Misclassification risk in Crypto
Misclassification of contractors and employees is an ongoing risk for web3 organizations. There are some key differences between the two, and getting it wrong can have serious consequences for organizations, such as fines, back payments, and a lot of operational overhead.
Many organizations label their workers as contractors because it seems like the easiest and safest approach. Concurrently, many workers prefer to be seen as contractors as it provides them more freedom in their work. However, workers that have a long-term, permanent commitment to a company - regardless of how they or the organization they work for labels them - are likely to be defined as employees by regulating authorities.
The danger here is that an organization could hire and treat workers as independent contractors, but the jurisdictions' regulating bodies may classify them as employees. This is a problem as there are different requirements attached to both. For employees, organizations are responsible for things like tax payments, statutory benefits, and legal employment contracts. These requirements vary from country to country, so things start to get difficult for a global workforce.
Factors That Determine How to Classify Workers
Although the lines are not black and white, there are some common (but not universal) threads across jurisdictions that dictate the terms of this relationship. They generally fall into three categories:
1) What is the relationship between the organization and the worker…
Contract: Simply identifying a contractor as such in a contract or agreement is indicative, though not sufficient, to determine the relationship
Permanency: A contractor is not intended to be a permanent fixture of your organization. The longer a worker is completing work for your organization, the more likely it is that a court would deem them an employee.
Relevance: Is the contractor performing duties critical to the core business? If so, they are more likely to be considered an employee.
Benefits: Contractors normally don’t receive employment benefits such as paid leave, pension, healthcare, etc. Providing these to your workers may make them more likely to be classified as employees.
2) What is the behavioral control between employer and contractor…
Control: If the employer gives detailed instructions on when, how, and what to work on, the relationship leans more towards being deemed employment.
Performance: If the worker is assessed and reviewed on the process of their work rather than just the outcome, this can indicate an employee relationship.
Training: Contractors should undertake their own training and professional development and are expected to be fully skilled without input from the employer.
3) What is the financial control between the employer and contractor…
Freedom: Can the contractor source other means of income, or does the employer allow them to only work with them? The latter is a significant factor in employment.
Payment frequency: Contractors are often paid variable amounts, hourly, or fees for completed services/deliverables. Employees are typically paid frequently and consistently.
Expenses: Does the employer cover any expenses incurred by the contractor, or does the contractor write these off as work-related expenses?
It’s important to note that this list is not exhaustive nor true across every jurisdiction. The classifications, factors, and weights can vary hugely from state to state and country to country. For example, the UK government adds personal service and hours/frequency of work tests (alongside many others) into their determination. The key takeaway is thus:
Simply labeling a contributor as an independent contractor does not mean they are seen as such.
So why do most organizations choose to label their workers as contractors?
Now that we have an understanding of misclassification, it’s important we understand some of the root causes that contribute to why organizations in Web3 are pushing for the contractor model vs. the employee model.
The two big ones that many organizations talk about are termination and payroll taxes.
When dealing with an independent contractor, the relationship is usually legally set up as a business-to-business relationship. The worker will either establish an LLC, corporation, or other legal entity that will then be engaged by the hiring organization to complete the work. The service agreement that sets out the relationship between the businesses may allow immediate termination of the worker’s entity.
This is in contrast to employment, which is usually governed by a combination of local employment legislation and common law jurisprudence. In many of these jurisdictions, employees are entitled to a ‘notice period.’ These notice periods exist to temper the uneven power dynamic between employees and employers, who can dramatically shift the lives of their workers through termination.
In a situation where a worker's role is terminated, and that worker, for whatever reason, is unhappy with the termination, they might decide to sue the organization stating they were an employee and not a contractor and were therefore entitled to a proper notice period. This could result in fines and potential charges against the organization.
One example of this happening in a traditional company can be found in Martin v. City of Los Angeles, No. 18-56714 (9th Cir. 2019). In this case, the plaintiff, had been working as an assistant for the defendant, the City of Los Angeles. The City of Los Angeles laid the plaintiff off without any notice period, and he sued the City, claiming that he had been wrongfully terminated without proper notice. The court agreed with Martin and found that he was an employee and not a contractor, and thus the City had violated the law by laying him off without proper notice. The City of Los Angeles was ordered to pay the plaintiff back wages and benefits to the amount of $75,000.
For a web3 organization with a global workforce, things could start to become extremely time-consuming and expensive if laid-off workers realize they were misclassified and choose to do something about it.
A second motivator to bring contributors on as contractors is simplifying the payroll for the organization. Because payments are being made between two businesses, payments can be made without any thought to taxes.
In both cases, though, taxes must be paid. The key difference is that for employees, the employer is responsible for paying their taxes, whereas, for contractors, the responsibility lies with them. The tax man gets his revenue either way.
Also, setting up the necessary payroll and tax rails for a global workforce is extremely complex and time-consuming, even more so when tokens are used. Having the worker deal with their own taxes is much easier for organizations. In some jurisdictions, it's more economically efficient regarding taxes to label workers as employees than contractors, and in others, the opposite is true.
Another key reason is that web3 organizations often have a globally distributed workforce. According to research from Grand View Research, the global web3 market size is expected to reach $64.1 billion by 2022, growing at a CAGR of 42.5% from 2020 to 2022.
Global regulations make it difficult for organizations to ensure they are following all the different employment laws in each jurisdiction they have workers. The sheer amount of different requirements and differences from country to country is usually more than enough for any founder, HR, or legal team to opt for labeling workers as contractors rather than employees.
The Main Risks of Misclassification
Misclassifying workers can result in various consequences for organizations. In the US, if the IRS determines that a worker is misclassified as an independent contractor rather than an employee, they can hit the business with fines that include; taxes that haven’t been paid and penalties for the misclassification itself. There is yet to be a clear precedent set in Web3, but looking further afield, the Uber case is the pin-up of misclassification.
The case itself isn’t clear-cut. Uber drivers decide when they want to work (much like an independent contractor). Yet, once logged in to the app, they are told where and when to go places to provide rides (a level of control typical of an employee/employer relationship). The case is still being settled state by state in the US but has so far resulted in Uber paying $8.4 Million in damages and over $100 Million in fines and taxes in California and New Jersey.
The likelihood of a government authority chasing a web3 organization for misclassification is slim but not nonexistent. What is likely to draw their attention, though, is a disgruntled employee making a big noise. If a worker decides to rage-quit a project and then goes to their lawyer claiming they have been misclassified as a contractor, suddenly government bodies have a vested interest. While it might not result in the level of fines Uber faced, it could still be a catastrophic blow for an organization.
How is the organization structured?
Entity-less: It might be more difficult to litigate against a case of contractor misclassification as there is no formal corporate structure through which the power differential between contractor and corporation can be proven. That said, an entity-less DAO is likely to be deemed a general partnership resulting in joint liability in the case of any action being brought against it. Put simply; it means a single member (or all members) of an organization could be responsible for any resulting punitive damages.
Corporate-wrapped: An organization wrapped in a corporate structure reduces the risk to its members as there is no general partnership. However, there is a much clearer duty of care and power imbalance between the workers and the corporate entity, increasing the risk of government authorities making a case for misclassification.
As stated, there is no globally accepted determination for a worker to be deemed an independent contractor or employee. The goalposts shift across jurisdictions. This is reflected in a whole range of employment, labor, and payroll legislation too.
The key takeaway here is that determining the proper classification for workers is important. It can save time and money, and the risks of getting it wrong, as highlighted, can be detrimental to a web3 organization. It’s critical to understand the differences and potential consequences tied to both, which is no small task.
At Toku, we have realized the risks involved here and can advise organizations on the best approach for efficiency and, most importantly, global compliance.
We are the first global compensation and employment solution for Web3. Covering both employees and contractors, our services include token tax and payroll processing, token grant administration, HR business partnership services, legal & compliant web3 employment, and more.