The rising cost of employees has forced many employers to run their companies with staffing as lean as possible. To cut costs while meeting production and service needs, many employers have turned to the use of a variable workforce.

A variable workforce has a variety of different definitions, but it basically refers to companies using any of the following:

• Independent contractors.

• Temporary employees.

• Professional employer organizations (PEOs) or leased employees.

Most organizations that use a variable workforce believe that using these organizations reduces their exposure to employment-related liability. In fact, the opposite can be true.

Independent Contractors

The distinction between an independent contractor and an employee is becoming narrower each year. Most organizations that use independent contractors have not properly addressed the potential governmental liability. The government agencies involved include the IRS, the Pennsylvania Bureau of Workers’ Compensation, the Pennsylvania Office of Unemployment Compensation and the Pennsylvania Department of Revenue (the taxing agency), as well as local taxing authorities. Each of these organizations would prefer an employment relationship over an independent contractor arrangement on the assumption that an employer will pay the cost of taxes on the employment relationship, but the independent contractor may not.

Many of these agencies have full-time staff devoted to auditing employers to determine if the independent contractor designation is appropriate. If it is found to be an employer-employee relationship rather than an independent contractor relationship, the employer faces billings and penalties. In fact, the Pennsylvania Construction Workplace Misclassification Act goes so far as to make it a criminal offense for a contractor to knowingly misclassify an employee as an independent contractor. The law also extends criminal liability to anyone contracting with the contractor who is aware the contractor is misclassifying workers. Though the Pennsylvania law is focused on the construction industry, other states have broader statutes that make it a crime to misclassify a worker.

In addition to state law issues, employers can be faced with significant penalties from the IRS if the IRS determines they have misclassified employees as independent contractors. If the IRS finds that the misclassification was not purposeful, but rather a mistake on the part of the employer, IRS penalties can include 1.5 percent of wages paid to the independent contractor/employee, 20 percent of the amount that should have been withheld from the employee’s wages for FICA. These penalties are, of course, in addition to back taxes that may be owed.

If the IRS determines that the misclassification was intentional, the penalties are even more severe, and the employer may not deduct the amount of tax assessed from the employee’s wages. Finally, the IRS will prosecute the owners and executives of companies that willfully misclassify workers, which can result in personal liability for the tax, interest and penalties owed.

Temporary Employees

The use of temporary employees offers employers the flexibility needed to handle the peaks and valleys of production and service. Unfortunately, most employers that use temporary-service firms rarely have actual contracts and, if they do have contracts, the contract is likely an out-of-date form contract that was not reviewed by counsel. The temporary employee that was not properly trained or lacks a facility-specific orientation presents significant liability for an employer through actions or inactions. Employers should take care to include appropriate hold-harmless and indemnity provisions in their contracts with temporary-service firms.

Many employers incorrectly assume that they have no regulatory issues as it relates to temporary employees. The employer that uses temporary employees may be subject to employment laws such as the Americans with Disabilities Act, the Family Medical Leave Act and similar laws if it is determined that they are a joint employer. Joint employment generally arises from overlapping authority over the employee. The general rule of thumb is that the more control the site employer exerts over a temporary employee, the more likely joint employment liability exists.

Another aspect of potential liability deals with safety. Who is responsible for providing safety training to temporary employees depends first on the parties’ agreement — a contractual agreement for training responsibility will be enforced. If the agreement does not define who is responsible for safety training, the Occupational Safety and Health Administration will evaluate the relationship between the employer and worker to determine who should be responsible. The primary factor is who controls the day-to-day activities of the worker. Though the temporary agency may be considered the “exposing” employer because it is the temporary agency’s employees who are exposed to safety hazards, the site employer can also be considered the “creating” or “controlling” employer because it controls the worksite and may be the entity creating safety hazards. OSHA may cite both the agency and the site employer, so each should ensure employees are properly trained.

Professional Employer Organizations

A PEO is an entity that provides employers with administrative services such as payroll, employee benefits, tax management and workers’ compensation coverage. The PEO is considered the “administrative” employer while the site employer continues to exercise control over the manner, method and means of the employee’s work.

More specifically, a PEO establishes a contractual relationship with its clients whereby the PEO manages:

• Payroll administration, including the payment of wages and employment taxes of the employee out of its own accounts.

• Tax reporting, including preparing and filing reports, collecting taxes due, and depositing employment taxes with state and federal authorities.

• The co-employment relationship by establishing and maintaining an employment relationship with the site employer’s employees, which is intended to be long-term and not temporary.

PEOs may also assume responsibility as an employer for specified purposes and generally share the responsibility of control of employee’s wages and safety.

PEOs began as something akin to a purchasing cooperative. The PEO model is based on the concept of cost consolidation, which is accomplished by consolidating large groups of employees under one entity to lower the incremental costs of employment-related costs such as benefits or workers’ compensation. Working with PEOs can present a challenge because the quality of PEOs varies widely. State agencies have been overwhelmed by the number of PEOs, which have very low start-up costs, which in turn leads to very little governmental oversight. Workers’ compensation, in particular, is a product that is highly touted by PEOs. Because of the escalating cost of workers’ compensation, many employers run to PEOs that offer savings of 20-30 percent of overall workers’ compensation costs.

Employers should use care in selecting a PEO. Because PEOs often focus their marketing on employers with high workers’ compensation costs, they often create a pool of clients based upon adverse selection. This makes the workers’ compensation carrier uneasy, which leads to higher rates and often cancellation. The PEOs then are forced to find alternative financing mechanisms including substandard carriers, larger deductibles or a variety of different funding mechanisms that can leave their clients exposed. These and other challenges make it difficult to identify a quality PEO.

How to Stay Protected

With all the potential pitfalls associated with the use of a variable workforce, there are a number of steps an organization can take to protect itself.

Step 1: Document the terms of the relationship. If it’s not in writing, it didn’t happen. It is important to have a written contract with all vendors, but particularly variable workforce employers.

Step 2: Verify classification. If you use independent contractors, make sure they are independent contractors. The most comprehensive test used to determine if an individual is an independent contractor is the IRS’s 20-part test. At a minimum, you need to make sure that you:

• Have a written contract;

• Do not assert control of the activities of the independent contractor, both in the contract and in practice; and

• Pay the contractor by the job rather than by the hour.

Step 3: Know your service provider. Look beyond the salesperson and the marketing propaganda and determine whether your provider has a good track record. You should request and review their most recent financial records. You don’t need complete disclosure of financial records; just make sure you know that the organization you are doing business with is financially stable.

Step 4: Obtain and check references. Request and check references from multiple sources including existing and former clients. Seek out references that have had a relationship with the provider for five-plus years, three-plus years and less than one year. Make sure they have stable long-term relationships with their clients.

Step 5: Know the principals. Run a business check on the principals to determine if they have a history and track record in the industry. Check to see if the principals started (and left) multiple prior companies, a warning sign that they may not be in business long-term. Check to see if there is litigation against the principals or the company. Many businesses have lawsuits filed against them, but check to see how many and/or if any governmental regulatory agency has filed an action(s) against the principal or the company.

Step 6: Know the corporate structure. The industry tends to create multiple layers of legal entities. Make sure that your contract and services are being guaranteed by all legal entities within their corporate tree.

Step 7: Verify licensing. Licensing of these service providers is done on a state-by-state basis. Verify that the provider you choose is licensed to do business in your state.

Step 8: Verify insurance. Determine what company provides workers’ compensation and verify the financial rating of that company. You should also determine how long the company has been with that particular carrier. Verify the existence of other critical insurance coverage, such as employment practices liability, professional liability (where appropriate) and automobile coverage. Insist on being a named additional insured on those policies and make sure that the carrier is required to give 30-60 days’ notice of cancellation. Remember that anyone can issue an insurance certificate, so verify coverage with the carrier directly.

Step 9: Follow the tax money. Periodically verify that your vendors are making payments on payroll-related taxes. Most jurisdictions publish a list of tax delinquencies. In addition, verify that the vendor is up to date on its unemployment compensation coverage.

Step 10: Manuscript the contract. Don’t sign a standard agreement; these agreements are written in favor of the variable workforce employer. Make sure “employee” is clearly defined. Confirm that the duties and responsibilities of each party are spelled out in the agreement. Remove any evergreen clauses. Also, though most PEO providers will require duration of at least one year, many form contracts also contain a provision that the contract is automatically renewed if not canceled within a certain time frame. Employers should also craft indemnification, attorney fees and selection of counsel clauses that fit their specific needs. •

Daniel P. O’Brien is partner in the Cleveland office of Fisher & Phillips. He specializes in risk and claims management with a specific emphasis on workers’ compensation. He can be reached at dobrien@laborlawyers.com or 440-838-8800.

James P. McLaughlin is an associate in the firm’s Philadelphia office. He represents employers in all types of employment matters, including issues related to the challenges presented by a variable workforce. He can be reached at jmclaughlin@laborlawyers.com and 610-230-2138.