What do you do when you need a qualified person quickly for a short-term project? For many the obvious answer is to hire a contingent worker or "temp" from an agency. Others may hire directly - someone they or an employee knows - on contract. The person hired is considered self-employed, no taxes are withheld, no benefits apply.

So far, so good. Smart companies make use of contingent workers to fill gaps, to complete distinct projects or to temporarily access highly specialized skills. The hourly or daily rate is often high in comparison to a regular worker in the same position but this is to compensate for a lack of tenure, security and benefits and/or you're paying additional "margins" that staffing agencies always charge on top of their temps' hourly rate. Temps and contractors offer the flexibility to staff up and down very quickly without the normal costs associated with hiring and terminating employees.

Companies get into trouble when they stray from their original intent where contractors are concerned. First, contractors should never be treated like employees. This means that you don't conduct your own background checks or performance reviews. Some would even caution against inviting contractors to company picnics, parties, etc. Most importantly, contractors and temps should be engaged for defined purposes and a limited period of time (usually less than one year).

Companies violate employment laws when they misclassify or "co-employ" contractors. Co-employment most often occurs when a worker from a staffing agency is treated like an employee. Companies often grow to depend on contractors. The scope of a project grows, the contractor stays longer than intended and begins to blend into the office environment. They attend company functions and, in some cases, are given raises and bonuses. Original contracts get extended several times and the distinction between contractor and employee is blurred. Before you know it, a "temp" has been with the company longer than most employees. If this employee is still being paid as a contractor (1099 as opposed to W-2, for IRS purposes) you're probably guilty of misclassification and exposed to penalties that could have very damaging consequences.

Misclassification occurs when an independent contractor is hired as such but is placed in an environment and works under conditions that make him or her, in effect, an employee. How do you know the difference? Is the contractor supervised? Do they work on site? Do they work full-time hours? Are you their only source of income? Do they use your equipment? Is there assignment indefinite? Do you define how the work of the contractor is done? In general, how much control do you exert over the "contractor"? These are the types of questions the IRS will consider in determining whether, based on the "preponderance of evidence", your contractor is an employee. If they decide against you, you may be liable for payment of taxes and benefits retroactively.

But it's not just the IRS you have to worry about. It is becoming more common for ex-contractors to sue previous employees for denial of benefits, stock options and other compensation based on the assertion that they were misclassified as contractors. Many readers will recall the $97 million settlement in favor of misclassified workers in the Vizcaino vs. Microsoft class action suit involving 10,000 workers last year. In this case, long-term contractors (referred to a "perma-temps" by the press) worked alongside Microsoft employees who, in some cases, became millionaires based on the value of their stock options. The contractors demanded equal benefits, retroactively.

So how can companies avoid lawsuits and IRS sanctions? First, ask yourself the questions two paragraphs above. If more than two or three describe your relationships with temps or contractors, you are on tenuous ground. If you're working through a staffing agency, your risks are reduced somewhat because the agency is considered the contractor's "employer of record" and it handles the tax payments. In this case, you need to be aware of the co-employment potential, which might lead to successful lawsuits from ex-temps. If you hire contractors directly (which is a great way to avoid the fees or margins that staffing agencies charge) you're exposed to greater risk. In these cases you have to be sure that the contractor is truly self-employed and not an employee in the eyes of the IRS.

One option for companies that wish to hire people on contract (which might include retired or downsized ex-employees) is to go through a service that acts as the contractor's employer of record but doesn't charge hefty agency fees. Gene Zaino, Founder and CEO of MyBizOffice offers one such service. According to Zaino, the IRS determines that contractors have been misclassified in 95% of the cases it investigates and "the effects, especially on smaller businesses, can be devastating". Zaino's service provides contractors with a range of support, but for employers, the most important aspect is piece of mind. MyBizOffice and services like it, work to limit the risk of co-employment and misclassification by acting as official W-2 employers of record for the contractor.

Whatever you do, be sure to actively distinguish between contractors and employees. If a contractor is too valuable to lose, convert him or her into an employee. The use of temps and contractors gives employers the chance to "try before they buy" and is a great way to recruit regular employees. Misclassification, on the other hand, is like the proverbial ticking time bomb.

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