The Hidden Complexities of Independent Contractor Classification

What is independent contractor classification?

Independent contractor classification refers to a worker's status as self-employed, meaning they provide services under a contract but are not considered employees, allowing them more flexibility but fewer benefits and protections.

Contents

1. Evolving Challenges in Independent Contractor Classification

2. The Consequences of Misclassification

3. How to Stay Compliant
4. Future Trends in Independent Contractor Classification
5. Preparing for the Future of Worker Classification

Spot the differences: Hybrid workplace edition! Imagine a new-age team, with the diverse kinds of workers you are likely to find in any modern workplace. You have your full-time employees, part timers, remote workers, hybrid workers, freelancers, contractors, incorporated contractors and gig workers. 

Now here’s the challenge – can you identify which out of these workers would be classified as ‘employees’ and who would be the ‘contractors’?

This challenge is not hypothetical. Thousands of employers around the world actually have to take this call – with real-world implications arising out of whatever they decide. In a truly hybrid environment, it’s not easy to make this distinction. After all, many of these workers may be working in much the same way and towards the same goal.

But while terming them ‘all a part of one team’ may be great for morale, it doesn’t work from a legal standpoint. Worker classification has a direct impact on your obligations as an employer under tax laws, labor laws, and various other federal and state laws.

In this blog, we’ll understand the real-world differences between the different types of workers and look at the various challenges that may arise while trying to classify them.

The criteria for classifying independent contractors

Among the types of workers discussed above, two primary worker classifications emerge. 

First, there are the employees. This includes the full-timers, part-timers, remote workers and hybrid workers. They may all work different hours, and from different locations, but these are all workers who are employed by your organization – to be a part of the team indefinitely until they resign or are let go for valid reasons.

The company controls when, how and where they work, and despite whatever flexibilities they may enjoy, the ultimate control remains with the employers. A full-time worker cannot just decide to start working on a hybrid or remote basis without prior discussions with the employer. Nor can a part-time employee decide they will work more hours – it’s not their call to take. Another thing all these workers have in common is that they all receive a set amount as their salary each month, with little to no variations.

The other category is that of independent contractors. This includes freelancers, contractors, incorporated contractors, gig workers and consultants. They are not employed by your company; they work with you on a contractual basis – their engagement with your organization lasts only as long as their contract does.

These workers can all set their own time, and decide where they’ll work from and how much they’ll charge. As long as they are meeting the terms of their contract, they can fulfill their responsibilities as they see fit. They don’t have a fixed salary that they receive from your company – they get paid only for the work they do.

This table outlines some key differences between employees and independent contractors. Use it as a quick guide to understand the differences – and for a more detailed look, read how to determine contractor vs employee.

Evolving Challenges in Independent Contractor Classification

So far, we’ve looked at the most straightforward differences. But in reality, classification is not always so simple. And with new policies and ways of working coming up every day, the challenges only get more nuanced. Now, let’s delve into some factors that may complicate independent contractor classification.

The Global Perspective on Contractor Classification

A lot of businesses engage in international hiring today, both with their employees and their contractors. But employers should keep in mind that various countries classify workers in different ways!

While the laws in your state may make it easy enough to classify workers, those same laws and regulations may not apply in other places. Let’s look at some examples:

• United States: Many states in the US use the ABC test to determine contractor vs employee classification. The ABC test looks at

1. Whether the worker is controlled by the employer in the way they work – both on paper and in reality.
2. Whether the tasks performed by the worker are core to the employer’s business.
3. Whether the worker operates as an independent entity in a trade or business that is of the same nature as they are performing here.
   
   But the ABC test results may not hold true if the employer hires a worker in certain other states where this rule is not applicable.

• Europe: In Europe, employers must consider the added complexity of EU laws. In some cases, a specific European country may see a worker as an independent contractor – but the broader EU law may rule the same case and find the worker to be an employee. Different European countries also have their own complexities.
  
  In Malta, for instance, independent contractors are required to establish a formal structure for their business – be it as a sole proprietor, a formal company or a partnership. However, if a contractor does not manage their tax responsibilities the way they should, it has fallouts for both the employer and the independent contractor. As a precautionary measure, many businesses are requiring freelancers to set up their own limited companies first, before signing an agreement – a move that proves to be very expensive for the freelancer.
  
  
• Japan: In most countries, employers may hire contractors working under an incorporated entity (like a staffing firm) with no issues. But in Japan, this may be seen as engaging in illegal ‘worker supply’ – where one company gives day-to-day instructions to the employees of another company.
  
  
• Chile: In Chile, employers must ask their contractors for government-issued certificates to prove their contractor status. If the contractor doesn’t provide this certificate, the company is obliged to start withholding taxes.
  
  
• UK: In the UK, the most recent IR35 update puts the responsibility of worker classification on private sector employers. However, the rules governing this have largely been found to be too complex, with employers opting for blanket classifications of workers rather than classifying each worker on a case-by-case basis. In fact, a startling 42.8% of contractors in one study feel that they have been wrongly classified due to these blanket measures – leading to financial fallouts of higher taxes. These indicate a need for more nuanced regulations that take multiple perspectives into account.

These are just some examples of the complexities that must be considered when the different laws of different states or countries come into play.

Industry-Specific Considerations

Now, let us look at some industry-specific contractor classification complexities, where the very nature of work makes a worker’s status uncertain.

• Gig work. Ride-share companies are the most obvious example here. Cab drivers for these companies usually work on contract. However, the work they do is core to the hiring company’s business. What’s more, ride-share companies do require them to maintain certain levels of vehicle safety and cleanliness. They also have rules controlling the drivers’ behavior while on shift, and require them to have a set amount of rest period between shifts. Though these are all done for safety reasons, this can be seen as the company asserting control over the gig worker – thus putting them in the gray area between employees and contractors.
  
  
• Media industry. Many media industry professionals work as independent contractors – think photographers, videographers, production and post-production experts, sound specialists, make-up artists and more. But various factors must be kept in mind to ensure that these professionals are not misclassified.
  
  A content creator hired to produce videos for a brand is obviously an independent contractor. But boundaries get blurred if brand managers start setting rules and controlling the way the content creator works. Imagine situations where the company representative requires that the content creator works from certain locations, dictates exactly how to shoot a video, or tells them just what to say. In these cases, the content creator may be seen as an employee that the company controls.
  
  

Tech industry. In the tech industry, many developer jobs are currently outsourced to contractors. Again, this needs to be considered on a case-by-case basis to ascertain classification. If a boutique or a bakery engages a developer on a contractual basis to create their website or manage their back-end systems, the developer would typically be classified as an independent contractor.

But consider how in big tech companies, a large percentage of the workforce is made up of contractors. These workers often do the same work as the company’s employees, work from the same premises, and are supervised by the company’s managers. This makes the authorities question the classification of these workers as independent contractors. Microsoft was famously pulled up for treating contractors as employees – resulting in a class action lawsuit worth $97 million.

And they are not the only example. Facebook is estimated to have 15,000 content moderators around the world, reviewing content and filtering out hate posts. While they fulfill a core function for the platform, they are all hired as independent contractors – putting them in the gray area.

The Rise of Hybrid Workers

The different ways of working also contribute towards blurring boundaries. Many companies today have remote workers in their teams. These workers do not operate from the company offices, choosing instead to work from home or from a different country altogether – just like independent contractors.

Similarly, you may have hybrid workers, who have the flexibility to choose where they work from on the days they do not come to office. This again, is very similar to independent contractors.

In all these cases, you will need to consider the other factors for classification. If you, as an employer, assert a degree of control over these workers, invest in training and equipping them, or offer them benefits, then they should rightfully be considered employees.

The Consequences of Misclassification

There are severe legal risks of worker misclassification, even if not intentionally done. Since an employer has to pay for taxes, benefits and insurance for their employees, trying to pass off their workers as ‘independent contractors’ is seen as a way to evade those payments.

• Operational Risks and Reputation Damage

Misclassification opens up the company to audits and scrutiny from legal and tax agencies. This can make it difficult for the company to operate. Moreover, these companies often continue being heavily scrutinized in the future too.

All this can result in heavy reputational damage. The company may find it tough to attract business, with clients hesitating to renew contracts and new leads refusing to enter into fresh agreements.

Their reputation also becomes synonymous with company culture. Employees are less likely to want to continue working there, and new talent may hesitate to join a business that has been known to engage in unfair labor practices.

• Long-Term Financial Impacts

  Companies found to have misclassified employees are of course, heavily fined by the authorities. But unfortunately, this is just a small part of the long-term financial fallouts they have to face.
  
  The employers are also required to make things right with the misclassified workers themselves. This involves paying them back wages for the entire period of misclassification – in addition to all the sick days, paid time off, health coverage and other benefits that they would have been entitled to. All of this can add up to a huge sum for just a single worker. This is compounded with the more number of workers found to be misclassified.

How to Stay Compliant

• Tools and Technology

Fortunately, today it’s easier than ever before to classify workers right and maintain proper compliance protocols. There are lots of new contractor compliance tools to enable this.

New AI-powered worker classification technology today helps determine worker status with greater accuracy. These engines keep up with changing laws and regulations in different geographies – reducing misclassification risks, even for global hires. This solves a major challenge for employers who would have otherwise struggled to keep educating themselves on various recruitment laws.

We also see lots of automated compliance software in the market that scan through worker data, highlighting any missing documents or flagging incomplete contracts.

Integrated payment systems are another great way in which new technology is easing compliance. These systems automate worker payments globally – by auto-generating invoices, disbursing payments in different currencies and creating audit trails for record-keeping.

• How TalentDesk Can Mitigate Risks

  TalentDesk’s software is one of the top tools in the market today, when it comes to compliance management. Our platform ensures you go about recruitment the right way from the get-go. It lets you create contracts in bulk and offers e-signing capabilities – thus reducing friction at the onboarding stage.
  
  We then save all your worker documents securely in the cloud. This means in the event of an audit, you know exactly where to locate every last document. No more having to search across different managers’ inboxes for the relevant contracts – or having to deal with data loss every time a manager leaves.
  
  If you would like to shield your business from compliance risks and fines, you can turn to our Agent of Record (AOR) services. Through this, we not only classify your independent contractors, but also take over all your legal admin and contractual responsibilities. We carry out AML checks and KYC verifications, ensure compliance with local laws as you onboard contractors, sign contracts on your behalf and even defend potential misclassification claims.
  
  Our robust Employer of Record (EOR) capabilities, offered through our partnership with Atlas, proves invaluable when you are hiring employees around the world. Here again, we take over all HR compliance obligations, keeping local laws in mind. Managing payroll, tracking time off and handling tax deductions becomes a breeze – as does disbursing benefits across countries.

Future Trends in Independent Contractor Classification

• The Impact of Remote Work on Contractor Rules

With remote and hybrid work becoming more common, lawmakers are continually updating the rules to determine contractor status accurately, despite blurred boundaries. One recent example is the United States Department of Labor (DOL)’s 6-factor update.

This new rule came into effect in March 2024, under the Fair Labor Standards Act (FLSA). Under this, the authorities will now classify workers based on 6 factors, including:

(1) Assessing a worker’s financial risk, and seeing whether they have an opportunity to make profits or losses.

(2) Whether the worker is under the employer’s control, and if so, what the nature of that control is.

(3) Whether the engagement is close-ended (like in a contract) or more permanent and open-ended (like in an employment relationship).

(4) Whether the worker is investing any capital in order to do the work, like purchasing equipment, or whether the employer is undertaking these investments.

(5) Whether the work done is an integral part of the company’s business.

(6) Whether the work demands high levels of skills that the worker is providing to the company.

Earlier, employers only had to assess the first two factors. This goes to show how the economic realities of contract work are changing and how the new laws are reflecting these new complexities.

Different countries are now also making allowances for these new ways of working – and are introducing digital nomad visas. Greece, Malta, Portugal, Spain, Croatia are just some of the countries that offer this visa, making them attractive destinations for remote workers.

• Upcoming Legislation to Watch

  Coming up next, companies can expect greater scrutiny when it comes to employee rights. A recent case of the overwork-related death of a 26-year-old employee in India has the country’s labor authorities paying due attention to unregulated work hours, particularly for remote and hybrid workers.
  
  On a similar note, the Fair Work Commission in Australia has passed an order giving employees the right to disconnect after work hours, with a potential fine of A$94,000 for companies who do not comply.
  
  Meanwhile in the Netherlands, Dutch tax policies will be enforced in every case of misclassification starting from 1 January, 2025. Earlier, these policies were only enforced in cases where there was an obvious abuse of the law. This full enforcement shows a changing trend of laws and policies getting stricter.
  
  These are just a few recent and upcoming updates – but they underline how laws keep evolving as new complexities of remote, hybrid and contract work emerge. Both employers and workers can expect the rules and regulations to continue evolving further, across geographies.

Preparing for the Future of Worker Classification

While engaging contract workers informally may have been a norm in the past, the risks of doing so will not be worth it in the future. The fallouts of misclassification are making proper onboarding and compliance protocols for contractors a necessity. Smart businesses will look at worker classifications proactively – if an audit is underway, it’s already too late! 

Hiring managers will need to gather the right documents, contracts and other independent contractor information right at the time of onboarding. For example, you’ll need to have a Form W-9 on file when onboarding local contractors and a Form W-8BEN for international contractors. The worker’s Tax Identification Number and other data collected through these forms will be required at the end of the year, when you file a Form 1099 Misc to record payments made to them. 

Additionally, handling classification manually is going to get more challenging. You will need to opt for flexible systems that automate these processes, changing laws and evolving regulations in mind. So, an outdated payment portal that does not allow new tax regulations to be integrated, will no longer serve.

Finally, engaging AOR and EOR services is going to be more advantageous than ever before. With the ever-changing labor and regulatory landscape, companies now have three options. First, to devote an incredible amount of time and resources to stay ahead of the changing rules. Second, to forgo the immense advantages of working with global contractors altogether. And third, to handle compliance through an agency specially equipped to handle these changing rules. It comes as no surprise that new-age businesses are opting for the last option!