Companies’ Compliance Concerns Regarding Independent Contractors 

Freelance workforce misclassification 101: what legal and finance teams should know

by Shahar Erez

The gig economy has exploded and, now more than ever, contract workers are in high demand. One report showed that month-over-month revenues in the gig economy increased 18% in June 2020 alone, according to an article in Forbes. What’s more, many organizations are leaning on these contractors to keep their businesses afloat in the wake of this monumental recession.

However, with this huge new wave of contract workers — and the opportunities it presents for businesses — comes a number of misclassification risks that finance and legal executives need to be aware of.

As recently as 2017, Harvard Business Review reported that up to 20% of businesses misclassify their employees. And this was before a global pandemic flooded the market with tens of thousands of additional contract workers. As this trend picks up, federal governments in countries around the world are setting stricter standards and regulations to ensure companies properly handle this growing workforce as they work to build (or rebuild) their organizations.

The problem? Most companies still don’t fully understand the basic differences between their relationships with traditional employees and those with independent contractors. In fact, most organizational leaders are unaware of the volume of independent contractors working for their organizations and, due to a lack of proper tracking tools and processes, they often grossly underestimate the amount of freelancers they employ. This knowledge gap can lead to expensive consequences, including back-taxes at federal and state levels; back pay for “wage theft,” retroactive insurance premiums, and additional penalties; back premiums for workers’ compensation insurance; and lawsuits from freelancers and independent contractors.

Below are some ways to approach the business of hiring and managing contract workers, and measures to implement so as to ensure a company is protected from unwanted consequences.

Who Qualifies as an Independent Contractor?

To qualify as an independent contractor, a worker typically earns income from multiple employers, and does not depend on a single employer for a majority of his or her income.

Additionally, the amount of control exerted over a worker is the largest factor in determining how he or she is classified in the eyes of the law. The more control an organization exerts in these areas, the closer they are to crossing the line from contractor status to employee status. However, it’s important to keep in mind that there isn’t a single list of items that can be checked off to determine whether or not an employee is considered a contract worker (and that list varies by state).

“There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination,” says the IRS website. “The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.”

Questions Employers Should Ask Themselves

When it comes to freelancers, not only in the U.S. but around the world, there are a few vital questions to ask to get a better sense of where the worker falls on the classification spectrum. The IRS lists three key areas — behavioral control, finances, and a worker’s relationship to the organization — used in determining their classification. Below are aspects of each that should be kept in mind as companies bring contract workers on-board. If the answer to most or all of the below questions is “yes,” it’s more likely that an employer’s relationship with the worker resembles that of an independent contractor instead of a traditional employee.

Determine what degree of independence the worker has. How much control is exerted over a worker is paramount in determining whether a business can consider them as independent contractors, or if they’re getting dangerously close to the traditional employee threshold. Here are three key factors to consider.

  • Self-supervision: Do they have the power to perform their tasks the way they want to — free from anyone in the company instructing them on process; and free from discipline, work rules, performance evaluations and other supervision and control?
  • Self-scheduling: Are they free to set their own schedule and work hours, with no attendance requirement?
  • Self-starting: Are they free to determine the order and sequence of their tasks, with no requirement to make regular progress reports to their employer?

What is the nature of their financial situation in relation to the company? In many countries, it’s important for businesses to make sure they are not the sole or majority source of income for their independent contractor. But how does an employer determine if this is the case? Here are four factors used to determine a contract worker’s financial setup.

  • Exclusivity and independence: Can they, and do they, have other paying clients — and do they market their services to the public?
  • Supplies and tools: Do they provide their own office and supplies, pay their own business expenses and hire their own assistants?
  • Task/hourly pay: Do they get paid only for work they actually do, like hourly pay or task pay, with no paid vacations or holidays? Is their pay free from employee-benefit executive compensation elements like bonuses, health/life/disability insurance and equity awards?
  • Business risk: Do they take business risks and bear the ultimate risk of profit or loss? Do they bear the risk of casualty loss (property/personal injury) and do they buy insurance?

How is the relationship set up? While it may be tempting to just hire contractors to perform every role in an organization — especially for small-business owners — there’s a lot of risk involved in that, especially when it comes to continuously employing an independent contractor in perpetuity, or on a long-term basis. Below are four factors that illustrate what the relationship between an organization and an independent contractor should look like.

  • Short-term: Is the relationship with the worker explicitly temporary?
  • Tax/social security: Do they make tax/social security payments and withholdings like a business?
  • Business cards/letterhead/email/title: Do their business cards and letterhead clarify their independence from the organization, and do they use a title unrelated to the company? Are they kept off organizational charts and internal structure documents? Does their email address make clear they are not part of the organization?
  • Core business functions: Is the worker performing specialized tasks that are not a part of the business’s core functions? (Examples of core business functions could include administrative assistant work or, in cases like Uber, could include serving as a driver for a company whose core business function is transportation.)

These questions can help companies determine contractor dependence, but they’re not all that need to be considered. There are three additional questions that are critical to ask, and that frequently factor into classification analysis.

  • Restrictive covenants: Is the worker free from non-compete, non-solicitation and other post-termination restrictions?
  • Training: Does the worker refrain from attending an organization’s training sessions as a student?
  • Organization structure: Does their operation stay separate from the organization’s structure and work procedures? (For example, including them in the payroll or HRIS could suggest they are part of an organizational structure.)

With the basics of contract worker classification now understood, what can employers do to ensure their company stays above-board with the contractors that they plan on hiring? First, it is important that they consult the full guidelines laid out by the IRS (Understanding Employee vs Contractor Designation: regarding these matters, but it is also beneficial for companies to start thinking about investing in a workforce management platform that specifically helps businesses reduce the manual labor and risk of managing this alternative workforce, ultimately creating a smoother process and experience for both the contractor and the employer.   

Shahar Erez is co-founder and CEO of Stoke. Stoke uses real-time data to streamline the entire independent contractor lifecycle with an emphasis on legal, tax and workforce classification. The Stoke platform provides reporting and alerting for documentation including W9 & 1099 forms, background checks and validating all required legal documents are in place (NDA, IP Data protection etc.). In addition, Stoke analyzes multiple data points to establish proper classification by state or internationally.

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