What are the risks of converting employees to contractors?

As an employer, you may find that some of your employees want to be classed as an independent contractor instead.

This can sometimes be a beneficial move for both parties, but often it can be extremely risky. As a result, it’s crucial that both you and your people understand the consequences.

In this article, we’ll look at some of those consequences, and explore the main risks in more detail.

What’s the difference between an employee and an independent contractor?

Ultimately, the difference between the two lies in the nature of your working relationship. Contractors tend to have a far greater deal of independence than employees, which is one of the reasons it can be such an appealing option.

Here are the key differences:

Employees

Employees work directly for your company and are subject to its control and direction. This usually includes adherence to set working hours, company policies, and specific job duties. They typically receive a regular salary and are eligible for benefits such as health insurance, retirement plans, paid time off, and other company-provided perks.

Importantly, employees are almost always protected under labor laws, and hold rights related to minimum wage, overtime, statutory benefits, and protection against unfair dismissal. As the employer, you are also responsible for withholding their income taxes and making contributions to social security and other programs.

Independent contractors

Conversely, independent contractors operate as self-employed individuals and provide specified services to clients. They have full autonomy over how, when, and where they perform their work, and typically have multiple clients.

Contractors are responsible for filing, paying, and managing their own taxes and social contributions. In nearly all cases, they are not eligible for benefits from the companies they contract with, and are not covered by the same labor protections as employees.

Contractor-client relationships are more transactional and project-based, and can be paid per hour, per project, or any other agreed-upon arrangement.

What are the risks for employers?

If your employees want to make this switch, there may be some potential upsides. However, it’s crucial to understand the risks involved before making any decisions.

These include:

Misclassification

Arguably the biggest risk is a potential misclassification lawsuit. If you misclassify an employee as a contractor, you could face legal action from the authorities in your team member’s country. This can result in significant penalties and fines, ongoing legal issues, and reputational damage.

Misclassification occurs when you treat your contractor like an employee — but without providing any of the tax contributions, benefits, and protections that an employee enjoys. If you convert your employee to a contractor in this way, the chances of misclassifying them is high.

What is misclassification — and how does it work?

As a result, many European countries are cracking down on this practice. Germany, for instance, already has severe penalties in place, and the European Union (EU) has recently enacted the Platform Work Directive, which targets bogus self-employment in the platform work sector. Governments in countries like Poland, where this practice is more popular, also have strict misclassification laws.

“Compared to the rest of the world, European countries are more likely to pursue misclassification claims and impose highly punitive penalties.”

Sam Ross, Chief Legal Officer at Remote

Another knock-on effect of this is that, if you are deemed to be misclassifying your employee, you will likely need to backdate taxes and benefits claims. This can lead to substantial costs for your business, especially if multiple team members are involved.

Financial risks

There are several financial risks associated with converting employees to contractors. One significant risk is the potential loss of tax deductions and benefits. When employees are converted to contractors, your business can no longer deduct their salaries from your taxable income. Depending on where you are based, you may also lose access to certain tax benefits, resulting in a substantial increase in your company's tax liability.

Another financial risk is the potential for higher contractor fees. Many employee taxes and contributions are split between the employee and the employer, but this is not the case for contractors, who are responsible for all of it. As a result, your team members may request more money to cover the differences, and to make up for the loss of their benefits.

Operational risks

Once your team members are classed as contractors, you may lose a significant amount of control over the way operational processes are followed. This can affect work quality, consistency, and productivity, and — in some cases — even lead to unsafe practices.

It can also negatively impact your company culture. A sudden split might create an “us and them” divide with your other employees, affecting collaboration and team cohesion.

In a similar vein, there’s nothing stopping your contractors from working for other clients — including your competitors. This can lead to potential conflicts of interest and divided loyalties.

Reputational risks

Rightly or wrongly, your use of contractors may be seen as a negative by external parties, such as potential clients and candidates. Even if it’s not the case, you may be perceived to be exploiting workers, or trying to avoid taxes and social contributions. As well as attracting negative PR, this can also draw the attention of the authorities.

If you’re a startup and you’re looking to attract funding, it may also be an issue for potential investors, who may be concerned about a perceived lack of stability.

What are the risks for employees?

In many cases, employees want to convert because of the increased autonomy and, in some countries, perceived lower tax rates.

However, there are numerous trade-offs, and it’s not always the best solution for your team members.

Specifically, they need to consider:

Financial risks

As contractors, your team members will (in the vast majority of cases) no longer be entitled to key benefits such as health insurance, retirement plans, paid time off, or sick leave. This means they must personally finance their insurance and retirement savings — often at a higher cost, as they are not part of a group plan. If they are part of an employee stock options program, they may also have to forfeit future stock options.

Many contractors charge higher fees to make up this shortfall, but there’s no guarantee that businesses will be willing to pay them what they are asking for. Instead, they may simply opt to hire another employee instead.

Legal and tax risks

Contractors are fully responsible for handling all their own tax filings, including income tax, self-employment tax, and any other applicable contributions. This requires careful record-keeping and financial planning to avoid penalties and interest from tax authorities.

They must also comply with various laws and regulations related to their industry, which can be complex and burdensome without the support of an employer's legal or compliance team.

Professional risks

Contractors may have fewer opportunities for professional development and career advancement compared to employees, who often have access to training programs and mentorship within your organization. Employers may also be inclined to promote internal employees, rather than contractors.

Also, as mentioned, contractors do not receive the same labor protections as employees. This means that if they start to perform poorly or the business wants to cut costs, they can be terminated instantly without any redundancy package or rights. This can lead to financial uncertainty and stress.

How can Remote help?

If you and your employee have fully assessed these risks, and you believe converting from employee to contractor is still the right approach, Remote can help. Our Contractor Management platform enables you to pay and manage contractors quickly and easily, and our offboarding process for EOR hires is simple and robust. 

However, it’s absolutely crucial that you both understand the consequences. Our in-house, on-the-ground experts can help you assess the risk factors in your team member’s specific country, while our Employee Misclassification Calculator can help you gauge your level of risk exposure.

To learn more, speak with your account manager, or — if you’re not yet a Remote user — speak to one of our friendly experts today.