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A guide to managing contingent workforce risk
November 3, 2021
Over the last two decades, large organizations have begun to realize the benefits of leveraging a well-managed, extended, contingent workforce. These benefits include accessing strategic skills only when needed, capacity management, cost-effectiveness, and—in theory at least—reduced employment risk.
However, governments and their tax authorities perceive that many models of self-employment and contingent workforce management generate lower tax revenues because they pay less direct tax than the employed. In fact, some, including the UK’s HMRC, Australia’s ATO, the IRS in the United States, and European tax agencies such as the Dutch Belastingdienst, take a more critical viewpoint.
As a result, worker misclassification legislation has been introduced in many jurisdictions to counter ‘false self-employment.’ If the worker was working directly for their end client and not via an intermediary, such as an employment business, umbrella company, or their own one-person service company, they would be employed and would, therefore, pay the same tax rates as any other employee.
Tax is only one area that can differentiate the permanently employed workforce from the extended workforce. Regulated occupations like professional services, trades, teaching, healthcare, and transport have rules and requirements. If your organization hires drivers, who are responsible for ensuring they hold the correct licenses, and who pays the fine for breaches when they don’t?
The resulting financial sanctions applied to the end-client organization hiring a misclassified or unqualified worker can be high. Back taxes, penalties, and fines for regulatory and license breaches are only the financial penalties you face. Reputational damage – think of Uber, Hermes, and other well-known gig economy hirers – can significantly impact other aspects, such as shareholder value.
And organizations that misapply the legislation and therefore cause financial damage to the highly skilled knowledge workers they need as part of their total talent strategy will lose that competition for talent and become uncompetitive.
What are the risks?
Organizations often choose to utilize an extended workforce to avoid employment risk. When assessed objectively, employees on permanent contracts attract many risks. They have to be searched for, selected, recruited, and onboarded. Employees want benefits, they get sick (and get paid for it), they want to go on holiday (and get paid for it), they need training, they can be expensive to let go when no longer needed, and they can have a great many expensive-to-implement employment rights, depending on their location.
In contrast, contingent workers turn up, do the job, and go, particularly highly skilled knowledge workers in sectors such as IT, finance, HR, and engineering, but also in any skilled and semi-skilled occupations. They don’t receive sick and holiday pay, pensions or benefits, or training and leave when the contract ends.
This flexibility means the extended workforce of contractors, interims, consultants, freelancers, and temps enables organizations and national economies to be highly competitive. If you have a surge in deliveries, you hire temporary drivers. Running an immunization program? Hire temporary nurses and locum doctors. But in the real world, it is not that simple.
Take worker misclassification. In the IT space, for example, a financial IT contractor expert in testing, earning £1000 per day on a series of short contracts, completing specific projects, may be very different from a first-line IT support desk operative earning £125 per day.
The contract IT helpdesk worker may work with a permanent employee, and they may be doing the same job. However, the contractor is paying less income and social security taxes. This could be disguised as self-employment, which is why many governments and their tax-collecting agencies have introduced worker misclassification legislation.
Worker misclassification
Most knowledge economies have introduced worker misclassification legislation to reclaim unpaid payroll taxes and social security contributions. The legislation is often, although not always, designed to extract that unpaid tax from the organization in the supply chain with the deepest pockets. This is usually the end-user client or the employment business supplying the worker.
This unpaid tax and social security, alongside the huge penalties, fines, and interest that also form part of the legislation, represents a significant risk to extended workforce users. There is also a secondary risk in some jurisdictions.
If the misclassification legislation shows a worker or group of workers as being employed, then these workers take legal action to claim all the employment benefits they should have received, such as sick pay, holiday pay, and so on.
Examples of worker misclassification legislation
- In the UK, enforced by HMRC, Off-payroll working, IR35, or the intermediaries legislation introduced in 2000 and updated in 2016 and 2021, uses ambiguous tests of employment that consider whether the worker is controlled, can send a substitute, and is obliged to work if their client provides it. The focus is on the relationship between worker and client, not the written contract. The 2021 changes mean end-user clients now pay unpaid tax.
- The Dutch Deregulering Beoordeling Arbeidsrelatie (DBA) was introduced in 2016 and modeled on the UK’s IR35. There is an online tool to help companies hire self-employed workers, plus the legislation is being updated as it is complex and ambiguous. Contractors, called ZZP’ers, have separate tax rules if they qualify.
- The United States US-1099’S/IC rules, enforced by the IRS, are one of the more straightforward examples of worker classification. They focus on control and the real nature of the relationship between worker and hirer.
- In each of these examples, the employer/end-user hirer is responsible for paying unpaid taxes and social security contributions if the worker is misclassified as self-employed and is really an employee.
How to prevent worker misclassification
Visibility is essential, as is local knowledge. In organizations with hundreds of thousands of workers globally, it is difficult to understand local employment and tax legislation and effectively monitor employment status. An essential step towards evaluating contingent workforce risk is to know your workforce:
- Who they are
- Where they are
- What they are doing
- Whether they have the correct qualifications/certifications
- Employment status
This visibility includes ensuring all workers are accurately categorized based on their engagement in reality – which can be a significant exercise. This is also true of qualifications and certifications.
Vendor management systems (VMS) help de-risk your extended workforce
A vendor management system (VMS) makes tracking and managing the entire lifecycle of any individual worker providing contingent work easy. You can capture granular details about the nature of their assignment and easily recall the data if required by a tax authority. Workers’ qualifications, licenses, and certifications can be stored and individually assessed to ensure compliance. Even onboarding, site access, and offboarding of workers who require access to facilities or networks can be tracked and managed.
To learn more about what a VMS is, what its key features are, and the benefits it can bring to your organization, download our free guide. This will guide you in how a VMS can aid contingent workforce planning, forecasting, management, and procurement.
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What is worker classification?
Worker classification refers to the process of categorizing workers as either employees or independent contractors based on specific legal criteria. This classification is crucial for determining tax obligations, benefits eligibility, and compliance with labor laws.
What does work classification mean?
Work classification refers to the process of categorizing workers based on their employment status, such as employee or independent contractor, which is essential for compliance with tax regulations and avoiding misclassification risks.
How to classify employees for workers compensation?
Classifying employees for workers' compensation involves determining their job roles, responsibilities, and the nature of their work to assign them to the appropriate classification codes. Accurate classification ensures compliance and proper coverage under workers' compensation laws.
What are the benefits of proper classification?
The benefits of proper classification include minimizing financial penalties, enhancing compliance with tax regulations, and improving overall visibility into your contingent workforce. This ensures effective risk management and protects your organization from legal complications.
How does classification impact contingent workers?
The classification of contingent workers significantly impacts their legal and tax obligations. Proper classification ensures compliance with labor laws, avoiding costly penalties and protecting both the organization and the worker from misclassification risks.
What are common worker classification errors?
Common worker classification errors include misclassifying employees as independent contractors, failing to recognize the degree of control exerted over workers, and not understanding the implications of specific labor laws, which can lead to compliance issues and financial penalties.
How to ensure compliance with worker classification?
Ensuring compliance with worker classification involves regularly reviewing and categorizing your workforce according to applicable laws and regulations. Utilizing a Vendor Management System (VMS) can help simplify this process by providing visibility and oversight, thereby mitigating risks associated with misclassification.
What laws govern worker classification practices?
The laws governing worker classification practices include the Fair Labor Standards Act (FLSA), the Internal Revenue Code (IRC), and various state regulations. These laws define the criteria for classifying workers as employees or independent contractors, impacting tax obligations and benefits.
What risks arise from misclassifying workers?
The risks arising from misclassifying workers include significant financial penalties, legal liabilities, and potential back taxes owed, as organizations may inadvertently fail to comply with employment and tax regulations, leading to damaging consequences for their reputation and operations.
How often should worker classifications be reviewed?
Worker classifications should be reviewed regularly, at least annually, or whenever there are changes in job roles, regulations, or business structures to ensure compliance and mitigate risks associated with worker misclassification.
What training is needed for classification accuracy?
Training for classification accuracy involves understanding the relevant legal standards, differentiating between employee and contractor roles, and utilizing tools like compliance frameworks and Vendor Management Systems (VMS) to enhance accuracy and mitigate risks.
What role does documentation play in classification?
Documentation plays a crucial role in classification by providing clear evidence of how workers are categorized, ensuring compliance with relevant regulations, and minimizing the risk of misclassification penalties. Proper documentation supports transparency and accuracy in workforce management.
How to communicate classification changes effectively?
Effectively communicating classification changes involves clearly informing all stakeholders about the updates, the reasons behind them, and the implications. Utilize multiple channels, such as emails and meetings, to ensure understanding and compliance across the organization.
What tools assist in employee classification?
Tools that assist in employee classification include specialized software like Vendor Management Systems (VMS), which help ensure compliance with regulations, and classification tools that analyze job functions to mitigate misclassification risks and maintain proper workforce management.
What criteria determine worker classification?
The criteria that determine worker classification include the level of control the employer has over the worker, the relationship between the parties, and the degree to which the worker provides their own tools and materials.
How do tax regulations affect classifications?
Tax regulations significantly influence classifications by establishing criteria that determine whether a worker is classified as an employee or an independent contractor. Proper classification is essential to ensure compliance and avoid potential tax penalties.
What penalties exist for misclassification?
The penalties for misclassification can be severe, including back taxes, fines, and other financial liabilities imposed by tax authorities. Organizations may also face legal action and increased scrutiny regarding compliance.
How can technology aid in classification processes?
Technology aids in classification processes by automating data gathering, ensuring accurate categorization, and improving compliance tracking. Utilizing sophisticated algorithms and tools enhances the efficiency and reliability of classifications, helping organizations mitigate risks associated with worker misclassification.
What industry standards exist for worker classification?
Industry standards for worker classification include guidelines established by the Internal Revenue Service (IRS), the Fair Labor Standards Act (FLSA), and various state regulations, which help determine whether a worker is classified as an employee or an independent contractor.
What is the process for disputing classifications?
The process for disputing classifications involves formally submitting a request to the appropriate regulatory authority or organization with supporting documentation, outlining the reasons for the dispute and any evidence that supports your case for reclassification.
How do state laws differ in classification?
State laws differ significantly in classification criteria for contingent workers, with some states applying stricter standards for determining employee versus independent contractor status. This can affect compliance and risk management, so organizations must stay informed about each state's regulations.
What impact does classification have on benefits?
The impact of classification on benefits is significant. Proper classification determines eligibility for benefits such as health insurance, retirement plans, and paid time off, thereby directly affecting the financial and legal obligations an organization has towards its contingent workforce.
What resources are available for learning classifications?
Resources for learning classifications include industry-specific training programs, online courses, government guidelines, and webinars that provide comprehensive insights into labor classifications and compliance standards. Additionally, consulting firms and specialized websites can offer valuable materials and updates.
How to classify remote workers appropriately?
Classifying remote workers appropriately involves determining their employment status—either as employees or independent contractors—based on factors like degree of control, nature of work, and financial arrangements. Ensure compliance with local regulations to avoid misclassification risks.
What are the consequences of misclassifying interns?
The consequences of misclassifying interns can be significant, including potential legal penalties, back wages, and tax liabilities. Organizations may face lawsuits and reputational damage, highlighting the importance of proper classification and compliance with labor laws.
How can audits improve classification accuracy?
Audits can enhance classification accuracy by systematically reviewing and verifying worker classifications. This process helps identify misclassifications and ensures compliance with tax regulations, ultimately reducing the risk of penalties and improving overall workforce management.
What are best practices for classifying freelancers?
The best practices for classifying freelancers include understanding the legal criteria for classification, maintaining clear contracts that define the nature of the work, and regularly reviewing your classification practices to ensure compliance with tax regulations and labor laws.
How does worker classification relate to job duties?
Worker classification is directly related to job duties as it determines how individuals are categorized (e.g., employee or independent contractor) based on the tasks they perform, their level of control over work, and the degree of independence attributed to their roles.
What are the key factors in classifying tradespeople?
The key factors in classifying tradespeople include the nature of their work, level of control exercised over them, their independence in performing tasks, and the extent of their integration into the business operations.
How to handle changes in classification over time?
Handling changes in classification over time requires regular reviews of workforce status, staying updated on regulatory changes, and adjusting classifications accordingly. Implementing a robust Vendor Management System (VMS) can facilitate oversight and ensure compliance throughout these changes.
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