Why it matters
Some businesses keep costs down by treating people who work like employees as self-employed contractors. The business avoids payroll taxes, pension or retirement contributions, paid holiday and other employment costs, and profit looks higher as a result.
Tax authorities, courts and tribunals look at how the relationship works in practice, not at the label in the contract. The tests differ by country, but they cover similar ground: who controls how, when and where the work is done, whether the person can send someone else in their place, who provides the equipment, whether they work for anyone else and how far they are part of the business. In the US, the IRS groups its factors under behavioural control, financial control and the type of relationship, and some states, such as California, use their own test, which treats a worker as an employee unless the business can show otherwise. In the UK, a person's status for tax can differ from their status in employment law, and a court or tribunal can make the final decision.
If workers are reclassified, the business can face back taxes, interest and penalties, plus claims for the rights those workers should have had. In a share sale, those liabilities stay inside the company you buy. In an asset sale they usually stay with the seller, but rules that move employees to a buyer automatically, such as TUPE in the UK, can bring some of that exposure with them.
There is a second cost that is easy to miss. Once the arrangement is put right, labour costs rise and earnings fall, so the earnings you value should reflect the corrected cost. Ask an employment or tax adviser to estimate the exposure, then deal with it through a lower price, a specific indemnity from the seller, or part of the price held in escrow or as a holdback.
In an asset sale you buy selected assets of a business; in a share sale (a stock sale in the US) you buy the company itself, with its full history. The choice shapes risk, tax and what needs consent.
TUPE is the set of UK rules that protect employees when a business, or part of one, moves to a new employer. Staff transfer automatically to the buyer on their existing terms.
Warranties are the seller's statements of fact about a business in the purchase agreement; indemnities are promises to reimburse specific losses. Together they decide who bears risks that diligence could not rule out.
How to spot it
- Much of the core work is done by contractors or consultants who appear to work only for this business.
- Contractors have been in place for years, work set hours, use company email addresses and equipment, and appear on the organisation chart.
- Contractor invoices are for the same amount every month, whatever the workload.
- Some contractors used to be employees doing the same job.
- Staff costs look low for the sector, or margins sit well above similar businesses.
- The seller describes a sizeable team, but the payroll lists only a handful of names.
Questions to ask the seller
- Who does regular work for the business, and which of them are on the payroll?
- How were the contractor arrangements set up, and did anyone take advice on their status?
- Do any contractors work set hours, use your equipment or work only for you?
- Has a tax authority, labour inspector or former worker ever questioned anyone's status?
- What would it cost to employ the people who do core work, and have you allowed for that in your figures?
- Would you give a specific indemnity for liabilities arising from how workers were classified before completion?
Documents to request
- A list of every contractor and consultant, with role, start date, usual hours, monthly cost and whether they work for others
- Contractor agreements and a sample of their invoices for the last 12 months
- Payroll reports and employment tax filings for the last three years
- Any status assessments, legal advice or correspondence with tax or labour authorities about worker status
- Details of any claims or complaints from current or former contractors