Employee or Independent Contractor? The Answer Can Have Costly Implications

When employers contemplate adding more staff, there’s an inescapable realization that affects their decisions: Employees come with costs. Not just the costs of wages and payroll taxes, but also expenses for employee benefits and a host of other things. 

Many benefits are voluntary in the U.S., while others—like unemployment insurance, workers’ compensation, Medicare, and Social Security—are required by law. The list of mandatory items tends to be longer outside the U.S. In the U.K., for example, employees are entitled to such benefits as:

  • statutory sick pay;
  • statutory paid holiday, maternity/paternity, and adoption leave;
  • statutory rest breaks; and
  • statutory redundancy (severance) pay.

Even without as many mandates, employee benefits in the U.S. account on average for almost a third of total compensation costs, according to recent data from the Bureau of Labor Statistics. The proportion is about the same in the U.K. and Canada, but in Japan and Germany, it’s over 40 percent, and in France and Brazil, it’s closer to 50 percent. 

In addition to the line items for benefits, the expense side of the ledger includes costs associated with other laws. Consider, for example, overtime premiums under wage-hour laws, such as the time-and-a-half rate required by the Fair Labor Standards Act when nonexempt employees in the U.S. work over 40 hours a week. 

Some countries’ overtime standards are more stringent. France requires overtime premiums for anything over 35 hours a week, while the threshold in Australia and Belgium is 38 hours. In addition, Canada and many other countries have overtime provisions requiring premium pay once employees work over eight hours a day. 

Independent Contractors to the Rescue?

While employers must factor these expenses into their staffing decisions, it’s not a foregone conclusion that hiring extra help means taking on the costs and obligations associated with traditional employees. As an alternative, businesses often use independent contractors. 

Rather than being added to the payroll, independent contractors are typically brought on for a particular project, paid a set fee, and then said goodbye to. 

However, employers should be wary about misclassifying workers, because wrongly treating employees as independent contractors can be a costly mistake. 

Most countries have established criteria for distinguishing contractors from traditional employees. While each country has its own rules, a key factor is almost always the degree of control a company can exercise over a worker’s activities. The greater the control, the more likely an employment relationship is to exist. 

In general—and subject to individual countries’ laws—an independent contractor: 

  • operates under its own business name,
  • is accountable for final deliverables but not for the methods used to provide them,
  • hires its own employees,
  • owns its own tools and facilities,
  • advertises its own services,
  • sets its own work schedules,
  • keeps its own records and files its own taxes,
  • is paid by the assignment, and
  • performs work for more than one client.

By contrast, an employee: 

  • works for a single company,
  • works according to a schedule established by the employer,
  • receives training from the employer,
  • receives benefits and allowances from the employer, and
  • is paid on a regular basis (e.g., weekly or monthly).

Treating workers as independent contractors might offer substantial savings in the near term, but employers need to be careful. If they misclassify employees as independent contractors, they risk exposure to liability for back taxes and stiff penalties, and they can also become the targets of costly class action lawsuits. 

Companies that use independent contractors should conduct internal audits to avoid such exposure. Some of the red flags that can signal misclassification problems include engaging independent contractors who are former employees, who don’t work for any other company, who perform the same work as employees, and who are subject to a high degree of company control over where, when, and how the work is performed. 

Here’s some closing advice: Don’t be penny wise and pound foolish. It can make financial sense to hire an independent contractor, but only if he or she actually is a contractor.

You can get further details on this subject from International HR Decision Support Network, which has a new chapter called "Worker Classification: Employee or Independent Contractor," available here to subscribers. Start your free trial today.