The all-connected modern environment brings many significant advantages to companies and startups around the world. Hiring independent contractors outside of the US, as well as managing remote workers, has become a trend, if not a norm. A US company can expand its independent contractor pool to many countries around the world and start collaborating with freelancers in Argentina, Japan, South Africa, or Spain. This possibility of looking for the best workers instead of those nearest to you is genuinely groundbreaking for many industries and companies worldwide.
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 workers
There are three setups to choose from when you want to hire people internationally:
- Opening a subsidiary
- Hiring a PEO using employer of record (EOR) services
- 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) and employer of record (EOR) services
This setup enables you to contract an outsourcing firm that does all HR services including international payroll, benefits, tax reporting, and training your behalf. The employer of record (sometimes referred to as global PEO) enters into a contractual co-employment agreement and becomes the hiring party on behalf of the company. This setup is necessary in cases when hiring independent contractors is not an option, and the workers must be hired as full-time employees.
Read more about what employer of record means.
Read more about the differences between Professional Employment Organization (PEO) and Employer of record (EOR).
Hiring independent contractors
This setup is widely spread across all company sizes. Hiring contractors has multiple benefits: the possibility to employ foreign workers or short-term workers, cost per employee savings, and the ease of contractor relationships.
Although it's the easiest to set, it can lead to tax evasion charges and IRS audits when local laws and different setups for contractors are not well understood. We will talk about all the aspects individually in the sections below.
Independent contractor or employee: Classification process
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 others suggest 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 (often called 1099 contractors in the US) are people who offer their professional services to clients. They are usually self-employed owners of small businesses that you hire for a fixed period of time or on a project basis. Every country has its own regulations that define their independence. According to the 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 in any way controls the work in terms of working hours or activities, the relationship might be viewed as employment. We've written in-depth about the differences between contractors and employees, so make sure to check out that article as well.
Who is an employee?
On the opposite, if the company controls the performance as a whole, the service provider is 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 likely an employee. In cases where there is an employment contract, the worker's status is evident, but independent contractors can start resembling employees in some scenarios. In those cases, there is a need to determine their status.
How to determine if a person is an independent contractor or an employee?
As we already mentioned, each country regulates the factors determining 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 sure 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 those in the US.
Do thorough research on local labor laws and local tax 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.
We have seen many countries introduce regulations such as Off-payroll working (IR35) in the United Kingdom, Assembly Bill 5 in California, and Independence Test for lump-sum taxpayers in Serbia.
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. For more countries, take a look at the local compliance section on our blog.
One more thing to keep in mind: some countries do not have an "independent contractor" classification. Some of them have different setups, such as entrepreneur, auto-entrepreneur, sole-trader, freelancer, etc. It's helpful to keep the proper compliance documents based on the structure the worker has.
To ensure you are not at risk of misclassification, it's worth investing in a local legal counsel that can help you determine how local laws interpret a working relationship.
How to avoid misclassification of independent contractors?
The misclassification of workers 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 to reduce payroll and the cost of employee benefits such as vacation or overtime pay, bypass minimum wage laws, 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. The penalties can turn out to be in hundreds of thousands of dollars, depending on the state where the misclassification happens.
Misclassifying employees as contractors also disenfranchises the workers, stripping them from their rights, protections, and benefits they should have according to the US laws. To avoid these risks, make sure to check out all the tests available, such as the DOL Economic Reality Test and the IRS test.
Creating an independent contractor agreement
Now that you have rightfully classified your hire as a contractor, it's time to put things into paper. A substantial 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 consider only the laws of one country. There is no one-size-fits-all contract for independent contractors. 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 takes 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.
Here's a complete guide on how to write an independent contractor agreement.
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 regarding ownership. In some countries, the work is owned by the 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 taxes are usually their sole responsibility, since we're talking about self-employment 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. Make sure your company is not liable for the taxes as this can pose risk to your business.
Reporting income of non-US citizens living outside of US
The 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 US taxes on certain items of income they receive from sources within the United States."
For a complete list of countries that have a tax treaty, consult the IRS website.
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 conducts any part of their services in the US, certain conditions need to be met to avoid tax obligation:
- The contractor was present in the US for no more than 90 days in a tax year;
- The payment to the contractor is lower than $ 3,000
- The payment to the contractor is for services performed for an entity or office maintained in a foreign country
How to collect tax forms for contractors required by the IRS?
File a IRS Form 1099-NEC 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, they should file IRS Form 1099-NEC (Non-Employee Compensation) to the IRS. Starting in the tax year 2020, companies working with contractors use Form 1099-NEC to file contractor payments instead of Form 1099-MISC, which was used in previous years. Effectively for the tax year 2020, what used to be Box 7 on the Form 1099-MISC becomes Box 1 on the Form 1099-NEC, and Box 7 on the 1099-MISC will be removed.
Form 1099-NEC was last used in 1982 and is now brought back to life by the IRS. On this form, employers report the total payments made during the year to each contractor that received more than $600. Form 1099-NEC should be filed to the IRS by January 31st for the previous year.
However, form 1099-MISC continues to exist, so make sure to check the use cases for both 1099 forms.
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
How to collect IRS Form W-9 for 1099 contractors?
US companies use IRS Form W-9 (Request for Taxpayer Identification Number and Certification) to get information from independent contractors they hire who are based in the United States.
Form W-9 contains the name, address, and Social Security number (or Tax Identification Number, known as TIN) of the 1099 contractor in question. Employers only need to ask for a filled-out Form W-9 from contractors they paid more than $600 to in the course of a year. Neither the employer nor the contractor needs to submit this form to the IRS since it is only a prerequisite for filling out Form 1099-NEC.
How to collect IRS Form W-8BEN (or W-8BEN-E) for foreign independent contractors?
The equivalent of the Form W-9 for foreign contractors is the IRS Form W-8BEN. It has two variations: Form W-8BEN for individuals and Form W-8BEN-E for entities (foreign companies, or the self-employed operating under a business entity). The contractor's status determines the form that needs to be collected.
These forms are used to prove that 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.
These forms are valid for three years and should be renewed if the relationship continues beyond that time. You can learn more about W-8BEN forms on the IRS' W-8BEN page.
Tax Implications for US companies hiring independent contractors
Hiring an independent contractor who is a US citizen living in the US (1099 contractor)
From the perspective of a US company, this is the most straightforward setup. The first step is to request the contractor to provide Form W-9. The company that hired the contractor will need to issue a Form 1099-NEC by January 31st to report payments higher than $600 in the previous year. The company doesn't have to withhold tax before making a payment to the contractor.
Hiring a foreign independent contractor living outside of the US
The US company doesn't need to report the payments they made to the foreign independent contractor to the IRS if they are not US-sourced income. The company also doesn't need to withhold any tax. However, the company does need 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 the 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 a tax treaty exists 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 US 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 Non-resident Alien Individual.
A US company hiring independent contractors in Canada
One of the most popular countries for US companies to hire contractors from is Canada; the shared language, culture, and proximity make Canadian freelancers the preferred choice of HR departments. If you are hiring a Canadian contractor to provide services to your company remotely, then all the same rules and forms apply as for residents of any other foreign country. Make sure to check the rules and regulations of Canada's equivalent to the IRS, the CRA (Canada Revenue Agency). Like its US counterpart, the CRA imposes penalties for misclassification of employees, but in cases where companies don't have a presence in Canada, the burden of the penalties falls on the contractor.
Finally, citizens of Canada (and Mexico) are also allowed to work in the US temporarily without a visa. If a person made US-sourced income as a non-resident, the hiring company must withhold 30% before payment is made and file a Form 1042 (Annual Withholding Tax Return for US Source Income of Foreign Persons). In case of a tax treaty, Form 8233 must be filled to claim exemption.
How to hire 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 if the service is provided abroad, and even if the contractor has spent sufficient time to be considered a tax resident of another country. That said, the company should issue a Form 1099-NEC (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 US 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 streamline onboarding and work with remote talent regardless of their location.
Our all-in-one solution covers:
- Local labor law compliant sample contracts that take into account both parties' countries
- Collecting Forms W-9, W-8BEN, and 1099 and filling them electronically directly to the IRS
- The easy payment process with multiple payment methods, local payouts, and 100 currencies covering 150+ countries
- Collecting compliance documents according to each country's requirements to mitigate misclassification risks
- In case you need to hire a full-time employee or switch an independent contractor to an employee status, Deel employer of record services can easily help you onboard workers fast, keeping everything under one roof.
Learn more about how Deel works on our product pages and schedule a demo to see it in action.