Top 9 Contractor Compliance Issues and How to Avoid Them (Guide)
10 MIN
The number of people working as independent professionals in the U.S. is steadily rising. As the independent workforce continues to grow, more companies are tapping into this talent source. When engaging this valuable talent pool, organizations must comply with an ever-changing—and often inconsistent—patchwork of policies and laws surrounding independent contractors.
Below, we review 9 common independent contractor compliance issues along with tips for how businesses can avoid them.
GATE
1. Ineffective Policies
While most businesses have some sort of policy in place regarding independent contractor engagement, these policies are rarely followed consistently. Hiring and others who are involved in the hiring process may work around or disregard a structured policy for various reasons. When contractors are engaged outside of a structured policy, critical 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 noncompliance is limiting headcount or changing the way employees are classified. For example, some organizations may transition employees to independent contractor status or freeze headcount but continue to engage contingent talent—some of whom, if properly classified, would be considered employees. That’s why it’s critical for businesses to have an independent contractor engagement policy in place that can be uniformly followed.
When implementing your policy, identify potential obstacles to its adoption and assess if there are barriers that can be altered or removed. If managers are bypassing an existing policy, it’s important to understand why and use this feedback to refine the process.
Most businesses have independent contractor engagement policies in place, but these policies are rarely followed consistently.
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’s 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 it.
Businesses 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 able to accept 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 satisfaction throughout the engagement process.
Liability insurance
Long-term independent contractors cite excessive liability insurance requirements as a common source of frustration. Requiring solo workers to hold a $5 million policy can be cost prohibitive and may even diminish the value of the engagement itself. So, it’s important to re-evaluate insurance requirements or work with a vendor who can provide the insurance coverage you require.
Administrative burdens
An unhappy work environment can arise from imposed tasks or burdens that distract independent contractors from focusing on the services they were hired to provide. Remember, independent contractors are not employees and cannot be treated as such.
Whether you primarily work with direct hire or independent professionals, a satisfied workforce is a critical component to becoming a Client of Choice—an independent professional’s top choice for a client partnership. Demonstrate a commitment to engaging independent talent by committing to a program that provides lasting value. To create a positive engagement experience for independent contractors:
- Provide onboarding support to create a positive 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 high-value project deliverables so independent contractors can see how their work is making a difference
While worker sentiment may not have a direct legal impact on your business, 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. For example: Workers who are classified as independent contractors may sometimes file for unemployment benefits. In many cases involving classification disputes, workers aren’t necessarily seeking benefits from the 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 authorities to ask more questions. In these instances, they 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 prioritizes independent contractor compliance both in structure and in practice. It’s not enough to have policies 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 W-2 employees. On the other hand, payments to independent contractors are reported with a 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.
Some misclassification is unintentional due to lack of understanding regarding worker classification laws and regulations. However, some companies make a deliberate choice to designate workers as independent contractors to reduce labor costs and avoid paying state and federal payroll taxes. When companies misclassify workers, and when workers underpay or fail to pay any taxes at all, government taxing entities have a legitimate concern over lost tax revenue. Therefore, it’s important to have a classification process that puts policies in place for engaging and managing your independent workforce.
There is no one standard rule when it comes to classifying an independent contractor versus an employee.
5. Too Much Work Control
One of the top causes of misclassification is control. Ask yourself: Where does the control originate in my organization? Mandates such as requiring set work hours or having contractors on-site fall under employment governance and can be problematic.
One of the most common issues is having traditional employees and independent contractors performing the same work. If you treat these types of 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 treatment 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, while 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?
6. Unions
Companies that are active in a heavily unionized industry 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 to 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 scrutiny of its classification decisions.
7. Extension of Employee-Like Benefits
Compliance issues can arise from a number of different 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 extend beyond its internal hiring practices and policies to include the employees or independent contractors engaged by the independent contractors working with your organization. If those workers are improperly classified, they may claim that they are employees of the independent contractor you engaged and of your organization. Upon a successful appeal, they could potentially be entitled to backpay (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 such lawsuits.
9. Insurance Carrier Audit
An audit from an insurance carrier may cause a dispute with an employer’s classification of independent contractors. 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. Your 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 independent contractors at all times and ensure that your policies align with government taxing entities, and federal, state, and local policies.
Avoiding risk
One of the best ways to guard against independent contractor misclassification and compliance risk is to have a systematic process for contractor vetting and engagement that guarantees policies and practices are consistently followed and upheld. A centralized program should include a process to determine whether independent contractors are truly self-employed. Utilize a questionnaire or checklist to vet contractors and request documents that validate self-employment. Gather information that can help you answer
the following questions:
- 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 along with additional information, it can help you determine whether 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. Never 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 doesn’t 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—and will 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 contractor’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. Once that’s done, you’ll want to make sure these policies are uniformly enforced throughout the organization. Also, create 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.
Partnering with a company that specializes in independent contractor engagement and compliance can help minimize your risk and ensure your business remains compliant.
Conclusion
Independent contractors offer a variety of benefits, but companies must always 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’s due to some change companies have made, such as a layoff or headcount freeze. If you choose to include independent contractors as part of your workforce, ensure that you have a policy that provides clear direction to your management team on how to engage, pay, and manage these 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 will use 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 ensure your business remains compliant.
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