The Contractor Conundrum

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

Entering a new market is a complex game. It takes careful planning, consideration and time. It can also be a costly exercise which is why it should come as no surprise that so many companies that are looking to enter a market should want to dip their metaphoric toe in the water through use of a contractor or two.

The problem with contractor arrangements though is that they are fraught with risk and in most major markets where companies often look to expand such as the U.S., the U.K., Ireland, Canada, Germany, Australia etc. contractor misclassification laws hold similar challenges even for short-term arrangements. The reason for this is that most companies that are looking to establish a presence in a country want to be able to build some brand recognition and client base and to do that you typically need someone on the ground who has existing relationships and can get out and be the face of your company. Generally, this means that this type of person will be working just for the one company, they will be the local representative and they will have business cards, a company email address and sometimes even branded clothing or other ‘swag’.

I have seen some companies attempt this through a distributor type model where they use contractors who might be selling a number of different brands, usually within the same industry. This approach certainly carries little risk legally from an employee vs contractor perspective but it can have mixed success and without being physically present in the country where your distributor is located on a semi-often basis, you have no real way of knowing whether the results that your product or service is generating are due to a lack of push or lack of interest in the market. If things go well that is a good indication of course but in the early days, for most companies, it takes time to build up momentum. And let’s be honest, no one sells your product or services as well as you will. While distributors certainly stand to profit if you experience success within their market, they are less vested in the outcome because they have diversified interests. They will be flogging the wares of a number of different brands not just your own. The other issue is that distributors generally want a fairly large piece of the pie and if they have any track record of success they may also want exclusive rights within the market. The demand for good distributors in certain markets and industries is high so it can also be extremely difficult to secure a deal. For all of these reasons, the distributor model is often not a viable option.

This then leads us back to the issue of contractors which is inevitably the option that most of the companies that we work with end up selecting if they do not want to launch straight into company set up and employment arrangements from day 1. The problem is that early mistakes can come back to haunt you down the track, especially when you experience come success and that is why it is crucial to do your research, obtain advice and weigh up the risk first before launching into a situation that may end up a costly error to correct down the track. There are also other options too that don’t need to place you at risk. For example, in the U.S. employer of record/PEO providers offer alternative employment arrangements whereby they can manage the relationship and take care of the administrative requirements such as payroll, tax remittance etc. In the U.S. these types of arrangements will generally result in a joint-employment arrangement with both parties having a relationship with the employee – typically this means that the employer or record/PEO provider will be the direct employer and the client company the secondary employer. It essentially acts as a hybrid type arrangement – somewhere between an employment relationship and that of a contractor arrangement. This can end up a much better option that engaging a contractor or attempting to find a suitable distributor but it can be costly as there is typically a mark-up of anywhere between 20 and 40% on top of the total employment cost applied as a services fee under these types of arrangements.

For some companies the contractor model is one that they will want to undertake regardless of the risks and so it is important to understand the local laws that apply if you are going to engage in this type of arrangement. It is also important to consider that the risk profile will change the longer that the arrangement continues so before engaging a contractor there should be a risk analysis conducted to determine the upper limits of which the company is prepared to accept the risk and allow the arrangement to continue.

In the US, contractor laws have been problematic for many years now. There has been some uncertainty at a Federal level and some of the states such as in California with AB 5 which has extended employee classification status to many workers as now companies must use a three-pronged test to provide that workers are independent contractors and not employees. It went into effect on Jan. 1, 2020, and required companies that hire independent contractors to reclassify them as employees, with a few exceptions. In September 2020 the California legislature passed Assembly Bill 2257, which rewrote a number of the requirements of AB5 and exempts a substantial list of job categories. Among those exempted from the strictures are still and video photographers and editors, freelance writers, content contributors, editors, translators, fine artists, and musicians but it still poses issues for companies wanting to use sales agents to test the waters for example.

Under the ABC Test, a worker is presumed to be an employee unless the employer can show that all three of the following conditions are satisfied: 1) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, 2) the worker performs work that is outside the usual course of the hiring entity’s business, and 3) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed. In states such as California therefore, companies are faced with significant challenges when attempting to characterize a relationship as one of that of contractor and client and the cost of misclassifying a worker can be extensive. In addition to back-payment, damages and interest, significant penalties can also be imposed. Needless to say, contractor laws are complex and can vary significantly from one country to the next and one state to the next. It is crucial to obtain advice, weigh up the options and risks and then make an informed decision about what is right for your business first before running head first into an arrangement that may end up costing you significantly down the track and my last piece of advice is please don’t try to adapt your existing agreements for use in a new market! That never ends well. Courts have little tolerance for companies that don’t take the time to understand the legal landscape of the environment in which they are doing business.

Guest Written By: Naomi Seddon