Remote work and hiring talents outside of the US has become a trend, if not a norm. However, many companies do not realize the legal implications and risks a cross-border work relationship carries. Truth be told, this information is often hard to find. This guide can help you determine what your company needs to take into account to run a risk-free business.
Disclaimer: This article is informational only, and does not serve as legal counsel. Although we try to keep it up to date, always check for the latest information on the respective institutions' websites.
Different setups for working with foreign service providers
There are three setups to choose from when you want to hire people internationally:
- Opening a subsidiary
- Hiring a PEO
- Hiring independent contractors
Opening a subsidiary
When a company has multiple workers in another country, opening a subsidiary might be necessary. Basically, you need to hire people as local employees. You need someone to open the subsidiary locally which entails legal work, opening a local bank account, etc. which is quite complicated.
Professional employer organization (PEO)
This setup enables you to contract an outsourcing firm that does all HR services including international payroll, benefits, tax reporting, and training of your workers. The PEO enters into a contractual co-employment agreement and becomes the employer of record. This setup is necessary in cases when hiring independent contractors is not an option. Deel is introducing a new service that will enable hiring full-time employees through 70 different PEO partners while keeping everything under Deel. Join the waitlist to be informed when it launches.
Hiring independent contractors
This setup is widely spread, across all company sizes. Although it's the easiest to set, it can lead to tax evasion when not understanding local laws and the different setups a contractor should have. We will talk about all the aspects individually in the sections below.
Go through a classification process: Independent contractor or employee
A company must weigh all the factors when determining whether a worker is an employee or an independent contractor. Some factors might indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. According to the IRS, there is no set number of factors that make the worker one or another, and no one factor stands alone in making this determination. Let's take a look at the classifications separately.
Who is an independent contractor
Independent contractors are people who offer their professional services to clients. Every country has its own regulations that define their independence. According to IRS, "The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done." If the payer is in any way controlling the work in terms of working hours or activities, the relationship might be viewed as employment.
Who is an employee
On the opposite, if the company controls the performance as a whole, the service provider is usually considered an employee. On top of that, if the company does expenses reimbursement, provides tools, conducts training, offers paid vacation and benefits, etc. the service provider is most probably an employee.
How to determine if a person is an independent contractor or not
As we already mentioned, each country regulates the factors that determine the relationship between the payer and the service provider. In the United States, there is a test called Reasonable biases or 20-Factor test, which gives you an overview of what an independent relationship looks like.
If you are not certain and need additional support, you can fill in Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) and request the IRS to review your case. Keep in mind that it can take at least six months before you get a determination and that each country has its local regulations that might be different from the ones in the US.
Do thorough research on local labor laws and new regulations
Just because a person is considered a contractor in one country, it doesn't prove that they are contractors in another country. Each country has its laws to determine this, and they often differ.
Take extra care to ensure an independent contractor is not an employee according to their local laws as well. Some countries require obtaining a contractor license which can help you avoid misclassification risks. We wrote about different requirements to set up as an independent contractor in many countries including France, Belgium, and the Philippines (and will continue to publish more, so keep an eye on our blog).
One more thing to keep in mind: some countries do not have an "independent contractor" classification and have different setups such as entrepreneurs, auto-entrepreneur, sole-trader, etc. It's helpful to keep the right compliance documents based on the structure the contractor has.
To ensure you are not at risk of misclassification, it's worth investing in a local legal counsel which can help you determine how local laws interpret a working relationship.
Avoid misclassification risks of independent contractors
The misclassification is often involuntary but sometimes it can be done in a deliberate way. Some companies will classify an employee as an independent contractor on purpose, in order to reduce payroll and the cost of employee benefits such as vacation or overtime pay, to bypass minimum wage laws, to avoid employee income tax withholding, etc. However, these are rights that must belong exclusively to the employee.
Therefore, the whole problem when misclassifying independent contractors is that it leads to tax law and employment law violations and penalties. This can run into hundreds of thousands of dollars of fines and penalties, depending on the state where the misclassification happens.
Write a tailor-made contractual agreement
Now that you have rightfully classified your hire as a contractor, it's time to put things into paper. A solid contractual agreement is essential when you are hiring any contractor, especially a foreign one. You need a contract regardless of the compensation value, project duration, or other factors. It will protect both you and the contractor from misunderstandings and ensure both parties hold their end of the bargain.
Avoid using a template contract you found online because they usually don't have all the necessary elements, or take into account only the laws of one country. There is no one-size-fits-all contract. It may sound like a time-saver, but you are risking a lot in the case of a lawsuit or dispute. Take time to create a contract that is taking into account local labor law regulations of both countries involved. Keep in mind that local regulations also determine the length of the contract. When the scope of work changes, it's advised to create a new contract every time.
A good contract should always outline the following:
- Scope of work, detailing the services offered by the contractor.
- Compensation and expenses if applicable.
- Relationship of the parties, including the status of each party, liability, and indemnification clauses.
- Ownership of work. Keep in mind that not all countries have the same regulations when it comes to ownership and in some, the work is owned by a contractor.
- Confidentiality and data clauses used to protect the data of the client. You can also include an NDA clause here.
- A non-compete clause that determines the activities that are limiting the contractor from doing the work for a competitor.
- Termination and notice clauses that outline the duration of the contract.
- Governing law determining the body responsible in case of any disputes.
Learn about reporting income and tax responsibilities
Independent contractors are usually responsible for covering their taxes, and the hiring companies are free from this responsibility. However, depending on the contractor's country, the company might be involved in the process of compiling and reporting compensation.
Reporting income of non-US citizens living outside of US
US tax rate applies to anyone who has made income in the US, regardless of their citizenship. That means that if an independent contractor is not a US citizen but has made income in the US still has to pay taxes according to the US rates. In some cases, a tax treaty has been established between the US and a country. According to the IRS, "under these treaties, residents (not necessarily citizens) of foreign countries are taxed at a reduced rate or are exempt from U.S. taxes on certain items of income they receive from sources within the United States."
How to determine whether the income is US-sourced or not
According to the IRS, the source income gained by offering services is determined by the location where the services are performed. That said, even if a foreign person works for a US company, the income they receive is not considered US-sourced income as long as every aspect of the service is performed outside of the US. In that case, a US company should not withhold or report taxes. In case a foreign contractor performs any part of their services in the US, certain conditions need to be met to avoid tax obligations.
Collecting necessary forms required by the IRS
File a 1099 Form to report US-sourced income to the IRS
If a US-based company hires US-based contractors who earn more than $600 within a year, Form 1099-MISC or Miscellaneous Income should be filed to the IRS.
A Form 1099-MISC needs to report the total payments made during the year to each contractor that received more than $600. A Form 1099-MISC should be filled to the IRS by January 31st for the previous year.
IRS is re-introducing the 1099-NEC Form for reporting in 2020
IRS is re-introducing the 1099-NEC Form for the tax reporting in 2020. Effectively for Tax Year 2020, what is now Box 7 on the Form 1099-MISC becomes Box 1 on the From 1099-NEC and Box 7 on the 1099-MISC will be removed.
When reporting non-employee compensation on Form 1099-NEC, the IRS explains that payment must be reported if all four of these conditions are met:
- It is made to someone who is not your employee
- It is made for services in the course of your trade or business
- It was made to an individual, partnership, estate, or, in some cases, a corporation
- The payments made to that payee were at least $600 or more for the year.
Collect a Form W-9 Form for US contractors
W-9 Form or Request for Taxpayer Identification Number and Certification is used by US companies to get information from independent contractors they hire who are based in the US. You can learn more about it in this article.
Collect a W-8BEN (or W-8BEN-E) Form for foreign contractors
The equivalent of W-9 Form for foreign contractors is called W-8BEN. It has two variations: W-8BEN for individuals and W-8BEN-E for entities. The form which needs to be collected is determined by the contractor's status.
These forms are used to prove a person (or entity) is not, in fact, a US citizen. The hiring company is entitled to rely on the claims made on these forms to determine obligations regarding tax reporting and withholding. If the information on the form differs from facts, and the worker does not qualify as a foreign contractor, the company is free from liability for not meeting tax requirements.
Tax Implications for US companies working with independent contractors
An independent contractor who is a US citizen living in the US
The company that hired this contractor will need to issue a Form 1099-MISC by January 31st to report payments higher than $600. The company doesn't have to withhold tax before making a payment.
A foreign independent contractor living outside of US
It's not necessary for the US company to report the payments they made to the independent contractor to the IRS if they are not US-sourced income, nor the company has to withhold any tax. However, the company needs to collect W-8BEN(E) as proof of the contractor's status.
An independent contractor who lives in the US with a visa that allows them to work in the US
The visa itself is not a determining factor in deciding if taxation applies. The place where service is performed determines the source of the income. If the foreign contractor lives and delivers their services in the US, the income is considered US-sourced and the company must withhold 30% as per non-resident tax rates. However, these rules do not apply in case of a tax treaty between the countries (mentioned earlier in this article) or if a person becomes a resident.
In addition to withholding tax, the company needs to file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons by March 15th of the following year. Learn more about the Form and requirements here. If there is a tax treaty between the US and the contractor's country, the contractor should file Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual.
A foreign independent contractor currently in the US without a visa (Canada and Mexico)
If you'd ever hire a foreign person without a proper work visa, significant legal risks could occur. A foreign person without a proper work permit carries significant legal risks and is by no means encouraged. However, citizens of Canada and Mexico are allowed to work temporarily without a visa. If a person made US-sourced income, as non-resident the hiring company must withhold 30% before payment is made and file a Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons). In case of a tax treaty, the Form 8233 must be filled to claim exemption.
An independent contractor who is a US citizen but lives abroad
The general rule is that US citizens are subject to the same tax rules regardless of their location. The IRS will still consider an independent contractor as a US citizen even if the service is provided abroad, and even if the contractor has spent sufficient time to be considered as a tax resident of another country. That said, the company should issue a Form 1099-MISC (given they paid the contractor more than $600 within a year) as it would to any US resident contractors. There are some cases where the tax implications change, so we advise you to take a look at the IRS' Tax Guide for U.S. Citizens and Resident Aliens Abroad or consult their FAQ page about International Individual Tax Matters.
Streamline working with independent contractors with Deel worldwide
Deel is determined to help companies and contractors work together regardless of their location.
Our all-in-one solution covers:
- Local labor law compliant sample contracts that take into account both parties' countries
- Collecting W-9, W-8BEN, and 1099-MISC Forms and filling them electronically directly to the IRS
- The easy payment process with multiple payment methods, local payouts and 60 currencies covering 150+ countries
- Collecting compliance documents according to each country's requirements to mitigate misclassification risks
Learn more about how Deel works on our product pages and schedule a demo to see it in action.