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The increased use of independent contractors by companies across the globe has led to a shift in the way that some work roles can be filled. The independent contractor relationship simplifies many of the complex employment challenges that a multinational will encounter when operating in foreign countries. By combining a remote work strategy with teams of contractors, a business can access a flexible and skilled international talent pool for many types of positions, without setting up multiple office locations.
This approach is not without perils however, as governments are cracking down on overuse of contractors, which in some cases is seen to undermine labor laws and worker rights to benefits, overtime and other employee protections.
This guide outlines the basic rules on classifying and hiring independent contractors, as well as the risks and consequences for a company that uses these self-employed individuals in foreign countries. At the end of the guide you will find guidance on potential solutions to overcome the challenges of hiring contractors for international work.
An independent contractor is any self-employed individual who performs services for a specific client under agreed terms and conditions. They may be known as independent contractors, freelancers or consultants, and are usually self-employed or may work through an umbrella or management company. The scope of work and length of service are spelled out in the contract, such as time allotted, deliverables, deadlines and project payment.
Independent contractors are not employees of the client, as long as they fall within the legal definition of a contractor. This definition is subject to interpretation, and will depend on the laws of the country where work is performed. The client’s only obligation is to pay the contractor for the agreed work, and once complete there is no further relationship unless a new project is contracted.
Further, contractors do not receive any of the statutory rights of employees, such as holiday pay, sick leave, health benefits, pension payments and severance pay. Contractors are essentially self-employed and responsible for managing their own benefits, tax payments and withholding from income.
For a business, there can be real advantages to hiring contractors for short term projects or occasional services. It can be a cost-efficient method to fill certain roles that do not require a full time employee. In general, hiring contractors is less costly than adding employees since there are no contributions required and the expense is fixed by the terms of the contract.
The advantages are amplified when hiring workers for international roles and projects, since there is often no need to comply with host country employment, payroll and labor laws when using independent contractors. All compliance falls to the contractor to fulfill.
Hiring independent contractors requires that the client specifically define the work parameters or services that they expect, but the contractor will have control over their time, work methods and equipment used. This is the primary distinction from employees, who are under the direction and control of their employer.
There will typically be a written contract or agreement in place, method of payment and verification of work quality and completion. Some contractors will want to use some type of escrow or incremental payment system with new clients, to protect themselves from non-payment issues.
Contractors are paid based on their output in time spent or work results. Sometimes a contractor will want to be paid a partial amount up front for large projects, but typically they will be paid upon completion. Companies should avoid paying contractors on a regular monthly basis, since in some countries that could be construed as one component indicating an employment relationship.
Actual payments can be made through bank or wire transfer, third party payment providers (such as Paypal) or check. Electronic transfers are the simplest and quickest across international borders, and the currency of payment should be spelled out in the contract, as well as who is responsible for paying any bank or transfer fees.
Payroll for independent contractors
Because contractors are not employees, they are not really on the company payroll. A contractor will normally invoice the client just as another business. Paying the contractor via the company payroll is not recommended and could be a step toward having the contractor re-classified as an employee by authorities.
Independent Contractors Tax Rates
Tax rates for contractors will depend on their country of tax residence and any local tax rules where the work is performed. The client has no responsibility for either computing or withholding taxes from contractor payments, however, some countries such as the United States do require that a company report payment amounts to tax authorities when a certain threshold is exceeded. There is more detail on US tax reporting later in this guide.
The written agreement or contract with the IC should contain specific terms that explain the services provided, terms of performance or completion and payment. It should also have conditions in the event of non-performance, remedies and partial payments if allowed. The contract will be limited to the named client and contractor, and only for the duration of the project or service.
At a minimum, there should be at least an email containing a memorandum detailing any verbal agreements or understandings, and if there is goodwill between the contractor and client this could be sufficient.
Do labor laws apply to independent contractors?
In most countries, labor or employment laws will not apply to contractors since they are actually a separate business, and not an employee of the client. Labor laws are designed to protect employee rights, but it falls to the contractor to protect their own interests and to pursue any non-payment or resolve conflict through normal legal channels.
Non-compete clause for independent contractor
A business may want a contractor to sign a non-compete clause preventing them from doing similar work for a competitor. Some contractors may resist agreeing to this type of term since it may narrow their work opportunities, but if the contract is long term or the client is important then the IC might agree to some limited form of non-compete to be included in the agreement.
In spite of the general rule that independent contractors handle their own benefits and pension payments, in Australia contractors must be paid superannuation (pension) under certain circumstances. If the contractor is a person (not a company or partnership) and is paid at least half the contract value for their labor and services, then superannuation payments are required by the client. The amount of the payment is 9.5% of the total labor amount of the contract.
If an independent contractor is under a long term agreement, they may request some type of benefits similar to an employee, such as access to a health plan. However, companies have to be careful about including contractors in employee benefit packages, as there is a risk that the worker could be reclassified as an employee under local laws. This issue of classification is important, and will be discussed in detail in the next section.Subscribe to get more insights like this.
Just because a business hires a worker as an independent contractor, there is no guarantee that they will be viewed that way by governmental labor or tax agencies. For this reason, standards and tests for classification are important, and present one of the very real challenges of hiring independent contractors.
The cross-border use of independent contractors has forced multinational companies to examine the specific employee classification rules in both their home country and foreign markets. While there is a trend toward using ‘on-demand’ workers to manage costs especially for short-term foreign assignments, there are also risks to relying on contractors for every type of work role.
It is possible that in some instances, the contractor relationship and scope of work will be re-classified as an employee relationship by labor and tax authorities, leading to penalties for misclassification. For this reason, it is essential to review the basic guidelines used for employee vs. contractor classification to ensure compliance.
Due to the importance of employment law protections, most governments have criteria that define the employee relationship, so that companies do not take advantage of exclusive use of contractors. In general, the primary difference between employees and independent contractors is the degree of autonomy the worker has in carrying out their duties. An employee is really under the control and direction of their employee, while a contractor meets their work obligations while being self-directed.
Depending on the specific country laws and regulations, there are a few key factors that are used for classification of employees and independent contractors.
The type and scope of the work assignment:
Long term work relationships may be construed as legal employment, especially if the contractor fills multiple, ongoing roles for the client. Even if an assignment is part time there is the risk that the worker could be classified as an employee.
Scope of work is also important, since contractors typically fill specialized or technical roles, rather than administrative or managerial positions. Generally, if the work is the type that is project based for a finite time, then it is probably a contractor relationship. Long term, part-time assignments could be classified as an employee relationship depending on the following factors.
Company control and direction over the worker:
Control over the worker may be the primary factor used in classification in most countries and will depend on several elements for each type of work relationship. For contractors, look for indicators that they control their own schedule and work methods. For employees, there will indicators that the company sets their hours and directs their work, and also may provide training.
Key Independent Contractor Indicators:
Key Employee Indicators:
While these criteria may seem straightforward and easily applied, there are grey areas that emerge as pitfalls for misclassifying a worker as a contractor. A few of these may include situations such as:
One worker cannot be both an employee and independent contractor for the same company. Even if the employee fills multiple roles, their employment relationship would cover the full range of work activity, and cannot be partitioned. However, it is possible for the same individual to be the employee of one company, and a contractor for another (for example offering consulting or training services on an ad hoc basis).
Employer misclassification of independent contractors
One of the reasons that companies use independent contractors is because of the cost-savings involved. The payment of benefits, employment taxes, social security and pensions makes a formal employee a more expensive worker by as much as 40%.
However, there is an increasing scrutiny of companies that use independent contractors simply as a means to avoid paying employee benefits and taxes. The construction industry is one area where it is common for companies to save money by classifying workers as contractors.
The high-tech industry also relies on freelance workers to fulfill specialized tasks or short-term projects, however they are now facing a new level of attention to ensure those workers are not actually employees. In some instances, a contractor can bring unwanted attention to a company by filing a claim for unemployment, which may trigger an investigation by the labor department into the company’s employment practices.
Also, there is the risk that contractors could file lawsuits seeking the same benefits and wage protections as employees, which in some cases may undermine a company’s reliance on contract workers.
In this case against driving companies Uber and Lyft, the contractor drivers have brought attention to the issue, and “the drivers, should they win these lawsuits, could be entitled to either hourly wages or a regular salary, as well as reimbursement for the money they’ve spent on things like gas and insurance as drivers for Uber and Lyft.” This is a very real risk for any company that uses contractors and freelancers to support their business model.
At a minimum, a company should use some type of checklist to ascertain whether a worker is truly a contractor, or acting more like an employee. Because there are general criteria used in almost every country, it is possible to identify misclassification issues before they arise and bring penalties for non-compliance.
Employee / Contractor Checklist:
Employee = Long term
Contractor = Short term
Employee = Directed by Company
Contractor = Self Directed
Employee = Broad responsibility
Contractor Limited scope of work, project based
Employee = Salary based
Contractor = Paid on project completion
Employee = Long term
Contractor = New association, short term
The following interactive self-test is one tool that can be used for preliminary classification of a worker at home or abroad, and it uses the criteria listed above to arrive at a probable classification.
The widespread use of contractors by companies has led to an increased scrutiny of work relationships by many countries. There is an obvious appeal for a company to use independent contractors, given the ease of initiating work, avoiding onerous immigration and employment laws, and the related cost savings. For short term or very specific assignments where the worker controls their own activities, a contractor relationship may be both suitable and legal.
However, if the company controls the work methods and time of the worker on assignment, then an employee relationship is probably in place. In many countries the rules that protect worker’s rights may carry significant back payment obligations, as well as statutory penalties for employer misclassification.
Governments are taking these cases seriously due to the significant lost revenues at stake. The US Department of Labor discovered over $270 million of unreported wages in 2013, along with $10 million in past due unemployment insurance contributions.
The penalties can be severe for misclassifying an employee as a contractor, and can include:
For companies that use contractors for overseas assignments, it is essential to understand the specific criteria used in each country for classification of workers. Most jurisdictions will have laws that define the employee relationship and factors that may contribute to having independent contractors actually construed as employees. This is important because there are major differences underlying a formal employment relationship that carry increased cost and legal obligations for the employer.
There can be significant penalties for misclassification, and a company needs to closely assess the specific country rules to avoid violating employment, tax and labor laws. The employee classification laws apply to both domestic and foreign companies with local subsidiaries, although in some countries such as China and the United Kingdom, the burden of arriving at the correct classification will fall on the worker.
To limit the risk of misclassification, the laws of the host country should be thoroughly researched and understood since the elements used to determine ‘right of control’ can differ in each jurisdiction.
If an employer misclassifies a worker as an independent contractor rather than an employee, the risks in the home or host country might include:
Nonetheless, many companies may continue to accept these risks due to the fact that using independent contractors is far more cost efficient than hiring employees for the same work assignment.
Workers who are self-employed contractors usually will be responsible for making their own social security, tax and other statutory withholdings. If the worker believes that there is actually an employee relationship, then these payments may go in arrears, since neither the company nor the worker is making the required contributions. If the company can show that a contractor relationship exists, then the unpaid contributions would be the responsibility of the worker.
The Australian employment laws are designed to protect the rights of workers and their statutory entitlements. There are two primary legal guidelines in Australia, the Fair Work Act, which governs worker rights and remedies in the event of misclassification; and the multi-factor test that is used to determine when an employee relationship is created.
In the event that an employer misclassifies a worker as a contractor, the consequences under the Fair Work Act will include:
As mentioned, Australia does require a company to make superannuation payments to independent contractors, even if there is no employment relationship.
Just as in Australia, misclassifying the work relationship will carry statutory liability for the employer in the following areas:
Employers are required to deduct income tax from an employee’s income, but not from independent contractors. Thus, if a contractor relationship is re-classified as an employee, past tax withholding will be due and could be the total responsibility of the employer if the worker is unable to make the payment.
Pension and Insurance
Employers in Canada must contribute to the national pension plan and employment insurance for each employee, but the law does not apply to contractors. If a work relationship is ruled as an employee rather than contractor, then the employer would be responsible for paying both their own share as well as the employee share of owed deductions, plus penalties and interest.
Typically, wrongful dismissal or termination claims are limited to employees, and independent contractors do not have the same statutory or common law rights surrounding notice periods or severance pay. However, a contractor with some length of service may attempt to receive severance pay by claiming formal employee status and the accompanying rights and benefits.
Employer Vicarious Liability
Vicarious liability for employers in Canada can arise when an employee’s acts or omissions create some type of harm to a third party. This law does not apply to contractors, and in the event of re-classification as an employee, the employer may find itself exposed to unforeseen liability for past actions of the worker.
In Belgium there are a few distinct differences from other jurisdictions, and in some cases the worker will share liability in the case of misclassification.
While employers are responsible for withholding income taxes, in the event of misclassification the employee could be liable for the past due taxes. The company would have to pursue a claim against the worker, as employer would still have direct liability for payment to the tax authorities. Liability for non-payment can be claimed by the tax office for up to three years preceding re-classification (5 years in the case of fraud).
Past due social security contributions resulting from re-classification are the sole responsibility of the employer. The company could face payment of both their own share as well as the employee share, plus penalties and interest. Contrary to the rules governing owed tax payments, the company cannot attempt to recover social security contributions from the employee, even if the terms of the contract provide a basis for making a claim.
If a work relationship in Belgium is re-classified as formal employment rather than as contractor, then the worker would have rights to make benefit claims from the start of the work relationship.
These benefits can include:
Given the economic impact of these owed payments and benefits, it is crucial that foreign employers entering Belgium clarify work relationships when entering the labor market.
Companies with operations in foreign countries frequently use independent contractors or freelance workers to reduce staffing costs, and avoid the commitment of an employment relationship. The benefits of using a contractor include savings on benefit packages, unemployment insurance and the expense of incorporating and running an host country compliant employee payroll. However, an independent contractor will not have the same job dedication as a full time employee, and once a project is complete then the relationship may end.
Employees on the other hand, will usually be on assignment as part of a long-term employment relationship, and will have a deeper involvement with the company that goes beyond the current project parameters. Along with an employee relationship are the related costs of employee benefits, pensions and relocation expenses.
Because of the trend toward use of contractors for specific work tasks, “increasing numbers of workers find themselves in contractual relationships that do not guarantee hours worked or provide benefits such as paid vacation, sick days, or pension benefits…Major corporations have opted to use subcontracting to perform basic functions, and many workers are now classified as independent contractors, eroding basic labor-law protections.”
There are two distinct methods for a multinational company to enlist and manage workers in a foreign market (who are not employees on temporary assignment and still paid in the home country.)
This section will outline the distinct relationships and responsibilities of independent contractors enlisted by a contractor management company, compared to employees of a Global Employment Organization (GEO, also referred to as a PEO in the US). It is essential for an employer to appreciate the differences before making a decision on which method is optimal for their business objectives and available resources.
Each method has advantages and disadvantages, depending on the type of work being performed, duration of employment and whether a worker is accustomed to working as a contractor or employee.
Pros and Cons of Independent Contractors
In some cases, an independent contractor will work through a management company, relieving some of the risk of misclassification. The contractor management company may act as ‘Employer of Record’ on behalf of the contractor, but there is no substantive employment relationship with either the management company or the end client.
In some countries such as the US, this is an important element since there are tests of control and management to define independent contractors for tax purposes. Failure to maintain worker autonomy could affect taxation of both the worker and the company.
Some of the functions of a management company for an independent contractor include:
The independent contractor’s work is directed by the end client in terms of time spent (hours/days worked) or productivity (milestones/deliverables), but the contractor maintains autonomy and flexibility in achieving client objectives. This is a key distinction from the employee relationship, and many independent contractors have specialized skills to offer companies expanding into new markets. They are used to working on their own, and willing to allow a management company to take care of the paperwork and steps required for local compliance.
The actual contract for work is with the management company, for the term of the contract or until completion of specific tasks. At that point, the contractor could continue with the management company for additional contract work if available.
If a company hires independent contractors (either working on their own or through a management company) there are certain advantages:
The disadvantages of using independent contractors include:
Given these points, the IC relationship might be preferable for a company that has a need for temporary skilled workers, and does not want to use any in house resources for payroll compliance. The only caveats are to ensure that they are engaged in a true independent contractor relationship and the IC has adequate employment compliance documentation
Pros and Cons of GEO Employees
When a company uses a Global Employment Organization (GEO) to provide outsourced employment services, the GEO is responsible for all aspects of employment and payroll administration. The GEO can be used to assign current employees abroad, or to engage independent contractors in a third party employment relationship.
There are obvious advantages for the expanding multinational company in utilizing a GEO:
There are some disadvantages of outsourcing employment with a GEO including:
Depending on the exact nature of the GEO employee solution used, there can be advantages for both employee and employer under this approach. The obvious positive element is the continuity of the employee relationship with the company, which offers the employee job security and benefits even while on foreign assignment. The fact that the GEO handles the primary local employment and payroll issues relieves HR of this burden, which can have compounded value when a company is expanding into multiple markets.
The decision to staff a foreign office with either independent contractors or GEO employees will depend on many factors including the scope of business activities, availability of current employees, confidence in outsourced employment tasks and future expansion plans. However, using either ICs or GEO employees offers a unique solution to the full office / DIY approach that requires significant company resources to initiate and manage in the host country.
For both domestic and foreign companies operating in the US, the decision to use either employees or independent contractors can have many consequences. Hiring employees entails a great deal of documentation, and requires a payroll and withholding process that can be costly and time consuming for human resource departments. For this reason, many companies are turning to contractors to perform the same work without the administrative burden and expense.
While the use of contractors can be much more cost-effective, there are strict guidelines used by the Internal Revenue Service to classify employment relationships, and enforcement is an increasing priority where tax revenues are at stake. Given these issues, it is worthwhile to consider the pros and cons of each type of worker, as well as evaluating the potential for misclassification.
If you decide to use employees, there are a myriad of regulations at both the state and federal level. Eligibility for employment must be verified with an I-9 form, for both citizens and non-citizens. All companies must have a formal business entity to run a compliant payroll, which includes licensing and obtaining tax identification numbers. There are withholding requirements for unemployment insurance, workers’ compensation, social security and income tax, and the employer must also make contributions for unemployment and Medicare funds.
If these steps seem burdensome, employers also have to be mindful of the civil rights protections that extend to the hiring, treatment and termination of employees, and any instances of discrimination could result in a lawsuit. Although most employment is ‘at-will’, some positions will require employment contracts, along with severance terms and other benefits. When a company evaluates hiring employees, it is easy to see why employees can be up to 40% more costly than an independent contractor.
Contractors or freelancers are essentially self-employed, and will handle most of the withholding and tax requirements on their own. There is no need for any employer contributions or documentation, except for issuing a Form 1099 each year that will list the amounts paid to the contractor (discussed in detail in the next section). There are few liability issues with contractors, although some companies in high-risk fields will want to obtain insurance that covers both employees and contractors.
The simplicity of using contractors has an obvious appeal to companies that are trying to manage costs and do not want the task of running payroll and offering benefits to workers. However, the US Treasury estimated that over $270 million in wages went unreported in 2013, as more companies attempt to use contractors rather than formal employees. Due to this trend, the IRS is becoming more vigilant in classifying workers, and will scrutinize the essence of the work relationship to make the final determination of either employee or independent contractor.
While there is no one test for classification, there are key elements that will be used by the IRS to define when an employee relationship exists. The agency defines the relationship according to behavior, financial control and type of relationship.
In general, if the worker is under the control or direction of others, is offered training or skills to complete their duties, receives benefits and only works for one company, then they are likely an employee. A common situation can arise when a company tries to transition an employee into a contractor relationship to save on costs, with little change in the actual work performed or type of position. This can be a red flag that may spur tax authorities to review all of the business’s work relationships.
Independent contractors on the other hand will have more than one client, have their own business name and record keeping, set their own hours and perform the work according to their own standards. If the contractor does not meet these criteria, then the IRS may investigate the company’s practices to see if an employment relationship exists. Following recent trends, it may be the contractor who files a complaint with the Labor Department, asserting that they are entitled to employee wages and benefits because of the nature of their position.
If a contractor is re-classified as an employee by the IRS or US Labor Department, the company may be liable for back state and federal taxes and unpaid contributions for Medicare, social security and unemployment insurance. There may also be amounts owed for overtime and wages that were not adequate under the contractor relationship, as well as other accrued employee benefits. There is also the potential for penalties if the company was using contractors simply to avoid tax liability.
For companies that are in doubt, the IRS offers a free evaluation with Form SS-8 of the worker relationship, a step that may be worthwhile for companies that are considering use of contractors.
Any US-based company that hires contractors to perform work or services may need to file Form 1099 with the Internal Revenue Service each tax year. Form 1099 is used to report payments to independent contractors, instead of the W-2 form used for employee wages. The provider of services may be a sole proprietor, partnership or even certain corporations, and reporting depends upon the 1099 thresholds and method of payment to the contractor.
The form is not complex, but a 1099 must be submitted for each provider of services, with accurate contractor identification and payment amounts. The Form 1099 can be found on the IRS website with instructions for preparing and filing the form.
There is a side issue for companies to consider when reporting payment amounts on Form 1099. Small or regular payments for service providers are common, but if a company is paying a large amount to a single contractor in the tax year, the IRS may begin to scrutinize the work relationship, to make sure the worker is not actually an employee.
The 1099 requirement is subject to certain restrictions, and there are two types of forms available depending on the method of payment:
1099-MISC: The most frequently used, the 1099-MISC is required if a company’s payments to an independent contractor exceeded $600 for the tax year. This threshold is for cash and check payments only, and there is a different form (1099-K) and thresholds used for payments via debit card, credit card or a third party payment system.
1099-K: A new dilemma is facing businesses with 1099 filing where services provided by attorneys, accountants and other professionals are paid by a debit card, credit card or third party such as Paypal. Those types of payments are reported on 1099-K, and not 1099-MISC.
The thresholds for reporting are much higher, and a 1099-K only needs to be filed if payments to a single contractor total more than $20,000 or 200 transactions. Therefore, electronic payments less than these amounts are essentially unreported to the IRS. This new threshold for electronic and third party methods would eliminate most contractor payments for a small business, offering some relief from the 1099 filing requirements.
There are some independent contractors who may take advantage of the reporting gap between the 1099-MISC and 1099-K, by not declaring the payments on their own income tax. The company that hires the worker does not have to be concerned about this gap in reporting, as long as they document the payments to a contractor for their own tax records as a valid business expense.
Regardless of which Form 1099 is filed, the company must include the worker’s correct name, address and social security number, as well as the exact amount paid during the tax year. Obviously, these amounts will be compared to the contractor’s own income tax return to note any discrepancies. If there is an error, then the company is obligated to file an amended form if requested by the contractor.
All 1099s must be supplied to the recipient by the end of January of the year following the tax year, and filed with the IRS by the beginning of March for paper forms and March 31st for electronic filing.
If a company’s contractor payments fall within the reporting guidelines, then it is mandatory to file the forms. Failure to file and provide the contractor with a copy is subject to a penalty of $30-$100 per form, up to a maximum penalty of $500,000. If a contractor requests a corrected form, and the business does not provide it, the penalty is $250 per form.
Non-residents Working in the US: In general, the 1099 reporting rules will apply to non-residents working in the US, since they may be obligated to file a Form 1040NR income tax return for non-residents. Due to tax treaties or other exemptions they may be entitled to some tax relief, but the reporting rules for the company that hires them are the same as for US citizens. The key criteria is that they work is performed in the US, which differs from a scenario where the non-resident offers services remotely from a foreign country.
Non-citizens Working in a Foreign Location: If a company hires a non-US citizen for remote work that is not performed in the US, then it is not necessary to file Form 1099 for that worker. The primary reason being that the foreign worker is not subject to US taxation. The company should verify that foreign independent contractors are non-US citizen and that all work is performed outside the US, using Form W-88EN.
However, there are new rules on payments from a US source to a foreign entity of any type designed to prevent money laundering and tax evasion. While these laws are not strictly related to contractor income reporting, US companies that intend to use foreigners for remote work should be aware of the additional requirements.
These rules stem from The Foreign Account Tax Compliance Act (FATCA), which requires reporting of US sourced payments to accounts of non-residents in foreign countries. The amounts are reported on Form 1042-S, and not Form 1099. US companies need to be aware of this law where they may make payments from a US bank account to a non-resident’s foreign account for services provided.
US-citizen Contractors Sent on Foreign Assignment: US citizens are liable for tax on worldwide income, regardless of the work location. All IRS reporting rules and guidelines will apply to US citizen contractors sent on foreign assignment. Where independent contractors perform the work does not affect the taxability of income, or the requirement to report any amounts paid under the 1099 rules.
Form 1099 for contractor payments is one way for the IRS to match the tax records of contractors with the payments reported by their clients. While the burden of filing the form falls on the company hiring the contractor, by filing accurate 1099s the company will fulfill its statutory tax obligation. Future articles will discuss the more problematic issue of foreign corporations hiring contractors in the US, as well as how state laws can affect reporting of contractor status and income.
As outlined above, if a payment to a contractor exceeds certain thresholds for the tax year, then a Federal 1099 should be filed with the IRS, and a copy provided to the worker.
This is all complicated further by the laws of each state in the US regarding reporting independent contractor payments for tax compliance.
In addition to the federal rules, many US states also have their own 1099 filing requirements, but as with many of the laws in the country, there are variations from state to state. Many states allow a combined 1099 with the federal form, simplifying the process into one step. A few states have no Form 1099 filing requirement at all, and a handful require a separate form from the federal version.
The states that allow combined filing with the federal Form 1099 will accept a copy of the federal form from the IRS, but this method is only available to a business that files electronically using the IRS system and is approved ahead of time.
California is one of those states, and also has a number of unique laws surrounding independent contractors and reporting payments. In particular, California has a strict reporting rule for California businesses hiring contractors that are working in other states or abroad, which should be closely adhered to for tax compliance by any business that sends contractors overseas.
The California rules reporting for independent contractor payments are far reaching, with the stated purpose of locating individuals who are delinquent in child support payments. This justification seems dubious given that the reporting rules apply to any contractor paid by a California-based business, regardless of where the contractor resides in the country or overseas, even if clearly outside the reach of California’s legal enforcement powers. Nonetheless, California businesses that hire contractors are required to abide by the rules as outlined below.
Please note that California EDD reporting rules are in addition to the combined 1099 state/federal filing process, and have a purpose that is not tax related. The effect is that there is in essence there is dual reporting obligation for companies making contractor payments, using both Form 1099 and Form DE 542 discussed below.
Form 1099: California is one of the states that allow combined reporting through the IRS electronic FIRE system. The correct Form 1099 is duplicated and sent automatically to California tax authorities to ensure inclusion in the state income tax return for the contractor. The contractor receives a copy and the company’s tax compliance duties are fulfilled.
Form DE 542: Unlike the federal Form 1099 rules that allow reporting of payments for the entire tax year, the California Employment Development Department requires that the information be filed on Form DE 542, “within twenty (20) days of EITHER making payments totaling $600 or more OR entering into a contract for $600 or more with an independent contractor…”
What this means is that each time payments or even a contract with an IC meet the $600 threshold, then a separate Form DE 542 has to be filed with the state. This is a filing burden that far exceeds the once a year for federal compliance, and illustrates how serious California is about monitoring the use of independent contractors by the state’s businesses.
Laws that pertain to overseas contractors have some limits, and often lack clarity on the scope of enforcement. For example, the contractor vs. employee contractor guidelines set out by the Department of Labor are not applicable to US workers in other global locations, while the IRS guideline will apply.
There are no reporting rules per se for contractors sent abroad by a California company, but the breadth of the language and definitions in the EDD state law make it clear that overseas contractors are not exempt. As one commentator stated:
“This reporting obligation in principle also attaches to the California business even if the independent contractor performs services wholly outside of California (even abroad) if the business is “headquartered” in California.”
A question arises whether non-resident contractors abroad are also subject to the California rules, since there would be no federal requirement to file a 1099 for a non-citizen worker who performed the services outside the US.
The answer would probably depend upon whether the non-resident had ever performed work inside the US for the California business. The work would not have to be ongoing, and even a brief visit could trigger California tax residency. If any income was derived from activity in the US, then California could require that a Form DE 542 be filed by the business to report the payments.
Foreign businesses entering the US market face a host of compliance issues surrounding business registration, employment, taxation and withholding. In order to simplify their sales and marketing efforts, some foreign companies will use independent contractors for certain types of business activity, avoiding the need to go through the process of running a compliant payroll for US based employees.
However, even if the use of contractors is valid (meaning they are not really disguised employees), there are still some reporting rules that must be adhered to under US law. All US businesses must file Form 1099 to report independent contractor payments over a certain threshold, and in many instances those requirements will apply to a foreign company as well.
The basic analysis to determine if a 1099 should be filed by a foreign company depends on 1.) The Company, 2.) The Independent Contractor and 3.) Where the Work is Performed:
For a company to file a Form 1099, it must be subject to the taxing jurisdiction of the US, and obligated to file income tax returns and all related forms. A foreign company is generally required to pay tax if they are concluding contracts, sales or otherwise generating revenue within US borders. This is otherwise known as permanent establishment, which means that the company’s in-country business activity is sufficient to make it subject to US taxation.
Depending on the country where the company is based, there are tax treaties between the US and many countries regarding what type of activity will constitute permanent establishment (PE). The criteria under a tax treaty could be more lenient if the company’s home country extends the same treatment to US companies, and this could determine whether taxes must be paid and forms filed, including 1099s.
If a foreign company’s presence in the US is strictly exploratory then they will usually not be required to file US tax returns or forms, and that includes payments to US citizen contractors. For example, hiring a marketing consultant based in the US to assess the market for products or services would probably avoid triggering PE. However, the contractor as a US taxpayer is still must report the income on their tax return, even if the foreign company does not file a 1099.
If a company does fall within the US taxing regime, then it would have to file 1099s for all US resident contractors that are paid amounts above the 1099 filing threshold. In other words, once a foreign business falls under US tax laws, it has the same reporting requirements as a domestic US company.
If the contractor is a non-resident, then the necessity to file a 1099 will depend on where the work is performed. If the non-resident contractor performs services on US soil, then they are required to file a US non-resident tax return for the amounts earned while inside the country. This in turn would require the foreign company to file a Form 1099 for that contractor. But, if the services are rendered remotely from a non-US location, then there is no need to file Form 1099, since the contractor has no ties to the US or its tax laws.
The penalties for failing to file Form 1099 are not extreme, but the greater risk for a foreign company is triggering permanent establishment. It is possible that simply hiring a contractor (resident or non-resident) and compensating them in the US could be sufficient to trigger PE, which would expose the company to US corporate taxes.
For example, if a contractor is hired on a commission basis to generate sales leads, then that could be enough to constitute “business activity” for the company, leading to the need to comply with all US tax reporting rules. The other hazard is that the contractor could be re-classified as an employee under IRS or Department of Labor guidelines, leading to other employment and payroll compliance issues.
While it may be tempting for companies to use contractors to avoid the logistical and regulatory hurdles of US payroll and tax compliance, there are pitfalls associated with overuse of contractors. This is especially true where a company might enlist the services of a US resident contractor, who in turn could file a claim for employee type benefits such as overtime, leave and healthcare. A foreign company could quickly find itself with a re-classified employee in the US, which could lead to numerous compliance issues.
For this reason, many foreign companies choose to use a PEO/GEO solution for hiring workers in the US, instead of risking the use of contractors. The GEO essentially employs the worker, ensures compliance with all tax and employment rules and eliminates the need for the 1099 filing, since the worker is now an employee and submits a W-2 form for wages. This also can lessen the risk of permanent establishment by the client, because the GEO (instead of the foreign company) is the local employer of record.
The next section outlines the GEO solution and services in detail.
As the use of contractors becomes more contentious in legal and regulatory circles, more companies are turning their attention to PEO/GEO employment solutions. A Global Employment Organization (GEO) service avoids the contractor classification and reporting conundrum altogether, by offering an employment solution that meets all compliance standards in any country where workers are on assignment.
The services of a GEO are designed to make international employment simple. The GEO and their local partners, become the employer of record and handle all withholding and payroll requirements in accordance with local law. Obviously, this will entail the payment of employer contributions and other employee benefits, but will minimize the risk of misclassifying contractors and being subject to back payments and penalties.
The GEO can also assist with all aspects of the employment relationship, and save a company the time and expense of running a local payroll through human resources from the home country. It may offer an ideal solution for small companies that have a need for compliant payroll processes, but do not have the budget for a DIY approach.
The GEO solution in reality is quite simple. The company outsources the local payroll and employment responsibilities to the GEO creating a unique relationship formed with the employee. The employee remains the substantive employee of the end client, but the GEO becomes the ‘Employer of Record’ in the foreign country. What this means is the GEO will handle the following administrative aspects of employment on behalf of the end client:
Despite the breadth of these responsibilities, the employee may still have a contract of employment with the end client, and their work activities are directed by the same. Items such has holidays, benefits, bonuses, and sick leave are all under the control of the end client in line with its own employee policies. Management of day to day work responsibilities will be directed by the end client, and the GEO will not be involved in any performance related issues that revolve around work activity.
Due to the complex laws surrounding classification of independent contractors and the very real risks of non-compliance, a company is better served by simply employing all workers through a GEO in foreign countries. Those who continue to hire contractors will need to stay current with the host countries classification standards, which are facing tighter enforcement in many countries.
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