When are freelancers really your employees?

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.

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