Balancing Act: Weighing the risks and rewards of independent contractor relationships in staffing
The employee-employer relationship is relatively simple. The legislation is clear about how to manage that relationship, and compliance – as time-consuming as it is – is well understood. But a payroll composed entirely of employees gives a business less flexibility to adapt to the ebbs and flows of demand.
Independent contractors provide a business with more flexibility, which in turn can make a business more competitive. An attractive proposition, to be sure. But along with that reward comes risk. Compliance is more complex, and the risks of noncompliance can be severe.
The key is finding the right balance for your firm.
Balancing those risks and rewards in the staffing business has always been challenging. In large part, this is due to the ‘triangular’ relationship in which a staffing firm operates. Like any other business, it has a client. But a staffing firm also has consultants who provide services to those clients.
That triad was complex enough in years gone by. Staffing companies developed business relationships with in-person meetings, and consultants worked on-site with those clients. The staffing company, their client, and the consultant were all usually in the same area.
Not anymore. Over the past decade, in a trend that accelerated during the pandemic, business has become more complex.
“There’s always been some remote work in IT staffing,” says Martin Borosko, “but post pandemic, the percentages changed significantly.” Borosko is Partner and Staffing Practice Leader with Becker LLC, with a particular focus on M&A transactions in the industry. “Now, you have a staffing firm in one state, possibly a client in another state, and a consultant who’s working remotely in a third state. That creates a lot of complexity with respect to how to structure relationships with these consultants, and to local state and tax compliance and employment law compliance.”
A single company could be dealing with separate sets of legislation and different tax structures for different clients, consultants, and even employees, giving rise to a host of considerations, and potential obligations.
Taxation and legislation
The first consideration is the tax and compliance obligations that may arise from doing business in different jurisdictions.
Leo Varner, Principal and National State Tax Leader with UHY Advisors, outlines the challenging compliance landscape. “You’re looking primarily at three types of taxes: income tax, sales and use taxes, and employment taxes. With all three of them, you have to understand what the sourcing rules are for a given state. It’s very complex.
The trigger for tax obligations is termed ‘nexus’. Like everything else in business, nexus used to be simpler to understand, because it was primarily physical. If your company had people or facilities in a state, you had a physical nexus, and therefore the obligation to report for tax purposes.
That changed with a Supreme Court ruling in 2018 in the case of South Dakota vs. Wayfair, Inc. While physical nexus still triggers tax obligation, that decision ruled that a nexus did not require a physical presence in a state. Instead, in this day and age, doing enough business in a state is sufficient, amounting to ‘economic nexus.’
How much business is enough? It depends on the state. Typically, however, it’s a threshold met by either a number of transactions, often around 200, or the amount of revenue, which usually ranges between $100,000 and $500,000.
In addition to tax structures, employment laws also differ from state to state. For some of these laws – like those governing restrictive covenants in California, for example – employees cannot waive them and agree to be bound by an otherwise illegal non-compete simply by signing a contract that contains language to that effect. And there are penalties for firms that operate in violation of these laws.
If that weren’t confusing enough, in some jurisdictions, you may have fewer tax obligations because of agreements between states.
“Some states work with each other,” Varner says. “They have reciprocity agreements in place. That simplifies the withholding process, so you’re not having to withhold in a bunch of different states if you’re operating in states that have reciprocity agreements.”
The only way to protect your firm from risk is to clearly understand your obligations in every jurisdiction in which you do business, and to remain in compliance with those obligations.
The way in which employees are classified can make it easier or more difficult to remain compliant with tax and legal obligations. Generally speaking, there are four ways to structure these relationships:
- Employee/employer (W2)
- Independent contractor (1099)
- Sole owner corp-to-corp (in which the firm contracts with consultant’s business entity)
- Subcontractor relationship (where the firm contracts with another firm in an agreement covering several consultants)
Employment legislation – covering wages and hours, PTO, workers compensation, even data privacy – varies from one state to another. That being the case, it is simpler in some ways to default to independent contractor or corp-to-corp contracts.
It’s not as simple as that, though. There are tests that the IRS and the Department of Labor applies to determine whether a relationship is classified correctly, and simply having an LLC in place is no guarantee that the relationship is corp-to-corp.
“We have our federal tests, which are dependent on the department that is enforcing the law that determines whether an employee is properly classified as an independent contractor,” says David Frankel, a labor and employment lawyer with Becker LLC, who specializes in the staffing industry. “You also have state specific rules that could be stricter than the federal ones. Then there’s wage and hour issues, PTO issues, and workers’ comp rules that are specific to states. There is paid family leave and disability insurance in some states. SoSo, there’s a whole range of issues that the triangular relationship introduces.”
The crux, in most cases, is one of control. If the company controls the manner and means of work, the relationship is most likely to be defined as employee-employer. This includes dictating when and how work should be done, supervising that work, and monitoring whether expectations are met.
In a corp-to-corp relationship, a consultant’s business should truly operate as a business. This means that they are able to take some work and decline other work, and that there exists the potential for profit and loss that is dependent on their ability to manage the business. Also, there should be a degree of impermanence in the working relationship – distinguishing it from an employee-employer relationship that only ends when one or both parties decide to do so.
If these tests are not met, then it’s possible that a consultant that – on paper – was classified as an independent contractor could be deemed an employee.
Misclassification is no small matter.
“If you get it wrong,” Frankel cautions, “it could lead to penalties, liquidated damages, interest, attorney fees, and back pay. If you don’t do certain things because a person’s an independent contractor, and then you find out they actually aren’t, that can lead to serious problems. Some of these federal laws have extremely steep penalties that keep building. So, the risks are substantial.”
Mitigating the risk
The strongest form of risk mitigation is a robust employment contract between your firm and its consultants. The contract, like any contract between one business and another, should be comprehensive in its terms and conditions. In addition to the broad strokes, ensure that the contract includes details such as arbitration provisions, indemnification clauses to allocate risk and protect clients, and a requirement that the corporation carry insurance. All these factors serve to distinguish it as a contractor agreement rather than an employment agreement.
“I’ve read a lot of consulting agreements and independent contractor agreements,” says Frankel, “and some of them are very well drafted. I’ve also seen agreements that are the opposite; they call themselves an independent contractor agreement and almost function as an employment agreement.”
Once again, this is a balancing act; long, text-dense agreements can be a disincentive for contractors, which is not especially conducive when competing for talent. But these agreements are your best protection should there be any question about the nature of the employment relationship.
Those questions can arise. Borosko points out that independent contractor relationships are a focal point in M&A transactions. “I’ve seen the risks that buyers uncover when they’re dealing with the acquisition of an IT staffing firm: state and local tax, the structure of their relationships with their consultants. I see how the management of that risk plays out in the structure of the deal, the indemnifications, the reps and warranties, the tail risk that a seller may have to deal with in a transaction.”
In addition to the risks arising in an acquisition, noncompliance can surface in other ways as well.
“You may have a small company,” Varner says, “but you’re providing services for a much larger company, a company under perpetual audits. Your invoice pops up and you didn’t charge tax when you should have. Now, you’re on the radar.”
Knowing your obligations and abiding by them is the only way to get value from independent contractor relationships, while minimizing your risk.
No one-size-fits-all answer
If you’ve read to this point hoping for a clear-cut answer about your firm’s obligations related to independent contractors, there is none. For every firm, the answers will be different. It is dependent on where your firm is located, where your clients are located, and where the consultants you employ are located.
Independent contractors can be a valuable part of your firm’s business mix. They can help your business operate more competitively and profitably. The key is to be aware that these arrangements create complexity, and that complexity creates risk. In striking that balance, though, seek expert financial and legal counsel to ensure that you’re managing the risks.