How Strategic Contract Design Can Reduce the Independent Contractor Reclassification Risk in Professional Services Agreements


KEY TAKEAWAYS:

  • Discover why independent contractor reclassification risk is a significant concern for companies engaging external professional resources, and comes with substantial legal, financial, and operational challenges.
  • Understand how relying on traditional risk mitigation strategies can be costly and detrimental to long-term projects that rely on the experience and continuity provided by these resources.
  • Learn how embracing a thoughtful contract design can significantly reduce the risk of reclassification while allowing companies to retain valuable professional talent.

Use Strategic Contract Design to Reduce the Independent Contractor Reclassification Risk in Professional Services Agreements by Robert Reynolds

In today’s globalized business landscape, companies increasingly rely on outside professional services for their professional needs. According to McKinsey Global Institute, the global independent contractor market is estimated between 84M and 126M people, or 3-5% of the global workforce, and growing. MBO Partners estimated that the 41 million independent workers in the US alone contributed over $1.28 trillion to the economy.

Statista projected that the global spend would reach nearly $500B by 2023, with professional services representing over 30%.

But while independent contracting offers benefits, it also comes with substantial risks. These risks include non-compliance with labor laws, litigation costs, back taxes and penalties, increased labor expenses, project disruption and reputation risk. This article presents a clear and feasible solution to these risks–contract design.

The Challenge of Reclassification Risk

The risk of independent contractor reclassification is a major concern for companies that engage external professional resources, particularly through traditional staff augmentation or time and expense (T&E) arrangements. For example, the reclassification of a contracted resource can lead to a host of legal, financial, and operational challenges such as non-compliance with labor laws, litigation costs, back taxes and penalties, increased labor expenses, project disruption, and reputational damage. When a contracted resource is reclassified as a customer employee, it can lead to numerous challenges. These challenges include legal issues like non-compliance with labor laws and litigation costs, financial burdens such as back taxes, penalties, increased labor expenses, and operational difficulties like project disruption. Additionally, companies may face reputational damage due to misclassification cases.

To manage this risk, many companies resort to regularly rolling independent contractor resources off projects and teams. While this approach may help mitigate the risk of reclassification, it also comes with significant costs. The constant churn of personnel can lead to project delays, reduced efficiency, and increased expenses, ultimately undermining the benefits of engaging external professional talent in the first place.

The Power of Thoughtful Contract Design

Fortunately, there is a way to mitigate independent contractor reclassification risk without sacrificing the value that experienced professional resources bring to long-term projects. The key lies in thoughtful contract design.

Typical Professional Service Agreements (PSAs) often suffer from structural issues:

  • Poorly defined scope and acceptance criteria
  • Inflexibility in changes and collaboration
  • Misaligned incentives favoring billable hours over value
  • Insufficient communication and validation with the client
  • Lack of clear accountability and risk-sharing

In contrast, an effective PSA has:

  • Well-defined yet flexible scope
  • Clear accountability and aligned incentives
  • Frequent collaborative communication
  • Framework optimized for smooth execution and positive outcomes

A well-structured PSA serves as the foundation for a mutually successful engagement between the client and the professional firm. This approach involves crafting contract templates for professional services that emphasize the autonomy and independence of contracted resources.

Three Key Engagement Models

When designing contract templates to address the reclassification risk, the first step is to identify engagement models that underscore the independence of the contracted resources. These models should be distinct from traditional staff augmentation or time and expense (T&E) arrangements, which can be more susceptible to reclassification risk.

Some effective engagement models include:

1. Managed Service Models: The Managed Service model is well-suited for engagements that involve the delivery of a packaged functional support capability, such as Level 1 or Level 2 support services. The provider commits to delivering a defined set of services under a service level agreement, often with associated service credits for breaches, a fixed monthly charge, and a detailed governance framework.

2. Project Models: In the Project model, the provider is responsible for delivering a specific set of deliverables, often on a fixed price or capped T&E basis. The engagement includes detailed specifications for the deliverables, acceptance testing, performance warranties, and milestone-based pricing.

3. Agile Team Models: The Agile Team model is applicable when the provider supplies professional resources to serve on a customer-organized sprint development team. The engagement typically includes defined sprint team roles, KPIs, pricing, governance, and strategic support commitments from the provider. Here, the provider resources have significant autonomy and independent accountability for their performance, while the provider also plays a strategic, consultative role in shaping the program.

By structuring contract templates according to these models, companies can create a clear distinction between the provider’s resources and the customer’s employees. This distinction is what reduces the risk of reclassification.

The Solution: Design-Forward Contracting Models and Tools

Once an appropriate engagement model has been identified, the next step is to adopt a suitable contracting model. For companies that source a large volume of professional services, a pre-approved contract design structure can be an efficient and effective approach. We recommend using a Master Services Agreement (MSA) with work order templates for each engagement type. These templates should address the specific components of each engagement model, providing a consistent framework for contracting.

To further streamline the contracting process, the MSA can include provisions for taking certain orders “off paper” and providing digital coverage for specific order types, such as T&E orders and certain Project or Agile Team orders. This approach can help accelerate the contracting process and reduce administrative overhead.

The Human-Digital Ecosystem

At Tangible, we understand the complexities of independent contractor reclassification risk and the importance of effective contract design. Our team of sourcing legal professionals has deep expertise in these considerations. We work closely with our Intelligent Sourcing Center applications to help companies navigate these challenges. By integrating human expertise with digital tools, we can assist with engagement model selection, template development, and the digitization of certain order classes. This holistic approach helps drive down support costs, accelerate the contracting process, and ensure compliance with customer reclassification risk policies.

Managing independent contractor reclassification risk in professional services contracts is a complex challenge that requires a strategic, proactive approach. However, by leveraging thoughtful contract design, effective engagement models, and the right contracting tools, companies can mitigate this risk while still realizing the benefits of engaging external professional talent. At Tangible, we’re committed to helping our clients navigate these complexities and achieve their business objectives. If you’d like to learn more about how we can support your professional services contracting needs, we’d love to chat!

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