractor misclassification risks:

Understand Local Compliance Laws

Contractor definitions and misclassification laws differ between countries and states, so employers should understand these differences to avoid noncompliance risks. For example, rules that dictate 1099 contractor misclassification in the U.S. differ from rules that dictate IR35 misclassification in the U.K.

Draft Clear Independent Contractor Agreements

Establishing a clear contractor agreement is critical to defining the terms of service and contractor/client relationship. The agreement must also follow country-specific regulations, adhere to contractor tax requirements, and use legal terminology for the contractor’s responsibilities.

Employers can work with an in-country partner or agent of record to draft locally compliant contracts and ensure they avoid contractor misclassification.

Use Self-Check Resources

Many countries provide guidelines to help employers avoid contractor misclassification. For example, the Internal Revenue Service (IRS) outlines the following categories for determining contractor classification in the U.S.:

  • Behavioral. Does the company control or have the right to control what the worker does and how the worker does their job?
  • Financial. Does the payer control the business aspects of the worker’s job, such as providing equipment or reimbursement for work-related items?
  • Type of relationship. Will the employer/worker relationship continue after the work is complete? Is the work performed a key aspect of the business?

Still, relying on local classification guidelines does not guarantee an employer’s safety from misclassification risks. Instead, employers should also consult a legal expert like an employer of record to ensure compliance.

Download our Foreign Independent Contractors: Risk Assessment Checklist to learn how to reduce risk and establish a compliant foreign presence as you expand your workforce.

Hire Compliantly Around the World With Velocity Global

Engaging talent in global markets requires due diligence to avoid misclassification risks. However, by working with an experienced partner that can provide in-country insight into locally compliant employment contracts, you can begin or continue your global expansion without the worry of facing misclassification.

Velocity Global’s Employer of Record (EoR) solution enables companies to quickly and compliantly hire talent in more than 185 countries—without the need for establishing local entities or relying on foreign contractors.

Contact Velocity Global today to learn how we can help ensure compliance when building your global team.