Legal Ways to Resolve Contractor or Employee Issues

Payment penalties, class-action lawsuits, and jail time.

Those are just a few potential consequences of misclassifying workers as independent contractors when they perform the work of employees. Some companies hire people as contractors to avoid paying social security taxes, medicare taxes, and other employee benefits and payroll taxes.

However, some employers may misclassify their workers unwittingly. The government established several types of tests to help employers determine whether their workers should be independent contractors or employees, but the criteria may not always be 100% clear.

In this article, we’ll walk you through the steps to take if you believe your contractor started to resemble an employee.

You might worry for a reason about your contractor's status if:

• You control when and how the contractor works
• The contractor has been working for you a long time
• The contractor is working for you full-time
• The contractor doesn't have other clients
• The contractor is an integral part of your team (i.e., a part of the sales team)

5 ways to determine whether your contractor is actually an employee

Employees have certain privileges over contractors, afforded to them by the Fair Labor Standards Act (FLSA). These privileges include (but aren’t limited to) minimum wages, unemployment insurance, and workers’ compensation.

The government wants to protect misclassified employees, which can only happen if employers determine workers’ employment status. Plus, independent contractor misclassification represents a huge tax revenue loss for the government. That’s why the government came up with several ways to determine if your worker should have employee or independent contractor status.

The IRS 20-factor test

Also called the “Right-to-control” or the common law test, the Internal Revenue Service’s 20-factor test gives employers 20 factors to assess classification in three categories: behavioral control, financial control, and permanency of the relationship.

Some of the questions you’ll answer include:

• Do you tell the contractor where, when, and how to work?
• Do you require the worker to follow set hours of work?
• Does the worker work full-time for you?
• Does your worker receive training from you?
• Do you reimburse the worker’s business expenses?
• Does your worker only work for you?
• Can you fire your worker?

If you answer yes to most of the questions, your worker is likely an employee.

Check out the full list of all 20 questions here.

Reasonable basis test

The reasonable basis test examines whether you have reasons to avoid withholding federal taxes from a worker. You can fairly give workers independent contractor status if:

• A past IRS audit didn’t discover illegal practices in the employer’s worker classification, and the employer didn’t receive any fines and penalties for that reason
• The employer’s industry already has a consistent practice in classifying workers in similar situations as independent contractors
• The employer has a court ruling that confirms their practice of classifying workers as independent contractors in similar circumstances
• The employer classified their workers according to official advice from an attorney or CPA

DOL's economic reality test

The US Department of Labor uses the economic reality test to determine a worker’s status. This test relies on evaluating a contractor’s economic dependence on an employer. Remember, independent contractors are self-employed—business owners in their own right who don’t depend on a sole employer like full-time employees do.

The test uses five primary factors to determine a worker’s status:

• The degree of control that a worker has over their own work
• The opportunity for profit or loss a worker has based on their investment
• The amount of skill necessary to perform work
• The permanence of the working relationship between the worker and the employer
• The extent to which the worker’s job is a part of core business activity

The first two factors carry more weight than the others, although it’s impossible to single out one factor that’s decisive in every classification case.

ABC test

The ABC test uses three critical factors to determine the worker’s status. It’s used across the US, but was first codified in California, by the California Supreme Court.

The factors considered in the ABC test classify a worker as an independent contractor only if they:

• Typically perform the same kind of work for other clients, too
• Perform work that’s not considered a part of the regular business activity for the employer
• Don’t receive instructions on how to perform the work

The ABC worker classification has recently seen changes in terms of defining an independent contractor and professions that fall into this category, especially regarding drivers for companies such as Uber or DoorDash. You can read more about it here.

Form SS-8

Form SS-8 is an IRS form you submit to ask for an official evaluation of your workers’ status.

If you’re not sure whether you should classify them as an employee or an independent contractor, you can ask the IRS for help. Note that your contractors also have the right to submit this form if they suspect they should have an employee status

Your options to avoid misclassification

Given that you still need your contractor’s services, you have two options to continue your working relationship: redefine the contractor’s scope of work and your degree of control or bring them on as an employee.

Redefine the contractor's scope of work and your degree of control

If you want to keep your worker on the team as a contractor, revisit your independent contractor agreement and redefine their work conditions.

For example, you can:

• Reduce the contractor’s workload (or hire another contractor to take over a portion of their work)
• Allow the contractor flexible working hours
• Let the contractor work anywhere they want, not just on your premises
• Allow the contractor to determine the best method for performing the work
• Reduce the contractor’s working hours so they can work for other clients
• Avoid reimbursing the contractor’s expenses

Bring the contractor on as an employee

If you want your contractor to keep working under the same conditions, but you’re worried about misclassification risks, you can end your independent contractor relationship with them and bring them on as a full-time employee.

This new employer-employee relationship will require a new written contract and new tax documentation. You will have new responsibilities as an employer, such as paying employment taxes or providing sick pay for your employee, that your new employee wasn’t entitled to before.

How to convert a contractor into an employee

If your budget and business plan allow you, you can convert your independent contractor into an employee. Here are the steps.

Make an offer to your contractor

Some surveys found that many contractors would actually love to have full-time employment. Your contractor might accept your offer, but you should make it compelling. Contractors typically appreciate the flexibility of contract work, so try to include a flexible work schedule or flexible PTO in your list of perks.

Use our employee cost calculator to find out how much to budget for the new employee, including salary, benefits, and payroll taxes.

Collect new employee information

Once your contractor accepts the offer, it’s time to collect the new tax forms you’ll need for an employee, such as the forms W-2 and W-4.

You may also need other information for employee benefits and tax purposes: whether the new employee is married, has children, owes student loans, needs equipment to perform the job, and so on.

Introduce the new employee to the team

To make your new employee feel welcome, organize intro calls with the rest of the team and allow people to get to know each other. The onboarding process should also include training sessions with the team manager, so your former contractor can learn about the internal processes and company culture.

Sending your new hire company swag is a nice touch to make them feel like a part of the team.

Add the new employee to your payroll

Your new employee is now on your payroll and doesn’t send you invoices anymore, so their data needs to be in your payroll software. This is a critical step that ensures accurate tax withholdings and employee benefits administration.

Read our getting-started guide on payroll management.

What if your contractor is foreign?

If you hire foreign contractors and they start resembling an employee, the implications are similar. You still need to evaluate your business relationship and determine what status they should have, with one (critical) difference. You need to consider the local employment law and tax regulations in the contractor’s home country.

Read more about your options to hire international employees.

Methods of hiring

If the foreign employee stays in their home country and performs the work remotely, you can hire them through an employer of record or open a local legal entity and hire them directly. In either case, you need to withhold their taxes according to the local tax laws and provide them with their country’s mandatory employee benefits.

Foreign labor laws

Whether you hire from Germany, China, Nigeria, or Peru, you will stumble upon different labor laws that define independent contractors and employees differently. It’s critical to gain familiarity with local employment laws and create compliant contracts.

Check out our global hiring guide to see labor laws and other regulations in countries worldwide.

Tax withholding

When your company considers hiring its service providers as employees, you should be aware of different tax withholding and reporting rules. It would be best if you took both the US (assuming your company is in the US) and the local country of your service provider into the equation.

If you’re sponsoring your new employee to come to the US to work for you, you should withhold the foreign employee’s income tax at the same rate as US residents. The tax withholding can be reduced or exempt if the employee’s country has a tax treaty with the US, and they claim this exemption through Form 8233.

Permanent establishment in the foreign country

A permanent establishment of the company means that the business has stable and ongoing activities that result in locally created income. In some countries, having employees, particularly those engaging in sales activities, is considered sufficient grounds for a permanent establishment.

Each country has its regulations for a permanent establishment, with some countries being more strict than others. You should seek counsel from local tax specialists before you hire employees in a foreign country.

Permanent establishment substitutes

One way to avoid permanent establishment would be to hire contractors who are incorporated in their local country as legal entities (companies, agencies, or others). A business-to-business contract will more likely be interpreted as “a contractor relationship” in many countries.

You can hire individuals as leased employees through a temporary agency or a partner business in the local country which hires them as employees. That way, your business can have a contract with the said local company offering the services as a contractor.

Hire contractors and employees hassle-free with Deel

Whether you decide to keep your worker as a contractor or convert them into an employee, Deel can help you hire anyone anywhere in a matter of seconds.

Our all-in-one platform allows you to make mass payments to your whole team in just one click and manage locally compliant contracts for your entire global team. With our customer support team working around the clock to help you with any concerns and a team of legal experts to ensure full compliance, nothing stops you from tapping into the global talent pool.

Want to see Deel in action? Schedule a demo with one of our experts.

Disclaimer: This post is provided for informational purposes and should not be considered legal advice. Talk to a legal professional such as an employment lawyer for more info.