Contractor classification for the purposes of taxation and employment rights is a global issue. Some countries like the United States of America (USA) have chosen to ‘follow the money’ for taxation purposes and financially punish the client for incorrect classification.
However, despite the existence of independent contractor tests by, for example the USA’s equivalent of HMRC, the Internal Revenue Service (IRS), it appears there are no simple answers – conflicting rules from other federal agencies and state administrations muddy the water.
And it’s possible that penalising clients for not correctly classifying workers has ultimately worked against the very vulnerable workers employee-versus-independent-contractor rules have been designed to protect, with major corporations simply moving jobs offshore. This is a trap HMRC must avoid when considering any IR35 changes or replacement.
IR35 in the USA – IRS tests for classifying workers
Highly skilled independent contractors in the USA have a similar profile to contractors and freelancers in the UK. In exchange for a higher hourly or daily rate, neither UK nor US contractors expect to receive any employment rights or benefits.
But in the USA, employers withhold income tax and pay Social Security, Medicare and other state and federal taxes on behalf of their employees, and the IRS is concerned that workers are classified as independent contractors simply to avoid these additional costs.
To counter this perceived evasion, the IRS applies a battery of tests in three key areas, which include:
- Behavioural aspects, which focus on whether the worker is controlled – this is a familiar category to UK contractors
- ‘Financial control’ – this is similar to the ‘in-business’ and financial risk criteria assessed under IR35, and also covers multiple clients and whether payment is by flat fee or time and materials
- ‘Type of relationship’ – this includes factors such as the written contract, provision of benefits and a factor similar to mutuality of obligation, ie whether the worker is expecting the paid work to continue.
Even greater uncertainty for US contractors?
According to the IRS: “Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.
“There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.”
This suggests the same level of uncertainty over tax and employment status for US contractors as experienced by UK contractors under IR35. And, to make matters worse for US-based contractors, it can take the IRS up to six months to officially determine a worker’s status.
Multi-agency jurisdiction and classification
Determining the employment status of a US contractor is further complicated by the plethora of federal and state agencies involved, which vary from state to state. For example, in California the federal and state agencies involved in the determination of a worker’s status include the:
- Employment Development Department
- Division of Labor Standards and Enforcement (DLSE)
- Franchise Tax Board (FTB)
- Division of Workers’ Compensation (DWC)
- Contractors State Licensing Board (CSLB).
It is even possible that different agencies will come to different conclusions, some determining that the worker is an independent contractor and others that the worker is an employee.
USA’s ‘IR35’ punishes the client, not the contractor
There are many similarities between the tests of employment in the UK and the USA, but the major difference in the two sets of rules are that in the UK, the contractor is financially punished if found to be a disguised employee, whereas in the USA, it’s the client that is penalised.
The IRS will demand all back taxes, Social Security, Medicare and other federal and state taxes and benefits in full, plus the same again as a penalty for each worker misclassified by the client, which could be a substantial sum if the engagement was several years in length.
In addition, as the US government is facing similar budgetary pressures as the UK government, the IRS has initiated a ‘research’ programme. Using this, it plans to review worker classifications of 6,000 US small businesses, suggesting a crackdown on firms employing misclassified workers.
Were HMRC to adopt a new independent contractor test that aims to penalise clients, possibly instead of contractors, that could provide greater clarity for contractors. But because of the potential increases in business costs, such a replacement to IR35 could ultimately lead to contracts being offshored.