How to Ensure Independent Contractor Compliance in the US
Engaging Independent Contractors (ICs) compliantly remains a hotly contested topic in the US. As self-employed workers become more common in the US (ICs are estimated to make up 15% of the workforce), the request for staffing agencies to engage them is rising.
US companies are embracing hiring contractors via staffing agencies to take advantage of the cost benefits, flexibility, and specialist skills they can provide for project-based work. But the question that often arises for recruitment agencies when determining payroll for their contractor is, ‘Are they an employee or independent contractor?’
This is where independent contractor compliance comes in. Which is why, in this blog, we explain the difference between an independent contractor and employee in the US, the risks of worker misclassification, and how you can ensure independent contractor compliance in the US.
What is an Independent Contractor in the US?
The Two Types of Independent Contractors
First up, before we go over independent contractor compliance, it would help to provide you with a definition of an independent contractor in the US.
An independent contractor operates as an independent business working on projects for multiple clients. An independent contractor in the US is equivalent to a limited company or sole trader in the UK. An independent contractor is responsible for their own:
Work schedule - How and when they complete the work
Wage
Work Insurances
Taxes (Individual and employer)
Sourcing their own benefits and healthcare plans
Work equipment
What is the Difference Between an Employee and an Independent Contractor in the US?
W2 vs Corp-to-Corp Independent Contractors
Before placing workers in the US, you must understand the difference between an employee and an independent contractor.
W-2 employees in the US
Generally, engaging a candidate as an employee in the US (also referred to as a W-2, explained below...) means that the employer is responsible for:
Withholding and remitting taxes from the employee's wage
Providing them with healthcare benefits, insurances, and taxes.
Determining the employee’s work schedule and daily duties.
Engaging Workers as W-2's is Best Way to Avoid Worker Misclassification
By default, all workers in the US are considered to be a W-2 employee unless proven otherwise through an assessment. If you want to engage an independent contractor, you must pass the Internal Revenue Service (IRS) and relevant state/federal tests which we will discuss later in this blog.
Independent contractors in the US
According to the IRS, the definition of an independent contractor in the US is, “An individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
Independent contractors are self-employed and are responsible for sorting out their own employment taxes, wages, work schedule, and more.
The two most common independent contractors are ‘corp to corp’ or ‘1099’.
Corp-to-corp (C2C)
An incorporated contractor
C2C is a relationship between a ‘corporation’ to ‘corporation’, hence the name.
The contract worker has an incorporated company
The contractor's business is responsible for their own taxes, benefits and insurances.
C2Cs are usually hired as an independent contractor to provide their expertise services to other businesses – this means they are not a W2 employee for the organization.
1099
An unincorporated contractor
IC’s Also Referred to as ‘1099 Contractors’ due to the Tax Forms They File
You’ve likely heard the term 1099 contractor, which is another type of independent contractor in the US. This name is coined from the 1099 tax form they are required to file. The main characteristics of a 1099 worker are:
A freelancer or sole proprietor
Completes specific short form tasks or projects for another business
Responsible for their own schedule, calculating and remitting their own taxes, benefits, insurances etc.
They file tax form 1099 when submitting their taxes.
US employment tax forms indicate independent contractor or employee status
The way workers are taxed in the US is a key determination of whether someone is an independent contractor or employee:
1099 taxation form – Filled in by independent contractors. They are responsible for calculating and paying their taxes to the US government, hence their independence from the organization they are completing a project for.
W-2 taxation form – Filled in by employees (Hence why employees and some contractors are referred to as W–2's in the US). In the US, taxes can be deducted from W-2 workers’ pay and remitted by the employer or payroll provider to report to the US government.
Why do Companies Hire Independent Contractors vs Employees?
Engaging independent contractors in the US is generally less expensive for businesses because the employment burdens do not fall on the employer. US employers may favor the benefits of engaging independent contractor's vs employees because they don’t have to provide ICs with:
Paid holidays
Employment taxes
Healthcare plans
401K (US version of a pension)
Equipment
The independent contractor is instead responsible for their own tax remission and employee benefits.
Risks if you Don’t Follow Independent Contractor Compliance
Due to the lack of tax and employment responsibilities the employer will hold when engaging independent contractors, the US is stricter on classifying a worker as an IC vs employee.
Worker misclassification risks
When the distinction between an independent contractor and an employed member of staff becomes blurred in terms of duties, benefits, and more, workers can be found to be misclassified in the US.
Regulators are cracking down on worker misclassification in the US, which deprives the US government of tax revenues and can lead to workers missing out on the above benefits which they may be entitled to.
The costs to businesses of misclassifying a worker as an independent contractor's vs employee include:
Backdated federal, state, and local taxes – What is owed in employment taxes to the US government.
Payment of back wages – W2 workers are entitled to back pay so if you misclassify them as an independent contractor, you must pay back wages.
Backdated employment benefits - The benefits the worker should have received since day one if they were classified correctly as a W-2 instead of IC, including monthly healthcare contributions and paid sick leave.
Backdated unpaid unemployment insurance contributions
Back wages for overtime denied to the employee misclassified as an independent contractor.
Damage to a company’s reputation – If you are known to misclassify workers this will affect your reputation within the industry and also when hiring future employees.
Legal damages – You could be called to court and charged. You'll be liable to pay huge financial penalties if found guilty of worker misclassification and legal fees.
Why Does the US Take Worker Misclassification Extremely Seriously?
Independent contractor compliance is taken very seriously in the US. The Internal Revenue Service (IRS) and the US Department of Labor (DOL) prescribe laws and regulations regarding workers classification, detailed specific rules employers must follow. On a federal level, correct worker classification is crucial for both IRS and Department of Labor (DOL) compliance.
The IRS wants to protect US workers rights and receive employment income tax
The Internal Revenue Service (IRS) takes independent contractor compliance seriously because they are concerned about:
Ensuring all US employees are protected and have access to benefits and employment rights.
Ensuring that workers are taxed correctly and regulated. Worker misclassification can deprive them of tax revenue they would acquire through employment taxes they receive from W-2s.
When businesses classify workers in the US, they must meet the IRS rules regarding the workers ‘independence’ and control in the relationship to determine if they are an independent contractor or employee.
The Department of Labor is Concerned About Fair Wages for US Workers
It is important that an individual is properly classified as an Independent Contractor or an employee under the DOL’s Fair Labor Standards Act, which creates wage protections including minimum wage and overtime obligations for employees.
The DOL have an economic reality test to determine a US worker’s classification as either an employee or independent contractor. This test uses two variables:
The type and extent of the worker’s control over the work
The opportunities available to the worker based on investments
The skill required for the job – is the task part of the organization's core operations?
States are cracking down on companies not obeying independent contractor compliance
The US is taking a serious stance to clamp down on worker misclassification to ensure independent contract compliance is followed. Look at these headlines straight out of the US which highlight the importance of following independent contract compliance.
The US department of labor sues Florida staffing company for misclassifying workers
Highlighting the significance of correctly classifying workers in the US, a staffing company in Florida may be liable to pay back wages and damages to over 22,000 workers who claimed to be misclassified as independent contractors.
In what might be the largest misclassification case in history, after an investigation it was found that the ‘independent contractors’ hired via the staffing company were:
Told they would be their “own bosses” and generate income from providing customer support to the staffing companies Fortune 500 clients.
The workers were subject to the company’s work scheduling policy
Required to create their own corporations or LLCs, or join existing entities, to support the staffing companies attempts to claim they were independent contractors.
If we haven’t highlighted it enough, the distinction between independent contractors and employees is essential to avoid misclassification. Proper independent contractor compliance requires adherence to specific criteria established by US authorities.
Still Want to Engage Independent Contractors in the US? Follow the Correct Independent Contractor Compliance Steps
We get it. You still want to work with independent contractors in the US to make the most of the benefits they offer businesses. With remote work, the flexibility they offer is unmatched. Follow careful steps to ensure independent contractor compliance and pair up with a partner like PGC who can provide you with the tools necessary to properly determine your compliance, and a solution to pay them if so.
Follow State Laws for Independent Contractor Compliance
Engaging independent contractors in the US often puzzles international business because of varying state and federal laws. The IRS standard law test is followed in the majority of states like Florida, Michigan, and Iowa.
However, certain states follow a worker’s classification rule referred to as the ‘ABC Test.’
Pass The ABC Test to Classify Workers as Independent Contractors
The ABC test, is a test US employers must satisfy in certain states to classify a US worker as an independent contractor.
While the ABC Test is now codified as law in California under AB 5, the test is used in Virginia, and has been in use previously in New Jersey and Massachusetts. The AB5 legalization states that every worker in the state’s it is present in is defaulted as a W2 worker.
Under the ABC test, to classify a worker as an independent contractor, the worker must meet all 3 of the following conditions:
The worker is free from the control and direction of the hiring entity.
The worker performs duties that are outside the usual course of the hiring entity’s business. For example, is it a graphic design business hiring an independent contractor to complete graphic design work? If so, that is part of the hiring entity’s core services as they should not be engaging independent contractors to complete the duties their team is responsible for.
The worker is engaged in an independently established trade, occupation, or business of the same nature of the kind of work performed for the hiring organization.
There are many exceptions, and if the exception applies, the Bill specifies which test that will apply, with the large majority likely falling under the Borello test.
How to Ensure Independent Contractor Compliance With PGC
Yes, after reading through the risks, it can seem intimidating when it comes to engaging independent contractors. But you have to be informed to ensure you follow independent contract compliance.
You’ll be happy to know that PGC can help you mitigate worker misclassification risks via an all-in-one solution, allowing you to assess your workers and pay them if you’ve determined they are within independent contractor compliance.
The best tool on the market based on industry experience
From our 23 years' experience being the ‘go-to’ contractor payroll and employment solution for international recruiters placing candidates in the US, we have been studying the US employment landscape.
We would only settle for the best and most compliant solution to help our clients engage independent contractors. Not only to protect our reputation as the longest serving employer of record in North America, but our clients who are new to the US market, and unfamiliar with US labor law.
Features of worker assessment tool
PGC’s clients have access to a robust assessment tool to carry out worker classifications to minimize the risks of engaging independent contractors.
The tool uses expert technology to evaluate prospective independent contractors under state-specific tests, including the ABC test, the federal guidelines, and case law.
The process to determine the worker’s classification include:
Job details submission - Two parties in the supply chain (the worker and hiring entity) must submit their answers to gauge whether they should be an employee or independent contractor. The tool requires details such as the candidate's work location, to ensure that federal and local law is followed.
Receive a detailed report – The tool provides a report on a scale of unlikely to very likely on whether the worker can be engaged as an independent contractor. This full-spectrum evaluation helps clients determine the relative risk of engaging workers as an IC.
Use this tool for full peace of mind for you and your worker
By utilising the detailed assessment, you will be provided the necessary information to assist in your determination of whether the candidate is an employee or independent contractor. The assessment will be based on federal (DOLR/IRS) requirements, state-specific requirements, and case law.
A lot of the above worker misclassification cases made the headlines because it was found that there was actually no worker assessment carried out. No wonder their workers were misclassified!
Ready to Engage Independent Contractors in the US?
Don’t take the risks, access a world-class worker classification tool at the best available rate on the market. The detailed report will help you determine whether your candidate is an employee or independent contractor in the US.
Even better, once you are happy to compliantly engage your US worker as an independent contractor, you can process your payments to them via PGC. Well, what are you waiting for? Find out how PGC can help you compliantly payroll W-2 and independent contractors in the US.
Disclaimer: All information written here is for general informational purposes only and is not intended to be a substitute for professional and/or legal services.