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Using Independent Contractors to Service your US Clients is a Complicated and Risky Strategy

A sensible and often used way for UK companies to test the waters and get a foothold in the USA is to make initial inroads through service providers and consultants already based in and familiar with the American market.  This generally takes one of two forms:  Either the UK company, directly or through an “employer of record”, administers one or more pay rolled employees to do the company’s work in the US; or the company directly engages independent contractors to do the same job. 

Companies that choose the employee route undoubtedly take the safer more predictable course.  On the other hand, many service providers refuse to be pay rolled, choosing instead to be independent contractors responsible for their own taxes and able to deduct expenses from their income.  While the contractor route seems at first glance to offer greater flexibility and financial reward for both the company and the worker, the choice is filled with hazards that can quickly make this by far the more expensive and riskier option.

Contractors:  Nexus or no Nexus?

One can hardly blame a company for seeking to avoid the trouble and expense of engaging employees.  Not only is there the expense of payroll taxes, but under US law, an employee in any state of the country constitutes a “nexus” with that state, requiring the company to both register to do business and pay a proportionate share of income taxes in that state.  For purposes of this article, a state nexus is simply a presence in the state that is substantial enough to require registration and payment of income taxes in the state.  Not all activities in a state rise to this level.  But understanding which do and which don’t is vital. Unfortunately, the notion that engaging an independent contractor resolves the issues is in many respects a fallacy. 

For purposes of state registration and income taxes, there are two types of independent contractors: Those that form a nexus with the state and those that don’t.  Very generally, the contractors that form a nexus are those that assist the company in “establishing and maintaining a market in the state”.  As a very general rule of thumb, if the contractor is facing and dealing with the company’s customers and clients, the chances are that he or she has created a nexus.  Some examples are: Sales representatives, installers, fulfilment centers, consultants providing services to clients, and repair personnel. 

Another way to think of it is, if the contractor is fulfilling a function of the company that the company itself would have to fulfil in order to develop and maintain its market, then the contractor has probably created a nexus for the company. Such being the case, the company is required to both register to do business in the state and, where appropriate, file corporate income tax returns in that state.

On the other hand, if a contractor’s role is limited to moving a product or service further along the supply chain, with no direct connection to the company’s market, then the contractor may arguably not be helping to establish or maintain the market and will therefore not create a nexus with the state.  An example might be an independent contractor engaged by a company to write a piece of code to be used in a larger application being developed by the company, but whose work has no direct engagement with the company’s market, customers or clients.

Staffing and recruiting companies can find themselves in a particularly confusing role when it comes to using independent contractors.  On the one hand the contractor is technically engaged by the staffing company and therefore creates a nexus for the staffing company in the state where he/she works.  On the other hand, it’s arguably the market of the staffing company’s client that is being serviced by the contractor and that client may be already registered in the state.  Cutting through the nuance however, the basic facts are that the contractor’s agreement is with staffing company and he/she has been engaged by the staffing company to service the staffing company’s market (i.e., its client).  Therefore the staffing company has a nexus in the state where the contractor works, so the staffing company needs to register in that state and most probably has a taxable presence.

Getting the above analysis wrong can be a very expensive mistake.  The consequences for failing to register in a state where you’ve established a business can have significant consequences, both financially and in terms of liability risk exposure.  Yet, even if you do get the analysis right, there’s the follow-on question of whether the independent contractor you’ve engaged really is a contractor or whether he/she should be, for legal and tax purposes, more properly deemed an employee.

Is the Contractor a Misclassified Employee?

In a prior blog post I discussed the misclassification issue in detail, which you can read here:

As the article points out, there are several indicia of whether a worker should be properly classified as an employee or a contractor. But for the sake of prudence and safety, if the worker works full time for the company or if the company is his/her sole source of income, then you absolutely need to obtain legal advice on this issue.  If your contractor is in California, then additional caution is required, as a new law, effective as of January 2020, redefines the line between contractor and employee in very restrictive language.

However much a company might save by using a contractor label inappropriately will pale in comparison to the possible federal and state penalties for unpaid payroll taxes, not to mention possible private claims for lost employment benefits such as healthcare and pension contributions. 

Recently, some contractors have been trying to avoid both the registration and misclassification issues by registering themselves as specific type of US business entity called a Limited Liability Company.  In their thinking, if they become their own company, as opposed to an individual, and register in their state, then both issues disappear.  While this can work in some instances, it doesn’t in most, and can create a whole new set of risks. It will be the topic of the next article.