CEO's Notebook

Short articles on such topics as how much misclassified workers can cost you; changing your distribution strategy; and getting commitment from contractors.

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Misclassifying Workers Can Cost You, Big Time

When are freelancers really your employees?

By Ilan Mochari

Ron Bourquin isn't the first executive to find out that the contractors he'd hired were actually his employees -- at least in the eyes of the law. But three years ago, after Bourquin's company inadvertently failed to pay payroll taxes for "between 6 and 10" of its workers, he learned the hard way.

Like many high-tech companies, Cardima Inc. -- a $3.5-million maker of heart catheters based in Fremont, Calif. -- relied on freelance consultants for highly specialized tasks. The problem was that some of the company's independent contractors logged 40 hours a week, worked exclusively for Cardima, and were paid by the hour. To the state of California, those conditions meant that they were Cardima employees. Bourquin, Cardima's chief financial officer, says that the company was required to pay the state a lofty sum, somewhere "under $25,000," in a settlement.

This type of misclassification error is common, according to employment-law experts. "Often small businesses believe that simply putting a label on a worker will solve the problem," says Jeffrey Pasek, chairman of the Labor and Employment Law Department of Cozen and O'Connor, a law firm based in Philadelphia. "They think that if they say someone is a contractor and the worker agrees, then it must be so."

Once Cardima realized it had violated the law, it enlisted a consulting firm to develop a questionnaire for prescreening potential workers. Questions included the following: "Can the worker document that he is in business as an independent contractor?" and "Can the worker prove that he has other clients and pays for all work-related expenses himself?"

Grilling prospective freelancers and keeping records of those results are just two measures that all businesses that use independent contractors should take. Noreen McDermott, a lawyer at the Palo Alto, Calif., branch of law firm Baker & McKenzie, suggests that companies hire only contractors who have incorporated. "That affords you the protection of being able to say that the contractor is an employee of his own corporation," she says. Another key factor to consider, McDermott adds, is the way in which the worker is compensated. A true contractor is paid not by the hour but by the project, with specific goals, fees, and completion dates set out in a contract.

Cardima now retains part-time help through a temp agency. Yet using a temp agency doesn't automatically exempt a business from paying payroll taxes and providing benefits. Pasek recommends getting indemnity agreements from all temp firms. But McDermott warns that even having indemnity agreements won't protect companies that are proved to be skirting employee-related costs.

Both agree, though, that state and national authorities are auditing employee misclassification like never before. And as with any government audit, you are guilty whether you meant to break the law or not.

Independent Testing

If you want to comply with state and federal regulations on classifying workers, talk to an HR expert. Rules vary from state to state.

Still, there are some basic guidelines suggested by the following experts: Andrew Schultz, president of Pro Unlimited Inc., the $110-million workforce-management consultancy in Boca Raton, Fla., that solved Cardima's ailments; Noreen McDermott, a lawyer with the firm of Baker & McKenzie, in Chicago; and Jeffrey Pasek, a partner at the law firm of Cozen and O'Connor.

• Pay independent contractors by the project, not by the hour. Separate contractors from the mainstream workforce. Almost anything -- a contractor's presence on your softball team or at company meetings -- can be used to prove that the contractor is an employee.
• Bar contractors from company resources. Truly independent contractors pay their own expenses, use their own equipment, and work on their own premises.
• Screen all incoming workers. Use a lawyer-approved written test, asking questions about the contractors' independence.
• Reassess the classifications of your workforce every six months. Regulations can change, as can your relationship with a worker. --I.M.

Hot Tips

If a big, newly public competitor of yours is getting good press, don't be alarmed about some new threat. First, do a little background check before you buy an analyst's hype about a competitor. Analysts at investment banks often take a shine to companies that they've taken public. That's the finding of a new study by Cornell University's Johnson Graduate School of Management. The authors -- associate professor Roni Michaely and Ph.D. candidate Kent Womack -- tracked more than 200 "analysts' recommendations of companies that completed IPOs in 1990-1991." According to their research, companies plugged by an analyst whose firm did not underwrite the initial public offering performed 50% better than businesses recommended by an analyst at the bank that orchestrated the offering. --Mike Hofman

Like most business owners who resell equipment, Kevin Dowd knows what it's like to be short on cash. Dowd is president of Atlantic Computing Technology Corp., a $6-million, 15-employee network-security company in East Hartford, Conn. To resell hardware, he first has to buy the equipment himself, then wait 30 days for the customer to pay him. Under those conditions, some owners would keep cash in the business by not paying themselves. Dowd preserves cash by paying himself but refusing to cash the check until he knows the business can cover it. That way, the payroll bookkeeping remains clean, and the cash supply doesn't run out. --I.M.

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