Legal Considerations of Using Contractors

The deal is inked. You knew your wireless technology was killer, and you were right. Then the panic sets in. How are you and your staff going to hit those deadlines? Most employees already sleep under their desks at night (if they sleep). You need bodies, fast. Coders, testers, tech writers–the works. The problem is, you aren’t going to need them for that long–a year or two, tops–and you don’t want to add that many new regular employees. After all, big payrolls make investors nervous, and let’s face it, you were generous with those stock options and benefits because you wanted to reward the people already with you for taking a big risk when you started the company.

The solution seems obvious: independent contractors. To ensure none of the contract terms is a secret, make sure that your independent contractors’ (IC) agreement spells out everything clearly: no long-term commitments, no paid benefits or stock, just a nice hourly wage. So you’re golden, right? Um, no. Actually, you may have just gotten yourself in deep.

Just ask Microsoft, which got sued by workers and wound up paying a whopping $97 million. Or Harvard University. Or Los Angeles County, Pacific Bell, Time Warner or any number of employers who have found themselves on the receiving end of a lawsuit from workers hired as temps and ICs claiming that they were really common-law employees entitled to the same benefits as regular employees. Just how bad can it get? Here is a partial list of trouble a company encounters when it mischaracterizes its employees as independent contractors.

IRS trouble Microsoft’s woes began when the IRS audited its finances and determined that Microsoft had improperly classified workers as ICs. That meant that Microsoft owed the federal government a large sum in unpaid tax withholdings (the employer’s share), plus interest and penalties. It also meant that certain benefit plans, which received favorable tax treatment because they were open to all employees, might lose that treatment unless the ICs were retroactively added to the plan.

ERISA trouble The Employee Retirement Income Security Act (ERISA) was enacted in 1974 to protect workers from losing certain benefits. If an employer is found to have mischaracterized employees as ICs, the workers may be entitled to receive ERISA benefits retroactively. ERISA-based denial-of-benefits claims include those for health insurance benefits, 401(k) benefits and stock option benefits, among others.

Other benefits trouble The mischaracterization of workers can bring into play myriad statutes and responsibilities that you probably wanted to avoid all along, including overtime pay, unemployment insurance, workers’ compensation insurance, holiday pay, vacation pay and sick leave. An employer’s failure to pay such wages (or provide such coverage) can result in awards of multiple damages, costs and attorney’s fees. And even more frightening for employers, some states allow workers to collect damages not only against the employer but also against individual corporate officers. It happens all the time under various wage statutes and workers’ comp statutes.

Statutory trouble Certain state and federal employment statutes apply only to companies with a set number of employees. For example, employers are required to offer Family Medical Leave Act benefits only if they have 50 or more employees. A company that thought it employed fewer than 50 employees could easily find that once the presumed ICs are added to the mix, it actually employs more than that.

So what should you do? Close up shop? No, but it does call for some serious thought and risk management. Here are some ways to protect yourself.

1. Just because you call someone an independent contractor doesn’t mean he really is. The IRS and the courts typically use a 20-factor test to determine if a worker is an employee or an IC. The factors generally focus on who controls the way work is performed. For example, expecting someone at the office at a specific time looks like an employer-employee relationship. But, if workers can set their own hours and decide whether to work from home, their own office or your office, the relationship starts to look more like an IC arrangement.

2. How you pay a person makes a difference. To start, ICs should be paid 1099 wages (without regular payroll deductions) as opposed to W-2 wages. If at all possible, payment should be structured on a per-project basis as opposed to an hourly, weekly or monthly salary.

3. Review the language of your benefits plans and any documents relating to those plans, like summary plan descriptions and employee handbooks. Carefully worded documents can exclude certain classes of workers. In Microsoft’s case, however, benefit plans stated they were open to all “employees,” which the court found included common-law employees.

4. Limit the amount of time that an independent contractor can work for your company and require breaks between projects. The longer an IC works for you, the more it begins to look like employment. If you really can’t live without a particular individual, it may be time to bite the bullet and hire the person as a regular employee.

5. Use clear, well-worded IC agreements, but understand their limitations. A clearly written, comprehensive IC agreement spelling out the details of the relationship is an essential risk management tool. On its own, however, even a good contract has limits to what it can accomplish.

6. Use a placement agency, but know the limitations of these arrangements too. Using a placement agency can help eliminate some, though not all, of the dangers of employing ICs. Reputable placement agencies pay not only the withholding taxes for their employees but also unemployment insurance and workers’ compensation insurance. Your agreement with an agency should contain indemnification language that states that the agency will defend and indemnify your company against any liability for a failure to pay taxes, insurance or the like.

7. Consider the downsides of having independent contractors as well as the benefits. Although employers are often aware of the benefits of hiring ICs, they are sometimes unaware of the risks involved and as a result fail to take proper precautions. For example, in the absence of a written agreement to the contrary, it is presumed that intellectual property created by an independent contractor belongs to the contractor individually (the opposite is true for an employee).

8. Don’t get greedy. If you want to hire a worker as an IC and reap the benefits of doing so, you need to give up some of the benefits of hiring an employee. For example, including employeelike restrictions in an IC agreement (such as a noncompete clause) may well lead a court, the IRS or another government entity to conclude that you really intended to hire the person as an employee.