The Importance of Compliance Classification: The How-to Playbook

Any business that regularly hires freelancers and independent contractors will understand the challenges of sourcing, hiring, onboarding, and managing ongoing administration, including paying that talent.??

However, often omitted from this list of challenges is contractor compliance. Or in other words, ensuring your worker classification is correct. This, on its own, presents a range of complex hurdles for employers. Needless to say, it’s essential to get it right every time, no matter where you, the employer, or they, the freelancers, are based.?

So, here in this article, we're taking a closer look at compliance classification and what you can do to ensure you manage your talent pool by the book.

But first:

1. What's Compliance Classification?

In short, compliance classification is a means by which you can classify someone you hire as either an independent contractor/freelancer or an employee according to local/international laws.

Why is this important??

For starters, employers have responsibilities they’re legally obliged to execute if someone is classified as an employee. For instance, in the US, this pertains to social security, tax, medicare tax, etc.; Similarly, in the EU, employees have legal rights relating to their working conditions. For example, the number of hours worked each week, holiday pay, sickness pay, maternity pay, etc.?

Generally speaking, most employees (regardless of their geography) have protections (to some degree or another) regarding minimum wage, family leave, sick pay, maternity leave, and other essential benefits.?

Interestingly, generally speaking, there are two main types of classification:

Independent Contractor (Freelancer)

For the uninitiated, a freelancer is a self-employed person who works with businesses to provide services or goods in exchange for payment. In addition, freelancers can sometimes provide specialist expertise that your business cannot access from its existing employee pool.

The contractor is bound to provide the business with the agreed-upon deliverables or outcomes. However, they typically control how, where, and the hours they work, etc.

Freelancers don’t receive workplace benefits and must pay their own taxes and insurance. An independent contractor may work for more than one business simultaneously. They also provide their own work equipment, set their own pay rates, and can work on specific time-restricted projects.?

Employee

In contrast, an employee works for your business, and you’re responsible for determining their work and how they do it. This includes controlling the hours they work, whether they receive training, whether they work remotely or onsite, and much more. You’re also responsible for providing the necessary equipment to ensure they can do their job justice. Lastly, and importantly, employees aren’t required to submit invoices. Instead, they’re paid via a business’s payroll.?

2. Why Is Compliance Classification Important?

While many businesses have HR managers to help hire either of the above, in some instances, individual departments or managers hire workers. In either case, there’s always a risk of incorrectly classifying a worker. Unfortunately, in the US, if a business doesn’t classify its workers correctly, they risk falling foul of the Internal Revenue Service (IRS) or other regulatory bodies like the Department of Labor (DOL).?

In contrast, in the UK, it’s the Inland Revenue, and in the EU, each member state has its own version of the IRS or Inland Revenue. For example, in the Netherlands, The Tax and Customs Administration or in Dutch: Belastingdienst. Elsewhere, in Germany, it’s the Federal Central Tax Office, or in German: Bundeszentralamt für Steuern, abbreviated BZSt.

Interestingly, even if workers think of themselves as freelancers, they could be legally defined as employees. Of course, it depends on their working relationship with a business.?

There are penalties for businesses if they don’t get their compliance classification right.?

For example:

In the US, the IRS can fine businesses sums of $50 upwards , an additional 1.5% of the wages paid, plus additional taxes.

In the EU, again, each member state has its own rules and penalties on worker classification. One example is in France, where if a worker is wrongly classified, the business has to pay social security contributions along with surcharges and penalties to the country’s Payroll Taxes Collecting Entity (URSSAF).?

Similarly, in the Netherlands , the employer is held liable for employee tax and social security contributions, plus they potentially face a workplace inspection by the country’s health and safety inspectorate.?

In the UK , if a business misclassifies a worker as self-employed to the Inland Revenue, they’re liable for employer and employee National Insurance contributions, under-deducted tax, and potential interest.?

The bottom line: To avoid penalties like the ones listed above, businesses must accurately determine the worker status of their staff.?

This is where a reliable and robust freelance management system can come in handy. For the uninitiated, a freelance management system is a software solution that helps companies streamline their freelance management procedures. This should have built-in compliance measures to help guide you through international employment laws, tax requirements, and pensions. In addition, all legal documents for each contractor should be securely stored in one place and easily accessible by both the employer and the worker.?

3. How to Determine Whether Someone Is an Employee or a Freelancer

As we’ve already stated, freelancers work independently and are self-employed. Freelancers work in near-on every industry. For example, dentists, writers, accountants, lawyers, photographers, graphic designers, and project managers - to name a few! It’s an extensive list.?

Fortunately, there are several ways to determine which employment category a worker falls into. Of course, this varies depending on the country your business operates from. But, typically, government websites will walk you through distinguishing freelancers from traditional employees.?

For example, in the US, businesses can turn to the IRS, whereas in the UK, it’s gov.uk. Elsewhere, in the EU, companies might refer to the European Commission website for information. However, businesses must also refer to their own country’s laws that implement particular EU directives for further clarification.?

Confused? Don’t worry; you’re not the only one to have felt that way. Luckily, there are ways to protect your business from accidentally classifying hires incorrectly:

4. Using a Freelance Management System for Compliance Classification

There are several reasons for why a business might use an FMS to ensure their worker classification is legally compliant (aside from saving them tons of administrative time!).?

So, with that said, we’ve listed just a few of the most notable reasons below:

An FMS Gets Classification Right

Some FMSs can walk you through the entire classification process when you hire someone. This should give you a better understanding of which category someone falls into and what documents they need to sign.

Automating this type of paperwork helps with compliance and minimizes the risk of human error. It will also ensure businesses don’t onboard incorrectly. For example, in some US states, it’s illegal for companies not to get freelancers to sign a contract. In addition, each EU member state has rules or regulations around self-employment. For example, in the Netherlands , businesses must have a ‘model agreement’ between themselves and any freelancer they use to outline the exact nature of the business relationship.?

An FMS Helps You Better Manage Your Freelancers

Businesses need to remember that freelancers are different from employees, and this, in turn, means managing them differently. For example, while a company can expect employees to work certain hours from a particular location(s) and only work for them, the same cannot be expected from a freelancer.?

For example, a freelancer is under no obligation to undertake an assignment when a business asks them to. However, with the help of a decent FMS, you should be able to see at a glance whether a freelancer has the required skills you’re looking for to execute a particular project. Matching projects to freelancers with the appropriate skill set should increase the likelihood of a freelancer wanting to undertake the job. However, the freelancer still doesn’t have to accept.?

On a slightly different note, an FMS may help to ensure that employer-freelancer boundaries aren’t blurred. For example, not accidentally offering freelancers employee perks and benefits. Instead, requiring freelancers to sign a formal contract that outlines expectations and deliverables can address this. A streamlined recruitment system should ensure that every hire (whether a freelancer or employee) signs a legal agreement outlining the working arrangement.

This should include the following information:

• Pay rates
• Deadlines
• Accountability
• Legal documents - including no-compete clauses, IP ownership, and NDAs that form part of the onboarding and compliance process .

A streamlined hiring process should also ensure that hires can access all the documents listed above and that those documents are securely stored. But, again, a digital approach is usually the most effective. For instance, using a freelance management system that can automatically send documents to all the necessary parties via a secure platform and then store them centrally.?

On the Money

Businesses must pay freelancers within a set number of days after an invoice is submitted. However, this can be difficult for companies and freelancers to keep track of if they’re still using an old-school method to keep tabs on payments. For instance, an Excel spreadsheet or another such manual system.

A contractor-compliant FMS can bypass slow manual payment systems to help businesses pay freelancers on time via a secure, automated payment system. It should also help you to securely manage and store bank details, tax information, and other data right from onboarding.?

Keep Yourself Protected

Aside from the legal requirements businesses need to adhere to stay compliant, there are other legalities to consider. For example, having policies in place to prevent freelancers from leaking sensitive information or plagiarizing content.?

This is where NDAs, confidentiality clauses, copyright and IP agreements, data protection agreements, non-competes, and other policies are essential. Rather than relying on trust, organizations can protect themselves by ensuring all their freelancers sign such policies during onboarding. This goes a long way to protect businesses against potential breaches.

Again, an FMS can help by keeping track of all submitted and signed documents to ensure that all necessary parties have signed in the correct place(s). If an FMS identifies a gap, it can be rectified before a freelancer starts work.?

In addition, if you’re sourcing and hiring freelancers from your own talent pool, you’ll doubtlessly be asking them to submit personal information, such as:

• Tax details
• Date of birth
• Social security numbers

…The list continues.?

An FMS can help you to store this data on a secure server and ensure compliance with the following:

• General Data Protection Regulations (GDPR)
• US state-specific laws such as the California Consumer Privacy Act
• US federal law

Are you interested in learning more about how a freelance management system can help you stay compliant? Then, book a free demo today.?