Contractor misclassification is a term used to describe the act of assigning someone to the wrong employment category. It often refers to employee misclassification, which occurs when a business classifies a worker as an independent contractor but treats them like an employee. This can lead to legal and financial risks for both the company and the worker.
Companies may intentionally or unintentionally misclassify workers to evade taxes and costs associated with employing a worker. Hiring an independent contractor is often more affordable than hiring an employee since companies do not need to pay compensation premiums, healthcare benefits, office space, and equipment costs or withhold income taxes, unemployment compensation, and unemployment taxes.
The tax regime in Nigeria, for instance provides for the PAYE (Pay As You Earn) and Withholding Tax under the personal Income Tax. We also have other forms of Taxes like the VAT (Value Added Tax) and Capital Gains Tax (CGT) etc. Ideally an employer is meant to deduct the appropriate tax rate for its employees as withholding tax; thereby holding a set amount of income tax from the employee's pay check. Such taxes are to be remitted to the appropriate Tax Authority. In other instances, independent contractors are also meant to remit taxes on the services they offer. In such instances where a 3rd party engages an independent contractor, the 3rd party may either withhold the taxes on such services and remit same to the tax authority, or, the independent contractor is paid the full sum and he or she remits taxes on his own (thereby shifting the liability to himself).
To determine if a worker is misclassified, businesses should look at the worker’s relationship with the company. Employees typically work for a single employer who has financial control over how they pay the worker. The employer withholds payroll taxes on the employee's salaries and directly supervises their work, controls the tools and equipment they use, and sets their work hours.
Independent contractors, on the other hand, are self-employed, often work for multiple clients at a time, and send invoices to get paid. They pay their own income tax and self-employment taxes since they are not on the company’s payroll. They choose their own tools, decide how to complete the work, and select their working hours.
Risks of Misclassification:
One of the primary risks associated with contractor misclassification is the risk of litigation. Workers who believe they have been misclassified may file a complaint with the Department of Labor or pursue legal action against the company. If the company is found to have misclassified workers, it may be required to pay back taxes and penalties, as well as provide back pay and benefits to the workers.
Another risk is the possibility of fines and penalties. Companies that misclassify workers may be subject to penalties and fines from the Department of Labor, the Internal Revenue Service, and other government agencies. These fines can be substantial, and they can quickly add up if a company has misclassified a large number of workers.
Misclassification can also damage a company's reputation. If workers feel that they have been treated unfairly or have been misclassified, they may speak out against the company on social media or other public platforms. This can damage the company's reputation and make it more difficult to attract and retain top talent.
To avoid contractor misclassification, companies should take steps to ensure that they are properly classifying their workers. This can include reviewing job descriptions, pay rates, and the level of control that the company has over the worker. Companies should also consult with legal counsel to ensure that they are in compliance with all relevant laws and regulations.
In a bid not to get caught in the trap of misclassification, an important factor is to clearly define the existence of an employment relationship or a mere relationship with an independent contractor. More interestingly, other than the Labour Act, no specific law sets out what factors would be considered in ascertaining whether an individual is an employee or an independent contractor.
However, in SS Co Ltd v Afropak (Nig) Ltd. ((2008) 18 NWLR 77 at p82) the Supreme Court prescribed the following criteria to provide guidance in making this determination:
i. The mode of payment (most times, the employee is paid a lump sum over a period of time, and not for each work done); ii. Ownership of the equipment, tools or instruments used in providing the services; iii. The ability to delegate duty; iv. The hours of work; v. The place where the work is carried out; and vi. The provision of office accommodation and a secretary.
One way to reduce the risk of misclassification is to use a third-party employer of record (EOR) service. EORs can handle the administrative and legal aspects of employing workers, including payroll, taxes, and benefits. This can help ensure that workers are properly classified and that the company is in compliance with all relevant laws and regulations.
The Labour Act remains the principal legislation for the regulation of employment contracts and relationships in Nigeria and it clearly defines the nature of an employment contract as reiterated in the suit in SS Co Ltd v Afropak (Nig) Ltd ((2008) 18 NWLR 77 at p82).
Contractor misclassification is a significant risk for businesses, and it can have serious legal and financial consequences. To avoid misclassification, companies should take steps to properly classify their workers and consult with legal counsel to ensure compliance with all relevant laws and regulations. There must also be a clear term of engagement that defines the scope of work and the extent of liability between parties. Using a third-party EOR service such as Cadana can also be an effective way to reduce the risk of misclassification and ensure compliance.