Registration of employees as sole proprietorship: risks of recognizing labor relations

An individual entrepreneur is an independent business entity, carrying out its activities at its own risk. Often, mainly for the purpose of optimizing the tax burden, Ukrainian businesses cooperate with individual entrepreneurs. This model is very common in IТ-business, sales, hotel and restaurant business, etc.

However, cooperation with individual entrepreneurs, in addition to the obvious advantages of reducing the tax burden, can have negative consequences for business. In this article we shall thoroughly analyze the risks of cooperation with individual entrepreneurs and ways to minimize the risks.

From time to time our company is approached by businesses on the issue of how to properly set up work with individual entrepreneurs and employees. Recently, a client contacted us to establish a call center using an individual entrepreneur instead of an employment relationship. We advised the client and helped him structure the relationship in such a way as to reduce the risk of penalties from the tax authorities and the State Labor Service.

The situation is different when a business contacts lawyers after receiving the first “bells” from the state authorities or during inspections when understanding the threat of possible penalties “on the horizon”. Resolving such issues will be somewhat more difficult.

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Labor and civil law relations for an IT company

Legislation of Ukraine and judicial practice helped to establish certain features that help to distinguish labor relations from civil law relations:

1. Process and result.

An employment agreement regulates the process of organization of work, while the civil-law contract involves obtaining a certain result. For example, constant work to ensure the activity of a website under certain conditions can be considered as a continuous process, while the main criterion for the creation of a computer program is the result of such work. The relevant position is defined in the rulings of the Supreme Court from 04.07.2018 in case No. 820/1432/17 and in case No. 815/954/18 from 13.06.2019.

Another obvious feature that distinguishes between process and result is remuneration. Labor legal relations are characterized by systematic payment for work performed, payment of remuneration under the contract with an individual entrepreneur is carried out, as a rule, on the basis of acts of acceptance and transfer of services rendered / work performed upon their completion.

2. Obedience to internal labor regulations and other documents.

It is considered that the individual entrepreneur is an independent business entity and performs work or provides services under a contract. That is, unlike employees, an individual entrepreneur is not subject to the requirements of labor laws, internal labor regulations and other documents and requirements defined by Ukrainian law for labor relations.

This does not mean that the individual entrepreneur has no right to visit the client company or use the client’s office equipment, if necessary. However, an important attribute of the employment relationship will be subject to the labor regulations, job descriptions and the hierarchy of control over the performance of work in the company.

Therefore, the contract with the individual entrepreneur shall clearly indicate the independence of the two business entities entering into legal relationships.

3. Combining work and individual entrepreneurship.

In some IT companies, employees and officers perform programming-related work at the same time. So, they are employed, but at the same time have a contract between the company and their individual entrepreneurship. Of course, this is a “red rag” for the regulatory authorities, which are very likely not to understand the essence of the legal relationship, and will point to the duplication of work of the individual entrepreneur and the employee under the employment agreement.

Of course, this model is not recommended, but it is not illegal either. If you use such a model of cooperation, you need to clearly distinguish between the duties of the employee under the employment agreement and the duties of the individual entrepreneur. All these points must be properly documented.

In any case, the regulatory authorities imposing penalties on the company must prove that there was a fact of physical persons work in the framework of labor activities, and the courts shall analyze in more detail the legal relationship between the customer and the contractor.

4. Schedule and place of work.

The existence of a clearly defined place of work, work schedule and work equipment are classic signs of the existence of an employment relationship. Obligatory presence at the workplace during the working hours and use of the equipment by the individual entrepreneur will be enough signs to attempt to recognize the legal relationship of the individual entrepreneur and the company as an employment relationship.

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State inspections of IT companies: What you should pay attention to

First of all, we are talking about inspections of the State Tax Service (hereinafter - STS) and the State Labor Service. The first “red flags” may be quite common requests or appeals of regulatory authorities.

However, regulatory authorities may also apply the latest approaches to inspections. For example, in the restaurant business, a customer, very persistently asking for a bill, looks at the consumer’s corner, or rather strange candidates at the interview, who are not so much interested in getting a job, as in getting information about the company. Yes, government agencies can get information for their inspections this way, too.

If the inspection is official, however, you need to remember the following rules:

• Always check the documents of the person performing the inspection. Usually, the employee of the state agency shall have a certificate and a referral for the inspection / decisions to conduct the inspection.
• During the inspection, be aware of the need to record any violations of the inspection procedure and deadlines. Document such violations to provide proof of appeal.
• The main document after the inspection will be the Act, in which the supervisory authority will specify all of the identified violations. Availability of the Act does not mean automatic prosecution and penalties. The decision to impose a fine can be appealed in administrative or judicial proceedings.

Unfortunately, in most cases, appealing against decisions of government agencies are effective only in court.

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Liability for lack of employment and “hidden employment”

In the case of cooperation with the individual entrepreneur, in practice, you may face the following most common risks:

1. Tax risk – during the tax audit the STS employees may be interested in understated financial indicators before taxation and at the same time the costs of contracts with the individual entrepreneur. According to the results of the audit, the tax authorities have the practice of indicating in the Acts of the audit the wrongful use of individual entrepreneurship instead of labor relations, which as a result reduces taxes and will accrue the amount of reduced tax and penalties.

In this case, the tax authorities may additionally assess personal income tax in the amount of 18% for each “employed” , accrue the military fee and increase the amount of pre-taxation. Accordingly, the amounts may be astronomical.

1. Inspections by the State Labor Service. If an employee is found not to be employed, the State Labor Service may impose a fine of UAH 65,000 for each violation. If the violation is repeated within 2 years, the amount of fine will triple.

The easiest and safest way is to take care of minimizing risks in advance, at the stage of forming relationships with employees.

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How to minimize the risks when concluding contracts with an individual entrepreneur?

A few tips for start-ups and established businesses to prevent unintended consequences:

1. If you start a business, we recommend analyzing and structuring the future business taking into account the requirements of Ukrainian legislation. If the business is already operating, we advise to audit the activities and documents of the company.
2. Your employees should be clearly informed and instructed about the required actions or inactions in case of inspections, searches or requests from state authorities.
3. Review all documents relating to cooperation with each individual entrepreneur. Analyze and adjust “weaknesses”, prepare Acceptance Certificates of services rendered / work performed for each operation.
4. Analyze the work of each employee and determine the presence or absence of signs of an employment relationship. In some cases, the best option to minimize risks is to conclude an employment agreement and arrange employment.
5. Respond timely to requests, appeals of regulatory authorities and check (this option is expected after the war) information about scheduled inspections of regulatory authorities.

Please note! Today, the legal regime of Diia City provides IT businesses with an opportunity to use gig-contracts, which combine signs of labor and civil legal relations.

We offer qualified assistance and our experience of working with IT companies of different sizes in Ukraine - we will audit your project and provide recommendations for the safe organization of the working process with your employees.

Please check the cost of our services for IT businesses here.

Everything about doing business in Ukraine here.