GUIDE | 10 MIN READ
9 Common Contractor Compliance Issues and How to Avoid Them (Guide)
Businesses that engage independent contractors must assess classification status, evaluate liability insurance and indemnification issues, consider immigration control, work through benefit issues, and account for government contracting and subcontracting nuances.
When contractors are engaged outside of a structured policy, vital steps in the classification and engagement process may be overlooked. This can leave businesses open to an increased risk for compliance issues.
Any type of claim filed against your company could reveal a deeper independent contractor compliance issue that needs to be addressed.
The number of people working as independent professionals in the United States is steadily rising. As this workforce continues to grow, so do the number of companies tapping into this talent source. When engaging this valuable talent pool, organizations must comply with the ever changing—and often inconsistent—patchwork of polices and laws surrounding the independent workforce. Businesses that engage independent contractors must assess classification status, evaluate liability insurance and indemnification issues, consider immigration control, work through benefit issues, and account for government contracting and subcontracting nuances. Below, we will review 9 common independent contractor compliance issues along with tips for how businesses can resolve them.
In this guide, you will learn more about the 9 most common contractor compliance issues and how to avoid them:
1. Ineffective Policies
While most businesses have some sort of policy in place regarding independent contractor engagement, these policies are almost never uniformly followed. Managers may work around or ignore a structured policy for any number of reasons. When contractors are engaged outside of a structured policy, vital steps in the classification and engagement process may be overlooked. This can leave businesses open to an increased risk for compliance issues.
A common source of policy non-compliance is limiting headcount or changing the way employees are classified. For example, some organizations may transition employees to contractor status or freeze headcount but continue to engage contingent talent—some of which, if properly classified, would be considered employees. It is critical for businesses to have an independent contractor engagement policy in place that can be uniformly followed. When putting this policy in place, examine any potential obstacles to policy adoption and determine if there are barriers that can be altered or removed. If managers are bypassing a current policy, it is important to understand why and use this feedback to improve the procedure.
Most businesses have some type of independent contractor engagement policy in place, but these policies are almost never uniformly followed.
2. Dissatisfied Workers
Workplace happiness impacts productivity and retention. While your organization may have a process in place for evaluating and improving employee satisfaction, this process likely does not extend to independent contractors. Worker sentiment may have little legal impact on your business, but it can be a significant factor in classification liability.
COMMON SOURCES OF DISSATISFACTION
While it is imperative to have policies in place to engage independent contractors, these policies should not be a source of dissatisfaction. Remember, most worker classification cases are close calls, with workers presenting some indication of both employee and independent contractor status. A satisfied worker who agrees with their classification is less likely to challenge that classification. Businesses must be careful to engage independent talent compliantly and sensibly. They should be mindful of how that talent sees and experiences their company. Engaging independent contractors in a way that leaves them feeling dissatisfied is one of the biggest reclassification risk warnings. Common sources of dissatisfaction with company engagement policies include:
LONG NET PAYMENT TERMS
Many organizations have a blanket policy in place for vendor payment. While larger vendors may be okay with net 90 terms, these payment terms are likely not practical for individual independent contractors. Aligning payment terms with market standards of 30 days or less can help to increase independent contractor happiness throughout the engagement process.
Long-term independent contractors cite excessive liability insurance requirements as a common source of discontent. Requiring solo workers to hold a $5 million policy can be very expensive and may even diminish the value of the engagement itself. Re-evaluate insurance requirements or work with a vendor who can provide the insurance coverage you require.
An unhappy work environment can stem from imposed tasks or burdens that distract independent contractors from providing the service they were engaged to do. Remember, independent contractors are not employees and cannot be treated as such.
A satisfied workforce, whether direct hire or independent, is a critical component to becoming a Client of Choice—independent talent’s top choice for a client partnership. Demonstrate a commitment to engaging independent talent using independentcontractor friendly terms and committing to a program that demonstrates lasting value. To create a positive engagement experience for independent contractors:
▪ Provide onboarding support to create a positive user experience
▪ Create a client-branded website to educate independent contractors about what to expect when engaging with your organization
▪ Encourage proactive communication from hiring managers
▪ Require managers to report on highvalue project deliverables so independent contractors can see how their work is making a difference
Worker sentiment may have little legal impact on your business, but it can be a significant factor in classification liability
3. Unemployment Applications
Any type of claim filed against your company could reveal a deeper independent contractor compliance issue that needs to be addressed.
Workers who are classified as independent contractors may sometimes file for unemployment benefits. In many cases that lead to classification questions, the worker isn’t even seeking benefits from the particular business that classified them as an independent contractor—they’ve simply left a job and have applied for benefits.
State-required paperwork that asks about other income can uncover an independent contractor arrangement that may lead the state to ask more questions. In these instances, a state agency may review the worker’s classification status and if the worker is found to be an employee, the employer will be forced to make unemployment contributions. This may lead to a more detailed investigation and the reclassification of similarly situated workers. The risk of misclassification can be reduced or eliminated by recognizing that your organization is not immune to this liability. Make sure that your business has a focus on independent contractor compliance both in structure and in practice. It is not enough to have polices in place if your practices continue to treat independent contractors like traditional W-2 employees.
Your state government may investigate your company if they have reason to believe your employees are incorrectly classified
4. Tax Audits
Tax audits are one of the largest sources of misclassification. As an employer, you have a responsibility to withhold and pay taxes for properly classified employees. Payments to independent contractors, on the other hand, are reported on Form 1099. Unlike employees, independent contractors are responsible for reporting and paying their own taxes. There is no one standard rule when it comes to classifying an independent contractor versus an employee. Instead, employers must weigh a variety of federal and state-level tests and guidance documents to determine how to classify workers.
While some misclassification is unintentional due to lack of understanding regarding worker classification laws and regulations, it is sometimes deliberate to reduce labor costs, and avoid paying state and federal payroll taxes. When companies misclassify workers, and when workers underpay or don’t pay their taxes, government taxing entities have a legitimate complaint of being cheated out of tax revenue. It is therefore incredibly important to have a classification process that puts polices in place for engaging and managing your independent workforce.
While some misclassification is unintentional, it is sometimes done deliberately to reduce labor costs, and avoid paying state and federal payroll taxes
5. Too Much Control
One of the top causes of misclassification is control. Ask yourself: where does the control originate in my organization? Mandating a great deal of oversight such as requiring set work hours or having contractors on site falls under employment governance and can be problematic.
One telltale sign is having traditional employees and independent contractors performing the same work. If you treat these workers in the same way, you are exposing your company to misclassification. Even if your industry commonly classifies workers as independent contractors— such as in the construction industry—you must ensure that your reatment of them aligns with the factors used to distinguish them from employees. Common differences between employees and independent contractors include:
- Independent contractors operate as their own business—they are often sole proprietors or have an incorporated business.
- Independent contractors are engaged for a specific project or time period, whereas an employee’s job may encompass a wide variety of duties and tasks.
- Independent contractors determine when, where, and how they work.
- Independent contractors can subcontract or delegate work and are allowed to openly market their services.
- Independent contractors are experts in their industry, whereas employees typically receive some sort of on-the-job training.
The No. 1 question to ask to determine if you have a misclassification problem is: where does control originate?
Companies that are active in a heavily unionized field should be concerned about any union efforts to reclassify independent contractors as employees. Typically, unions are not in favor of independent contractor engagements and may try and use new legislation to bring claims against employers. Unions tend to view independent contractor agreements as a way for corporations to avoid union organization. If a business classifies workers as independent contractors in a traditionally unionized area, it may experience more than the usual scrutiny of its classification decisions.
7. Extension of Employee-Like Benefits
Compliance issues can arise from a number of sources, but perhaps one of the most perplexing involves corporate extension of employee-like benefits to independent contractors. Or, more specifically, the failure of businesses to specifically exclude independent contractors from accessing benefits available only to employees. When identifying potential compliance-related risks, organizations should:
- Avoid treating independent contractors and employees similarly, particularly in terms of supervision and control. Doing so introduces vulnerability to misclassification challenges, which can result in costly fines and penalties.
- Incorporate language that specifically excludes independent contractors from certain employee-only benefits.
Minimizing exposure to compliance issues is a perpetual balancing act.
8. Insufficient Hiring Policies
An organization’s compliance responsibility must go beyond internal hiring practices and policies, extending to the employees or independent contractors used by the independent contractors your organization engages. If those workers are improperly classified, they may claim that they are both employees of the independent contractor you engaged as well as your organization. If successful, they could potentially be entitled to back pay (including overtime) with interest and retroactive benefits commensurate with your regular employees. If your contractors violate the Fair Labor Standards Act (FLSA) wage and hour statuses, U.S. Immigration and Custom Enforcement (ICE), Department of Labor (DOL) guidelines, or any state, local, or federal hiring laws, your company could be at risk. Wage and hour class action lawsuits are relatively easy to certify, and a worker-friendly regulatory climate has contributed to a substantial increase in associated suits.
9. Insurance Carrier Audit
An audit from an insurance carrier may dispute an employer’s classification of independent contractors. For example, workers’ compensation audits are conducted after each policy period ends or expires. The audit is used to reconcile your premium base against the estimates used to establish the actual earned premium for the policy. In the case of workers’ compensation, the insurance carrier may surmise that it has potential claim exposure from an independent contractor even if the worker and employer have agreed to use an independent contractor classification. To offset this perceived risk, the insurance carrier may assess higher employer premiums and failure to pay those premiums could result in a loss of coverage.
Therefore, an independent contractor program must include stringent record keeping and governance control. You should have an accurate count of contractors at all times and ensure that policies and worker treatment align with government taxing entities, and federal, state, and local policies.
One of the best ways to guard against independent contractor misclassification and compliance risk is to have a systematic process for vetting and engagement. Build out a program that guarantees policies and practices are consistently followed and upheld. A centralized program should include a process to determine whether or not independent contractors are truly self-employed. Utilize a questionnaire or checklist to vet contractors and request documents that validate self-employment. Gather information that allows you to determine
- Does the independent contractor have a fictitious or assumed business name?
- How is their business structured?
- Do they have a business address and phone number?
- Where do they perform their work—at home or at a separate business location?
- Do they meet your requirements for insurance?
- Do they employ or engage other workers? If so, are these workers employees or independent contractors?
- How do they market their business?
- What other clients have they worked with?
This checklist will not provide conclusive evidence of independent contractor status, but, together with additional information, it can help you decide if treating this worker as an independent contractor will be a risk. Always keep in mind that independent contractors are business entities and should not be treated as potential employees. Do not ask them to complete an employment application and if you provide a written questionnaire be sure to have the words “independent contractor” prominently displayed on the document. If the questionnaire does not reveal any red flags, the following documents can be useful when considering the three categories—Behavioral Control, Financial Control, and Relationship of the Parties—that the IRS recommends reviewing when determining worker classification:
- Written Contract or Scope of Work (SOW): A written contract or SOW helps to demonstrate the items outlined under Behavioral Control; it can show that the true structure of the work relationship is consultative in nature. It can also tie into the assessment of Relationship of the Parties by describing the permanency of the relationship whether the relationship is
ongoing or defined for a specific period of time.
- Insurance and Certificate of Insurance (COI): Having insurance or a COI helps to document the investment and opportunity for profit/ loss noted under Financial Control.
- Marketing collateral: Marketing collateral, such as a professional website or ad copy, can serve in support of Financial Control, showing the independent co tractor’s services are available to the market.
If you conclude that the worker can safely be treated as an independent contractor, you will need to have a written independent contractor agreement that outlines the terms of the engagement. Make sure these polices are uniformly enforced throughout the organization. Finally, have a written policy that aligns with both your business practices and all applicable laws that govern the use of independent contractors. Review this policy for appropriateness and adjust as needed over time.
Insurance audits can be costly for employers who are misclassifying independent contractors, even if they are doing so unintentionally
Independent contractors provide many benefits, but companies must be conscious of changes in the legal landscape. Practice recognizing potential compliance problems before they turn into costly litigation. Often, when independent contractor compliance issues arise, it is due to some change companies have made, such as a layoff or headcount freeze. If you choose to utilize independent contractors as part of your workforce, ensure you have a policy that provides clear direction to your management team on how to engage, pay, and manage contractors.
While there are many steps you can take to avoid misclassification risk, independent contractor engagement is a confusing road to navigate. Firms like MBO Partners have an established methodology in place for evaluating and engaging independent workers for clients and utilize proven best practices for minimizing or eliminating issues with contractor engagement. Partnering with a company that specializes in independent contractor engagement and compliance can help minimize your risk and make sure your business remains compliant.
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