Independent contractor laws and tax regulations can make it difficult for businesses to scale. Nearshoring, though, can provide a scalable option.
Regardless of the industry, there is one obstacle every business owner must overcome: hiring help without going bankrupt.
Human capital is the single most important asset a business has. However, the cost of hiring the right talent can be tough to swallow. That is even more true for startups and small and medium-sized enterprises (SMEs).
What, though, should small business owners do, at least in the early stages of their business, to find qualified employees without incurring financial problems?
Business owners look for creative hiring solutions that won't kill their bottom line and leave the business bankrupt before it ever has a chance to get going.
Two of the most common solutions they come up with are freelancers or independent contractors, or outsourcing to extremely low-cost countries in Asia. There is a better solution that is right under most business owners' noses.
The challenges of outsourcing to Asia have been covered ad nauseum. Utilizing independent contractors can have significant consequences for your business if you aren't careful.
In this article, I outline the pitfalls of using independent contractors and discuss an alternative that could be the perfect balance for SMEs.
The challenges of working with independent contractors
Businesses turn to independent contractors or freelancers for obvious reasons. Primarily, they help a business avoid dealing with complicated employment and tax laws that can have expensive ramifications.
Independent contractors can often complete a job quickly, and unlike using offshore outsourcing companies, contractors are fluent in English, which makes communicating expectations and the parameters of a project easier.
There are significant risks that business owners either push to the back burner or don't comprehend when it comes to using this type of employment structure, though.
The enforceability of independent contractor agreements
Most independent contractor agreements are virtually worthless. They are nearly impossible to enforce, unless you are hiring through an agency. You have no idea whether a contractor will be trustworthy.
Most independent contractors work for themselves; they are freelancers, and, as a result, don't carry liability insurance that could protect you if you were ever sued by a client.
You could employ a contractor through an agency and have the agency's liability insurance as a backup, but many agencies have contracts in place to protect them in the event of a lawsuit.
Tax liabilities of working with independent contractors
The Internal Revenue Service defines an independent contractor as "an individual…[who] has the right to control or direct the result of the work and not what will be done and how it will be done." They further clarify that "You are not an independent contractor if you perform services that can be controlled by an employer."
For businesses that misclassify employees, the IRS can levy the following penalties:
- A $50 fine for each W-2 form that has not been filed
- A fine of 1.5% of total wages for not withholding income taxes
- A 40% penalty of FICA taxes that were not paid plus 100% matching FICA taxes that the employer should have paid (interest also accrues from the date taxes should have been paid)
- A penalty of 0.5% the unpaid tax liability for each month it is unpaid up to 25%
That alone could sink many small businesses.
Independent contractors' legal obstacles
It's also possible for an independent contractor to report you to the IRS, claiming they are an employee. While you may not face tax penalties, you will have to open your books to the IRS.
Apart from independent contractor agreement enforceability and potentially being reported to the IRS, there are other potential consequences. How labor-friendly the state where your business is located in can determine how the laws ‒ and your actions ‒ are interpreted.
Maintaining consistent quality
This last concern is less about tax and legal liabilities than about working with a contractor. Freelancers need to have multiple clients, which means you never really know how much time or care they are devoting to your projects, and that can have a drastic impact on the products or services you provide to customers. If you want to build a good reputation and engender the trust and loyalty of customers, you must provide them with consistent quality.
How nearshoring solves these problems
For business owners, there is an option to hire independent contractors or freelancers. You could potentially nearshore your operations to a country located right next door, like Mexico. Nearshoring in Mexico offers advantages for businesses based in the United States and Canada.
First, it can eliminate the liabilities of working with independent contractors, including the issue of recourse should you ever be sued.
Second, with nearshoring, you could reduce potential tax liabilities because you are paying a third party that employs the worker. There is no claim that they are independent, as they are employed by the agency.
Third, because the nearshored employee works for a third party, any potential legal claims that arise are directed against their employer – not you, the client of the employer. Further, using an agency does not require you to establish operations in the nearshored country.
Fourth, with nearshoring, it is easy to maintain consistent product quality. You can train workers precisely on the work that needs to be completed, and you can have it done exactly the way you want it.
You should always seek tax and legal advice from your advisors. However, nearshoring could help you scale your business while avoiding the pitfalls of employing independent contractors.
Business.com does not provide tax or legal advice. Readers should consult their own attorney(s) or tax advisors to understand the tax and legal consequences of any strategies mentioned in this article.