A Guide For Employers Contemplating The Use Of The Contingent Worker

In an effort to control costs and enhance competitiveness, many employers have discarded traditional employer-employee relationships, and have instead increased their reliance on "contingent" workers, including independent contractors, leased employees, and temporary employees. The increased use of contingent workers is due primarily to the desire of companies to increase overall efficiency while at the same time decreasing overhead by limiting their tax liabilities, insurance and other employee benefit costs, as well as their statutory liability under federal and state employment laws. Because flexible staffing through the use of contingent workers is on the rise, it is critical that the consumers of these staffing arrangements understand both the benefits and the potential hazards of entering into such arrangements. Indeed, an employer may not always get what it bargains for when it buys into a contingent employee relationship. There is a fine line separating employee status from contingent worker status. Notwithstanding the employer and the worker's view of the employment relationship, should it later be determined by either the IRS or a court that the various legal requirements needed to establish the employer-contingent worker relationship have not been met, the employer may be liable for substantial and unexpected monetary penalties under tax and other employment-related statutes.

Determining whether an employee qualifies as a contingent worker requires a fact sensitive inquiry, and often varies depending on the context in which the inquiry is made. For example, a contingent worker may be considered a non-employee of a company for purposes of state workers' compensation laws, yet the very same worker may be considered an employee in the context of certain federal and state anti-discrimination laws. Further, misclassifying a worker as an independent contractor, rather than as a regular employee, can result in severe monetary penalties to the employer, as computer software giant Microsoft Corporation recently discovered. Microsoft hired hundreds of "free-lance" workers to perform various jobs throughout the company. Microsoft considered these particular workers to be independent contractors, and therefore, the company did not pay any payroll taxes on behalf of these workers, nor did it allow them to participate in its various employee benefit programs. After conducting an audit of Microsoft in 1989 and 1990, the IRS concluded that Microsoft's free-lance workers were in fact not independent contractors as the company believed, but rather regular employees of the company. As a result, Microsoft was required to pay back payroll taxes to the government on behalf of this group of employees. More significant, however, was a later court decision which held that the Microsoft employees in question were also eligible to participate in Microsoft's stock purchase program which the company had offered to its other employees, and might be eligible to participate in Microsoft's 401(k) plan, depending upon the specific terms of that plan.

As the Microsoft decision illustrates, the consequences of misclassifying a worker as an independent contractor can be far-reaching. As such, it is critical that employers fully understand the factors governing the creation of the employer-contingent worker relationship, and its effects on an employer's obligations under various laws. This article examines the different categories of contingent workers, and follows with a look at the benefits and risks associated with employing such workers, as well as the factors which courts will apply should questions of worker classification arise.

The primary characteristic of the contingent worker is that he or she is technically "employed" by an entity other than the one receiving his or her services. Generally, the contingent worker fits into one of three classifications: the independent contractor, the leased employee, or the temporary employee.

An independent contractor is a business person hired for a specific project to achieve a specific result. Generally, the person is in business for himself or herself rather than an employee of the hiring company, and is working to achieve a profit, not a wage. Independent contractors are usually not eligible for unemployment, workers' compensation or employer sponsored benefits. Likewise, the employer is not responsible for paying any federal or state imposed payroll taxes on behalf of an independent contractor. Significantly, individuals who meet the true definition of an independent contractor are not considered employees of the company receiving their services for any purpose, including anti-discrimination laws and laws governing payment of employee benefits.

Unlike the independent contractor, leased employees are individuals employed by a "leasing company" which rents the employees to a second employer. The leasing company interviews, hires, trains and directs each employee to a specific job assignment with a second employer who has requested an employee with specific skills. The second employer pays a fee to the leasing company for use of the employee. The fee is typically arrived at by examining the total payroll costs incurred by the leasing company, plus a fixed percentage profit. The leasing company is then responsible for paying the employee, including bearing the burden of payroll taxes. When the second employer no longer has a need for the leased employee, the employee reports back to the leasing company for reassignment. In the leased employee scenario, the employee is considered an employee of the leasing company, yet the leasing company and the second employer can frequently be considered to be "joint employers" for many purposes, including liability under state and federal non-discrimination statutes.

The temporary worker, most often referred to as the "temp", has a relationship to the second employer similar to that of the leased employee. The major difference between the leased employee and the temp is that while the leased employee may be employed by the second employer for what is often career length duration, most temps are hired with an expectation that they will be assigned to the second employer for a limited duration assignment. The temp is most often employed to supplement the second employer's work force in situations such as employee absences, temporary skill shortages, seasonal workloads, and special assignments and projects.

Of these three categories of workers, it is the independent contractor relationship which creates the most difficulty for employers. However, the use of leased and temporary employees also pose problems which employers may not consider when entering into such employment relationships.

The use of independent contractors in the United States has increased steadily over the past decade. Many reasons exist for the increase, including a desire among employees to be free of the permanence of the employer-employee relationship, and the attractiveness of being one's own boss. However, employers are still the driving force behind the increasing use of independent contractors. The reasons are straightforward. Independent contractors offer a number of advantages for an employer. These advantages include: increased flexibility in staffing permitted by avoiding the creation of a permanent employment relationship; decreased costs realized through eliminating eligibility for participation in employee benefit programs, such as pensions, insurance, and profit sharing; additional decreased costs realized by avoiding the need to pay payroll employment taxes such as social security, unemployment, and workers' compensation; elimination of administrative expenses associated with implementing the various payroll deductions which are necessary for regular employees; allowing employers greater flexibility in staffing and reduced overall overhead; elimination of the need to pay overtime compensation to employees; elimination of the threat of union organization as well as problems encountered by employers facing a unionized workforce. The employer is also significantly protected from lawsuits for wrongful discharge and discrimination in employment. These laws protect "employees," and as such, an independent contractor who lacks an employment relationship generally cannot invoke the protection afforded by such laws.

On the other hand, there are substantial risks associated with employing independent contractors, as the Microsoft case painfully illustrates. These risks flow almost exclusively from the potential liability of an employer who has improperly hired workers as independent contractors, and it is subsequently discovered that the workers do not qualify for independent contractor status, and are instead regular employees of the company. In such situations, the employer will be responsible for both the employer and employee share of payroll taxes, as well as any penalties and interest imposed for failure to pay such taxes in the past. The employer may also be exposed to workers' compensation claims by a misclassified employee for which the employer's insurance carrier may deny coverage. Moreover, as was the case with Microsoft this year, liability may be imposed on the employer for past benefit payments under the employer's employee benefit plans. Last, a shift in status from independent contractor to employee permits the employee to invoke the protections of various statutes designed to protect employees, such as anti-discrimination statutes and federal laws governing the wages and hours of work of employees. As such, an employer may find itself defending claims by its misclassified independent contractors for past discrimination or failure of the employer to pay overtime compensation for past hours worked.

Because misclassification has expensive consequences, it is critical that companies determine whether their independent contractor relationships can withstand scrutiny. Determining which workers may legitimately be called independent contractors is made on a case by case basis, and is not affected by either the employer or the employee's understanding of the employment relationship. Indeed, the determination is extremely fact specific. Often, the same type of job, or two employees within the same job classification, can be characterized in different ways based on minor factual variances in the employment relationship. While different employment related laws mandate varying tests to be applied by courts when determining the existence of an independent contractor relationship, most frequently, the determining factor in these various analyses is the "right to control" -- who has the right to control the worker as to how work is accomplished? The "right to control" is a difficult concept. Often, an employer will control certain aspects of a job, while the worker controls others. Therefore, courts have been unable to assign a precise definition to the "right to control." The following factors are instructive on this issue, and indeed are the very factors considered by the Internal Revenue Service for determining the existence of independent contractor status:

1. Instructions: Does the employer give instruction on when, where and how the work is to be done, or does the employer merely direct the result to be achieved? If the former is true, then the worker is most likely an employee rather than an independent contractor.
2. Training: Does the worker have to be trained, or does he or she provide an already built in level of competence?
3. Integration: Are the workers' services integral to the employer's normal operations or called for only sporadically? Those services integral to the employer's normal operations are generally deemed employees.
4. Hiring, supervision and compensation of assistants: Does the employer or the worker select, direct and pay any individuals who assist the worker in achieving his or her results? If the employer does so, the worker is most likely an employee.
5. Method of compensation: Is the worker paid by the hour/week versus a price for a project or set of results?
6. Benefits: Who pays payroll taxes/insurance for the worker and his or her assistants?
7. Duration of relationship: Does the worker perform for the employer in an ongoing open-ended fashion or on a one-shot/sporadic basis?
8. Exclusivity of relationship: Does the worker perform services for one or more employers at any given time?
9. Control of hours, location and particulars of work: Does the employer or the worker set hours, places and order and sequencing of the work?
10. Oral or written reports: Is the worker required to report his or her progress to the employer? If so, then the employer is exercising greater supervision over the worker. Such supervision is indicative of employee status.
11. Investment: Does the worker have a significant investment in facilities/equipment used in the performance of the work?
12. Furnishing of tools/materials: Does the employer or the worker provide necessary tools, equipment and materials for the performance of the work?
13. Profits vs. wages: Does the worker have the opportunity to earn profit as a result of management skills, or is the compensation more like a set wage?
14. Discharge/Termination: Can the worker be dismissed at any time for any reason, or must there be some breach/failure to perform the work? The easier it is to dismiss a worker, the less likely she is to be held an independent contractor.

Obviously, not every factor is present in every employment relationship. The degree of importance to be given to each factor, therefore, depends upon the occupation being considered and the factual context in which the services of the worker are being performed. Nonetheless, an employer must be familiar with these various factors before entering into a relationship with an independent contractor.

In order to insulate itself from entering into a relationship which could be reclassified by the IRS or the courts to the employer's detriment, the employer should structure its independent contractor relationships with the above factors in mind, and must be prepared to relinquish the degree of control it normally exercises over its employees in return for the various benefits that a proper relationship can provide to the employer. The employer should draft a written agreement between itself and the contractor which expressly sets forth the added independence which is being given to the worker. The agreement should also state that the worker is receiving an enhanced compensation package in consideration for his or her ineligibility for employer sponsored benefit plans. Such an agreement is not binding on a court faced with making a determination as to the worker's status. However, such agreements may be persuasive as to the parties intentions, and can demonstrate that it was the parties' intent to vest the worker with a great degree of control over his or her own work. In that sense, a solid agreement may provide protection for the relationship.

Because misclassification of a worker can have such grave consequences, a business hiring such persons should maintain a file for each independent contractor it deals with, which includes the following: a copy of the independent contractor's certificate of incorporation or articles of incorporation, its by-laws, or at the very least its federal tax identification number; any invoices from the independent contractor to the company; records of repairs performed by the independent contractor in connection with his or her own work; business forms such as business cards, letterhead, and invoices showing the name, address, and telephone number of the contractor's business; copies of any telephone listings and advertisements for the contractor's business; photographs of equipment displaying the name of the contractor's business; copies of the Schedule C from the contractor's federal income tax returns; copies of anything reflecting services performed by the contractor for other businesses; and a copy of the written agreement establishing the relationship between the company and the contractor. Information of this sort tends to demonstrate the independence of the contractor, and can be persuasive as to his or her status if the relationship is challenged.

Additionally, employers should use caution when contracting for services which the employer also hires regular employees to perform. Evidence that the service has historically been performed by a regular employee may defeat the argument that the contracted employee is a true independent contractor. Last, employers should examine their employee benefit programs to ensure that the programs unambiguously identify those individuals who are eligible for the benefit, as well as those individuals who are not eligible for the benefit. Doing so may insulate an employer from retroactive benefit payments on behalf of independent contractors who are reclassified as employees.

The use of leased employees and temps raises fewer concerns than those outlined above in conjunction with the independent contractor relationship. This is true because there is generally no question as to the identity of the "true" employer of such workers. These employees are clearly employed by the leasing company or the temporary help service. Because these workers are employed through and paid by another entity, it is difficult to classify the worker as a full fledged employee of the second employer, and tax issues regarding payroll withholding will rarely arise.

There are several benefits associated with the use of leased employees and temps which account for the incredible increase in the use of such staffing over the past several years. Leased employees and temps can meet temporary staffing needs that arise due to employee vacations or temporary fluctuations in work, without the added burden of paperwork and accounting requirements involved in "employment." Further, because the employer is using the employee for only a limited purpose or for a limited time, leased employees and temps are an attractive alternative. Using such employees eliminates the need to spend the time and money typically associated with training, hiring and firing of permanent employees. Further, leased and temporary employees can provide many of the same benefits listed above for the use of independent contractors, such as lower payroll administration costs, lower benefits costs, and the opportunity to obtain cheap, specialized expertise in a particular area.

The primary risk associated with leased and temporary employees is the chance that the second employer may be considered the ultimate "employer" of the worker under various state and federal laws, including tax laws, workers' compensation requirements and, in particular, employment anti-discrimination statutes. A court or a state or federal agency may determine that a leasing company is merely a sham operation that is, in fact, simply another part of the contracting company. Further, the leasing company or the temporary help service as the case may be, and the contracting employer may acquire "joint employer" status, subjecting both entities to many legal requirements.

The contracting employer exercises a great degree of control over the leased or temporary employee on a day-to-day basis, often supervising the employee, controlling the employee's working conditions, and determining the employee's duties. As such, the contracting employer will often be responsible for any unlawful employment discrimination under most federal and state civil rights laws. Such considerations may interfere with the contracting employer's ability to ask the leasing company or temporary help service to remove or replace an employee that holds a protected status under such anti-discrimination laws for fear that such a request will result in a lawsuit against the contracting employer by the terminated employee. Nevertheless, such considerations will exist in the classical employer-employee relationship in any event, and therefore, should not outweigh the various benefits associated with the use of the leased or temporary employee.

Employers contemplating the use of leased or temporary employees should select a leasing company or temporary help service carefully. The employer should seek recommendations from other employers in similar industries to find qualified contingent worker providers which can meet the needs of the employer's particular industry. Further, the employer should review the hiring and training procedures of the leasing company or temporary service and be certain that the company or service is hiring employees with the appropriate skills that can best meet the employer's needs. An employer should also scrutinize its agreements with a leasing company or a temporary help service to ensure that the entity is assuming the appropriate payroll responsibilities and is complying with appropriate laws.

While it is beneficial to employ contingent workers in certain circumstances, an employer must be aware of the potential problems which can arise during the relationship. Because these relationships do not insulate the employer from liability in many situations, it is important to identify whether there is a need in the organization for contingent workers, and to limit their use to those positions where the employer can foresee a clear and substantial benefit from their use. Finally, it is advised that a company consult with an attorney versed in the various issues attendant to contingent employees prior to entering into any contingent worker relationship. Good advice and properly drafted agreements can reduce the potential for expensive penalties and costly litigation in the future.

First published in October 1997