Hiring contractors overseas has many advantages and provides more flexibility in global expansion. Employers can hire contractors for specialized projects, save time and money that would otherwise be spent on hiring full-time employees, and test a new workforce in an international market.
However, hiring contractors carries risks of misclassification. Misclassifying contractors leads to fines, back wages, and legal headaches. Additionally, since employment regulations vary globally, the risks increase significantly when hiring international talent.
In this guide, learn the differences between contractors and employees and how to avoid the risk of misclassifying independent contractors.
What is independent contractor misclassification?
Misclassification of independent contractors refers to the illegal practice of categorizing employees as contractors, which denies them their right to benefits and other legal protections. The classification depends on factors such as the worker’s financial relationship with the company and the degree of control over their work.
The misclassification of the contractor is often an attempt by the employer to avoid paying taxes. If caught, the employer is liable for unpaid taxes, employee back wages, and other legal fines. Even if an employer unwittingly classifies their workers incorrectly, they still face similar consequences.
Independent contractor vs employee: main differences
Unlike employees, contractors are self-employed and are not on the company’s payroll. Besides, employers hire contractors for short-term work while investing in a long-term working relationship with their employees.
Check out other key differences between contractors and employees below.
Benefits and taxation
Employees are entitled to legal benefits, such as health insurance, retirement and paid holidays. Conversely, entrepreneurs do not receive benefits from their customers and must pay them independently.
An employer withholds appropriate taxes from the wages of its employees while contractors pay their own taxes. Additionally, international contractors working for US clients must complete Form W-8BEN to certify their non-US residency and avoid double taxation. The customer is responsible for providing the Form W-8BENand the contractor is responsible for completing it and returning it to the client.
Employees are on the company’s payroll and are paid a salary or hourly wage. Contractors are not on the payroll and can receive payment in various ways, including on time, in advance, or when the project is completed. The employer and the contractor must describe the terms of payment in a contractor agreement.
Employees are generally subject to a fixed schedule and specific obligations defined by their employer. On the other hand, entrepreneurs 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 being paid. Contractors can also choose to work for multiple 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 can also benefit from development opportunities that help them grow professionally.
However, contractors come to work already trained in their responsibilities. They focus only on the specific tasks required by their client in accordance with the contractor’s agreement and only receive information relating to their contractual obligations.
What are the risks and penalties for misclassifying employees?
Employers can face several risks and penalties if they mistakenly classify employees as contractors, including:
- Back taxes. Employers are required to reimburse national, state and local taxes.
- Benefits for the back. Employers must pay benefits due to the employee, such as workers’ compensation, medical insurance, vacation and sick pay.
- Legal fines. Employers may incur costs for damages and attorneys’ fees. Misclassification can also lead to class action lawsuits.
- Damage to reputation. In addition to financial impacts and legal headaches, employers risk having a negative reputation among their peers and potential talent.
How to avoid the risks of misclassification of independent contractors
Despite the seriousness of the risks of misclassification, compliance is possible with due diligence. The following steps help employers avoid the risk of misclassifying independent contractors:
Understand local compliance laws
Contractor definitions and misclassification laws differ between countries and states, so employers should understand these differences to avoid compliance risks. For example, the rules that dictate 1099 contractor classification error in the United States differ from the rules that dictate IR35 classification error UK
Draft clear independent contractor agreements
Establishing a clear agreement with the contractor is essential to define the terms of service and the relationship between the contractor and the client. The agreement must also adhere to country-specific regulations, meet contractor tax requirements, and use legal terminology for contractor responsibilities.
Employers can work with an in-country partner or official agent to draft contracts that comply with local standards and ensure they avoid contractor misclassifications.
Use self-verification resources
Many countries provide guidelines to help employers avoid misclassifications of contractors. For example, the Tax Service (IRS) describes the following categories for determining the classification of contractors in the United States:
- Behavioral. Does the company control or does it have the right to control what the worker does and how the worker does his 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 completed? Is the work performed a key aspect of the business?
Yet relying on local classification guidelines does not guarantee an employer’s security against the risk of misclassification. Instead, employers should also consult a legal expert such as a official employer to ensure compliance.
Download our Independent Foreign Entrepreneurs: Risk Assessment Checklist to learn how to reduce risk and establish a compliant foreign presence as you expand your workforce.
Hire in full compliance worldwide with Velocity Global
Engaging talent in global markets requires due diligence to avoid risks of misclassification. However, by working with an experienced partner who can provide in-country insight into employment contracts that comply with local standards, you can begin or continue your global expansion without worrying about being misclassified.
Velocity Global Employer of record (EoR) enables companies to quickly and compliantly hire talent in more than 185 countries, without the need to establish local entities or hire foreign contractors.
Contact Velocity Global today to learn how we can help you ensure compliance when building your global team.