Are those workers really contractors?

Employee or contractor? The status of workers in the gig economy is literally a taxing question. Baker Tilly explores the issues potential buyers must consider before investing.

Labour is one of the largest costs for many organisations, particularly in the serviced-focused gig economy, and it’s a crucial element of due diligence for potential investors.

But finding a consistent position when it comes to the status of workers in the gig economy is literally a taxing question.

One jurisdiction’s independent contractor is another’s employee and regulations vary across state and provincial borders, let alone between countries.

Legislation passed in California in November 2020 classified Uber and Lyft drivers as contractors, reversing an earlier court decision, but across the Atlantic, governments took a different view.

Spain led the world in legislating that delivery riders are indeed employees of the platforms they work, a move applauded by unions and some workers, but drawing the ire of a section of the delivery rider community in Spain who lamented that they had lost the autonomy that drew them to the job in the first place.

While the incentives vary by jurisdiction, it’s estimated employers can save up to 30 per cent by hiring an independent contractor, in the process avoiding paying items such as payroll taxes, unemployment insurance, workers’ compensation and disability, as well as benefits that include pensions, sick days, health insurance and vacation time.

Classifying drivers as contractors has allowed ride-share and delivery platforms to flourish, and it’s prompted businesses in other sectors to question whether their workers could also be reclassified.

But while the financial incentives of a contractor workforce are obviously attractive for the bottom line, the penalties for getting it wrong can be severe, as several lawsuits attest.

Outside of civil suits, penalties for breaching labour laws range from hefty fines and retrospective payment of taxes, to criminal charges for offences deemed intentional.

Business leaders are not hesitating to ask the question of advisors about whether their employees can be reclassified as workers. The problem is the answers are complex and not always what they want to hear.

Robena Jafari, who leads Baker Tilly US’s international tax services and transfer pricing, says many companies come with pre-conceived ideas about what they want their workers to be.

“They say, ‘we don’t want to deal with payroll taxes or FICA (Federal Insurance Contributions Act), so these workers are all independent contractors,’” she says.

“It’s very rare that somebody has actually gone to the exercise to see whether a worker is truly a contractor. They just say, ‘If we don’t put them on payroll, they’re automatically presumed that way.’

“In an international context, which is where I generally practice, clients are forced to think about this in ways that they’re not comfortable with.”

With many interpretations, clients are often left looking for broad brush answers which are just not there.

“It’s complex and clients often don’t understand the complexities,” Ms Jafari says.

“We tend to say, ‘These are just my employees, or these are just independent contractors,’ without fully appreciating that the United States can see it differently to Spain, and France can see it differently than the United Kingdom.

“That often leads to taxation in one jurisdiction, and then another country sees that business as their income, so you have the same bucket of income being taxed twice.”

The United States itself is a working example of the complex nature of domestic tax laws, says Baker Tilly Illinois tax principal Colin Walsh.

“I’ve spent 10 years practising the state of Illinois, and Illinois has a very high standard that essentially says a worker is your employee unless you prove to us otherwise and meet very strict criteria,” he says.

“Whereas for federal purposes, there’s a facts and circumstances control test, so it’s a little bit more subjective.”

Key questions for gig economy investors

The flexibility offered by the gig economy remains attractive for workers – COVID-19 has led to many more workers looking for contract work.

But what does the tension of the legal status of gig workers mean for investors looking to buy or invest in platform-based businesses?

Ms Jafari says the complexity of the employee versus independent contractor debate isn’t a deal-killer when it comes to mergers and acquisitions, but it is certainly a key part of the conversation.

“That’s less a reflection of the substance of this conversation but just more an indication of where the market is right now,” she says.

“There seems to be a  huge aversion to being conservative. We’re seeing a lot of buyers coming in and just absorbing risk and fully understanding whatever we absorb, from a risk standpoint, we’re going to get on the exit.

“It’s never been a situation where it stopped a deal.”

Ms Jafari says agreements that classify workers as contractors but operate differently pose a  risk.

“Substance over form matters greatly in this scenario,” she says.

“We get into due diligence, and we see agreements, and they’re functioning in a totally different way than the agreement says.

“If it’s not implemented the way it’s supposed to, the agreements are not useful.”

In the United States, Mr Walsh says potential purchasers of a business, from a tax perspective, are just as interested in agreements as the authorities.

“The IRS (Internal Revenue Service) has a Form 4669 agreement that businesses ask independent contractors to sign,” he says.

“If they sign it, it is a legal document under penalties of perjury that states the contractor received the income, reported the tax, and paid whatever tax liability was owed.

“The IRS then cannot hold you, the employer, liable for the withholding of taxes because it’s already been paid by the worker.

“It’s a means through which clients, who are looking to sell their business, can reduce risk around worker classification issues.

“So, businesses go through the exercise of having the workers sign these Form 4669s to reduce their risk, and then they hand that to the buyer and say, ‘Help me understand how you can reduce the purchase price of this business because I have these signed documents from the payees saying they’ve paid the tax, so there is no exposure there’.

“But it’s the buyer of the business who looks at these agreements and needs to be satisfied with the risk, just as much as the IRS or the Department of Labor, so we’ve seen it come up increasingly there as part of acquisitions as opposed to an audit.”

Mr Walsh says the factors that businesses need to consider in determining whether someone is a contractor or an employee are like those that courts would use should they be called in to make a determination.

“And if the employer is dictating when and how you go about doing your job, then that’s suggestive of control.

“We can look at the factors and help draft a contract that makes clear that someone is an independent contractor.

“But when the employer looks at that contract, and they lose some of that control, they might not like it so much.

“It’s this balance between business needs and tax, and sometimes, we need to be careful not to let the tax tail wag the dog.

“If you really want to control the worker, that’s your prerogative, but you need to treat them as an employee.”