In the best-case scenario for employers, we will start the new year with the recession over, the economy robustly bouncing back and companies expanding workforces through the quickest, most flexible, least costly means possible: hiring contingent workers.

Sounds wonderful in the abstract. But in reality, the term “contingent worker” raises red flags for labor and employment experts. While acknowledging the economic benefits of taking an alternate route to hiring new employees, they caution that in today’s litigious environment and with state and federal regulators looking aggressively into hiring practices, contingent workforces are a potential legal quagmire.

“You may have changed the label–from employee to contingent worker–without changing the legal reality,” says Ann Margaret Pointer, a partner at Fisher & Phillips. “You may have cut out some of your orientation expenses and training expenses, but you may still be legally responsible for those workers.”

Numerous titles fall under the umbrella term of contingent worker: flex worker, temporary worker, part-time worker and independent contractor. In a recent report, “The Emerging New Workforce: Employment and Labor Law Solutions for Contract Workers, Temporaries and Flex-Workers,” Littler Mendelson predicted that 50 percent of the workforce added in 2010 will be made up of contingent workers. “As a result, approximately 25 percent to as high as 35 percent [of the total workforce] will be made up of temporary workers, contractors or other project-based labor,” the report concluded.

The trend is already well underway. For example, in August Hyatt laid off about 100 housekeepers at three hotels in Boston and replaced them with temporary workers hired through a staffing agency. The new workers earn nearly 50 percent less per hour than the fired employees and receive no benefits. The move sparked a demonstration, calls from public officials including Gov. Deval Patrick for boycotts of the chain and nationwide media coverage.

And the potential impact of hiring contingent workers extends beyond public relations considerations. The consequences of not following proper classification procedures, state statutes or federal employment laws “can be horrific,” especially in the current class-action environment, says Garry Mathiason, a senior shareholder at Littler Mendelson.

He notes that Secretary of Labor Hilda Solis is pushing for stronger enforcement of wage-and-hour regulations, meaning “soon there will be additional investigators augmenting the plaintiffs bar. This will be like driving with 300 highway patrol officers covering every exit.”

Out-of-Sight Liability

The late economist Audrey Freedman is credited with coining the term “contingent workforce” in the 1980s to describe part-time and temporary workers who are employed only for particular projects and are not counted as full-time employees. Over the years, the question of who is liable for those workers has become a slippery issue.

“One effect, from a corporate standpoint, of having people who are off the payroll and kind of out of sight is you just forget what your contingent liabilities might be,” Pointer says.

Those liabilities center on misclassifying employees as contingent workers.

“Anti-discrimination and wage-and-hour laws generally cover only ‘employees’ and generally do not protect independent contractors,” says Michael Schmidt, a member of Cozen O’Connor. “Employers who misclassify individuals that truly should be considered employees may be liable under statutes that provide for certain wage and benefit remedies.”

States with specific statutes, the IRS or the Department of Labor could seek administrative fines or penalties for violations. An employer that misclassifies workers could be liable for millions of dollars in unpaid tax withholdings, workers’ compensation and unemployment insurance contributions, and benefits, as well as back pay if wage-and-hour laws were violated.

“Until recently, I don’t think a lot of employers were as active as they could have been in trying to track contingent workforce numbers,” Mathiason says. “It’s to their advantage to set up compliance standards so they don’t end up with a surprise.”

Classifying Conundrum

Those surprises sometimes are generated by confusion over how to classify employees. That is: Who is and who is not an independent contractor?

“Every effort in Congress to clarify and get a sharp and clean definition of ‘independent contractor’ has failed,” Mathiason says. “The reason for that is the government does not want to grow independent contractors because it’s too hard to track tax revenue.”

Meanwhile, states are stepping in with their own regulations. In May, for example, Maryland adopted the Workplace Fraud Act of 2009, which allows the state to crack down on employers who wrongly classify their employees as independent contractors or do not classify them at all.

Schmidt estimates at least a dozen states have enacted legislation similar to Maryland’s. In July, Rep. Jim McDermott, D-Wash., reintroduced federal legislation that defines the rules by which companies can classify workers as independent contractors and imposes new penalties for misclassifications.

A charge of misclassifying workers is not something any employer wants to face, as software giant Microsoft learned in 1999. The 9th Circuit ruled in Vizcaino v. Microsoft Corp. that workers whom the IRS characterized as common-law employees were entitled to participate in Microsoft’s 401(k) and stock-purchase plans. Microsoft argued that the workers had signed an agreement that they were to be treated as independent contractors, were treated differently from employees and were paid through the accounts-payable department. The court found that since Microsoft had misclassified the workers, the contractual agreements were no longer applicable.

Staffing Solutions

Mathiason notes that to avoid legal complications, many companies are appointing contingent workforce managers with responsibility for those workers. “They also often set up an outside audit procedure to do background checks, look at the pay arrangements to make sure taxes are being properly treated and that some of the basic tests for being a contingent worker get met,” he adds (see “Taking Control”).

Perhaps the best approach for employers, experts say, is to contract with a contingent provider–a staffing or payroll company–that is responsible
for everything from hiring temporary workers for a specific project to evaluating their performance to tracking taxes.

“Most companies try to keep the relationship with contingent workers at arm’s length,” Pointer says. “If the worker is on the Ajax Temp Services payroll, for example, let Ajax be the employer.”

But Pointer adds: “Just changing who the paycheck writer is doesn’t necessarily change who the legal employer is.”