Pretty soon, the definition of “traditional workforce” will be considered an outdated relic of the past. Today, independent contractors and freelancers play an integral role in the modern workforce. Yet many companies still don’t know how to manage IC compliance or even try to properly manage it.
The reason for this is most HR departments aren’t responsible for independent contractors’ (IC) compliance. New hire onboarding processes usually refer only to full-time employees. There are no documented onboarding processes for non-payroll workers, which jeopardizes IC compliance from day one.
It is standard practice for HR departments to invest hundreds of thousands of dollars in Human Resource Management (HRM) systems to ensure employee compliance. However, most companies today still attempt to manually manage their freelancers. This includes dealing with legal, tax-related, and classification requirements for contractors.
In this post, we’ll dive into why IC compliance is a challenge for many companies (whether they realize it or not), and how you can ensure IC compliance – the simple way.
This article is part of our guide on Employee Classification.
Who owns IC compliance?
Traditionally, HR is responsible for employee compliance—and they know exactly what to do.
HR professionals are trained and experienced in onboarding employees, making sure they sign the right legal contracts, providing all of the benefits they are entitled to, and ensuring they’re aware of their protections. HR also works closely with finance to get every employee’s tax documents and withholdings lined up.
But when it comes to IC compliance, this level of organization is lacking within most companies. There is still no clear “owner” of IC compliance.
Most HR departments have not yet developed systems or processes for managing the legal, tax, and classification aspects of IC compliance.
As a result, there is a serious lack of clarity—from the HR, legal, and finance perspectives—on how many contractors even work with companies. From our experience as a freelance management system (FMS), we’ve found most CFOs underestimate the number of ICs their company works with by 60% to 70%.
That leaves a lot of room for error.
The 3 components of IC compliance
The key to managing IC compliance for a growing non-payroll workforce is awareness. As a company, it’s impossible to comply with contractor laws and regulations if you don’t know what they are.
Here are the three main components of IC compliance to be aware of:
1. Legal contracts
Legal contracts set you down the path toward IC compliance by defining the nature of the work relationship and clarifying both parties’ obligations in a legally binding agreement. Not only do these agreements set the tone for the actual work relationship, but you can also refer to it in court should the need arise.
Here’s a common example:
Independent Contractor Relationship. Consultant and the Company are independent contractors and nothing contained in this Agreement shall be construed to place them in the relationship of partners, principal and agent, employer/employee or joint ventures. Neither party shall have the power or right to bind or obligate the other party, nor shall it hold itself out as having such authority.
Additional clauses that define responsibility for worker expenses, who owns intellectual property, and how the work relationship may be terminated also support IC compliance.
Signing the contract should be the first step of contractor onboarding. This helps establish IC compliance from day one. After both parties have signed a general legal contract, you will want to consult your legal department to evaluate whether additional types of contracts are needed, such as a NDA or data protection agreement.
The second primary component for managing IC compliance is taxation. By filing the correct tax documents with the right tax authorities, you can ensure you remain in compliance with tax codes relevant for contractors throughout the entire contractor relationship.
Freelancers and independent contractors are responsible for reporting their income to the IRS, paying Self-Employment Taxes, and paying income taxes themselves. However, companies that work with contractors and pay them more than $600 per year must provide them a Form 1099-NEC by January 31st. You’ll want to be sure you collect a Form W9 when you first hire a freelancer to ensure you have all of the information you need to accurately fill out Form 1099-NEC.
3. Workforce Classification
Correct worker classification is essential to IC compliance. The first step to accurately classifying freelancers and independent contractors is becoming familiar with the classification tests used in relevant states or localities.
Unless you are aware of the classification tests your company is subject to, you risk misclassifying your contractors and exposing your company to significant risk.
The most commonly used tests in the US are the IRS 20-Factor Test, the ABC Test, and the Economic Realities Test. While each of these relies on different factors and rules for determining worker status, the goal is the same: to determine whether a contractor actually qualifies as a contractor.
In some cases, these tests will conclude that a worker who you hired as a contractor in fact qualifies as an employee. In that case, your company is responsible for complying with local labor laws, such as providing the benefits and protections afforded to employees in your state. You will also be required to deduct income taxes from the worker’s pay and report withholdings to the IRS. Alternatively, you may decide not to continue working with the contractor.
IC compliance is possible with the right approach
The first step to IC compliance is defining who owns it. Just as HR owns employee compliance, each company that works with freelancers and contractors must have total clarity on who’s responsible for managing IC compliance.
Once established, the department or team in charge must have total awareness of everything involved, from legal contracts to taxes to classification. Consistent monitoring and evaluation of each of these components is essential for long-term compliance and avoiding penalties.
While small companies that work with just a handful of freelancers may be able to develop the processes and protocols for managing IC compliance themselves, larger companies—especially VC-funded enterprises—will need to take a more systematized approach.
With an FMS, compliance is effortless. This makes it possible for large companies to scale up their ranks of contractors and take advantage of all of the benefits they offer. By centralizing contracts and onboarding checklists, automatically and continuously evaluating worker status, and managing contractor tax forms, you can be confident that nothing will fall through the cracks.