Article
3 min read
Author
Michał Kowalewski
Published
September 27, 2021
Last Update
June 28, 2024
Table of Contents
You might worry for a reason about your contractor's status if:
5 ways to determine whether your contractor is actually an employee
Your options to avoid misclassification
How to convert a contractor into an employee
What if your contractor is foreign?
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Payment penalties, class-action lawsuits, and jail time.
Those are just a few potential consequences of misclassifying workers as independent contractors when they perform the work of employees. Some companies hire people as contractors to avoid paying social security taxes, medicare taxes, and other employee benefits and payroll taxes.
However, some employers may misclassify their workers unwittingly. The government established several types of tests to help employers determine whether their workers should be independent contractors or employees, but the criteria may not always be 100% clear.
In this article, we’ll walk you through the steps to take if you believe your contractor started to resemble an employee.
Employees have certain privileges over contractors, afforded to them by the Fair Labor Standards Act (FLSA). These privileges include (but aren’t limited to) minimum wages, unemployment insurance, and workers’ compensation.
The government wants to protect misclassified employees, which can only happen if employers determine workers’ employment status. Plus, independent contractor misclassification represents a huge tax revenue loss for the government. That’s why the government came up with several ways to determine if your worker should have employee or independent contractor status.
Also called the “Right-to-control” or the common law test, the Internal Revenue Service’s 20-factor test gives employers 20 factors to assess classification in three categories: behavioral control, financial control, and permanency of the relationship.
Some of the questions you’ll answer include:
If you answer yes to most of the questions, your worker is likely an employee.
Check out the full list of all 20 questions here.
The reasonable basis test examines whether you have reasons to avoid withholding federal taxes from a worker. You can fairly give workers independent contractor status if:
The US Department of Labor uses the economic reality test to determine a worker’s status. This test relies on evaluating a contractor’s economic dependence on an employer. Remember, independent contractors are self-employed—business owners in their own right who don’t depend on a sole employer like full-time employees do.
The test uses five primary factors to determine a worker’s status:
The first two factors carry more weight than the others, although it’s impossible to single out one factor that’s decisive in every classification case.
The ABC test uses three critical factors to determine the worker’s status. It’s used across the US, but was first codified in California, by the California Supreme Court.
The factors considered in the ABC test classify a worker as an independent contractor only if they:
The ABC worker classification has recently seen changes in terms of defining an independent contractor and professions that fall into this category, especially regarding drivers for companies such as Uber or DoorDash. You can read more about it here.
Form SS-8 is an IRS form you submit to ask for an official evaluation of your workers’ status.
If you’re not sure whether you should classify them as an employee or an independent contractor, you can ask the IRS for help. Note that your contractors also have the right to submit this form if they suspect they should have an employee status
Given that you still need your contractor’s services, you have two options to continue your working relationship: redefine the contractor’s scope of work and your degree of control or bring them on as an employee.
If you want to keep your worker on the team as a contractor, revisit your independent contractor agreement and redefine their work conditions.
For example, you can:
If you want your contractor to keep working under the same conditions, but you’re worried about misclassification risks, you can end your independent contractor relationship with them and bring them on as a full-time employee.
This new employer-employee relationship will require a new written contract and new tax documentation. You will have new responsibilities as an employer, such as paying employment taxes or providing sick pay for your employee, that your new employee wasn’t entitled to before.
If your budget and business plan allow you, you can convert your independent contractor into an employee. Here are the steps.
Some surveys found that many contractors would actually love to have full-time employment. Your contractor might accept your offer, but you should make it compelling. Contractors typically appreciate the flexibility of contract work, so try to include a flexible work schedule or flexible PTO in your list of perks.
Use our employee cost calculator to find out how much to budget for the new employee, including salary, benefits, and payroll taxes.
Once your contractor accepts the offer, it’s time to collect the new tax forms you’ll need for an employee, such as the forms W-2 and W-4.
You may also need other information for employee benefits and tax purposes: whether the new employee is married, has children, owes student loans, needs equipment to perform the job, and so on.
To make your new employee feel welcome, organize intro calls with the rest of the team and allow people to get to know each other. The onboarding process should also include training sessions with the team manager, so your former contractor can learn about the internal processes and company culture.
Sending your new hire company swag is a nice touch to make them feel like a part of the team.
Your new employee is now on your payroll and doesn’t send you invoices anymore, so their data needs to be in your payroll software. This is a critical step that ensures accurate tax withholdings and employee benefits administration.
Read our getting-started guide on payroll management.
If you hire foreign contractors and they start resembling an employee, the implications are similar. You still need to evaluate your business relationship and determine what status they should have, with one (critical) difference. You need to consider the local employment law and tax regulations in the contractor’s home country.
Read more about your options to hire international employees.
If the foreign employee stays in their home country and performs the work remotely, you can hire them through an employer of record or open a local legal entity and hire them directly. In either case, you need to withhold their taxes according to the local tax laws and provide them with their country’s mandatory employee benefits.
Whether you hire from Germany, China, Nigeria, or Peru, you will stumble upon different labor laws that define independent contractors and employees differently. It’s critical to gain familiarity with local employment laws and create compliant contracts.
Check out our global hiring guide to see labor laws and other regulations in countries worldwide.
When your company considers hiring its service providers as employees, you should be aware of different tax withholding and reporting rules. It would be best if you took both the US (assuming your company is in the US) and the local country of your service provider into the equation.
If you’re sponsoring your new employee to come to the US to work for you, you should withhold the foreign employee’s income tax at the same rate as US residents. The tax withholding can be reduced or exempt if the employee’s country has a tax treaty with the US, and they claim this exemption through Form 8233.
A permanent establishment of the company means that the business has stable and ongoing activities that result in locally created income. In some countries, having employees, particularly those engaging in sales activities, is considered sufficient grounds for a permanent establishment.
Each country has its regulations for a permanent establishment, with some countries being more strict than others. You should seek counsel from local tax specialists before you hire employees in a foreign country.
One way to avoid permanent establishment would be to hire contractors who are incorporated in their local country as legal entities (companies, agencies, or others). A business-to-business contract will more likely be interpreted as “a contractor relationship” in many countries.
You can hire individuals as leased employees through a temporary agency or a partner business in the local country which hires them as employees. That way, your business can have a contract with the said local company offering the services as a contractor.
Whether you decide to keep your worker as a contractor or convert them into an employee, Deel can help you hire anyone anywhere in a matter of seconds.
Our all-in-one platform allows you to make mass payments to your whole team in just one click and manage locally compliant contracts for your entire global team. With our customer support team working around the clock to help you with any concerns and a team of legal experts to ensure full compliance, nothing stops you from tapping into the global talent pool.
Want to see Deel in action? Schedule a demo with one of our experts.
Disclaimer: This post is provided for informational purposes and should not be considered legal advice. Talk to a legal professional such as an employment lawyer for more info.
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