Like many startups in the New York City, online fitness community BuiltLean relies on a collection of contractors to tackle projects from video production to Web development. “I think they enjoy the flexibility of freelancing,” said founder and Chief Executive Marc Perry, who turns to sites like oDesk for the talent he needs to keep his traffic at 1.2 million page views a month.
Someday, the former hedge-fund investment analyst hopes to “scale” the company enough to rely on regular, full-time employees. Meanwhile, Mr. Perry finds that working with freelancers brings savings, such as lower office-space costs.
There's no doubt it's cheaper and easier in some ways to employ a “contingent” workforce made up of freelancers, contractors and temps. The trend picked up during the recession, when hiring budgets were tight.
But for employers who don't handle the paperwork carefully, there are big risks. Officials at the state Department of Labor and other agencies have been cracking down more frequently on misclassification. That is when companies treat workers whom officials say should technically be employees as contractors — or don't pay them on the books at all.
“At the state and federal levels, there has been increased enforcement with respect to misclassification of employees as independent contractors,” said attorney David Fisher, a member of the labor and employment group at Davis & Gilbert in Manhattan.
Mr. Perry consults with legal counsel regularly about how to handle the hiring paperwork and work assignments for his contractors. When new freelancers join his 12- to 15-person crew, he asks them to sign an independent-contractor agreement to make sure they understand their role. But he may be unusual.
In 2013 alone, the state's Joint Enforcement Task Force on Employee Misclassification — made up of the Department of Labor and a posse of other government agencies — identified nearly 24,000 instances of employee misclassification by employers statewide, an increase over 2012, according to its recently released annual report.
The task force said it discovered $333.4 million in unreported wages and assessed nearly $12.2 million in unemployment insurance contributions. The cost for employers found to be violating the rules — and required to pay back wages and unpaid unemployment insurance contributions — can be hefty.
“Depending on how many freelancers or independent contractors they have used, the penalties assessed can get rather large and be prohibitively expensive for smaller employers,” said Mr. Fisher.
Mr. Fisher's firm is negotiating to reduce a $50,000 penalty assessed by the state Workers' Compensation Board for an international business that recently started up in the U.S. After one former worker's unemployment claim triggered an investigation, the state decided that the company should have classified that individual and about four others as employees, not contractors, over eight months of work.
Some misclassification cases are being prosecuted for fraud. The state Department of Labor completed more than 2,200 fraud investigations in 2013, reporting that it had discovered $271.2 million in unreported wages by employers and nearly $10 million in unemployment insurance contributions due.
The stepped-up enforcement comes at a time when federal and state governments are hungry for tax revenue. The task force's report pointed out that the state's Unemployment Insurance Trust Fund had a deficit of about $3.26 billion, because of high unemployment.
“Some state and state-agency budgets may still be in the red,” said attorney Christopher Parlo, a partner in the employment practice at Morgan Lewis in Manhattan. “One way of bringing in additional revenue to unemployment and workers' compensation is to crack down on what's perceived to be independent contractor misclassification.”
It isn't just the state Department of Labor that's pursuing employers who misclassify, according to Mr. Parlo. “It's a combination of the tax authorities, the wage-and-hour folks at federal and state departments of labor, and the officials with unemployment insurance and workers' compensation,” Mr. Parlo said.
Growing startups at risk
The task force's report said that its effort to halt misclassification protects law-abiding companies from unfair competition by companies that aren't paying taxes and safeguards the rights of misclassified workers, who lose protections traditional employees have in areas such as workplace safety.
Some companies deliberately misclassify low-skilled workers to skirt paying taxes, benefits and overtime, according to Christopher M. McNerney, an attorney at Outten & Golden.
Mr. McNerney is currently involved in a case in which he is seeking overtime pay and other remedies for a group of low-wage, delivery drivers in the city who, he says, typically worked six or seven days a week for 12 to 14 hours a day wearing an employer's uniform, but were deemed contractors by the company. “The people we're seeing are offered take-it-or-leave-it contracts,” he said.
Most often, however, companies make innocent mistakes when trying to interpret labor laws — often in cases where the worker has actually asked to be treated as a contractor, say experts.
“Given how complicated the tests are, there is no one thing you can do that will always be the golden bullet that will prevent any misclassification,” said Mr. Fisher. For instance, a freelancer who helps with a project might seem to be a contractor — but might not be considered one legally if he doesn't, for example, advertise his services on a website, have his own business card, use his own computer or show other signs of operating a business.
Mr. Parlo and others say that the Fair Labor Standards Act, which took effect in 1938, doesn't take into account the flexible and remote ways that technology allows people to work these days. Many companies care more about workers' results than having them sit in an office all day under the watchful eye of a boss. “It's completely out of touch with how today's workplace functions,” Mr. Parlo said.
Legislators are inclined to support laws that limit independent contracting, according to Mr. Parlo, because it is easier for government agencies to collect taxes from employees' paychecks than from contractors. Employers don't have to report the annual income of an individual contractor on a 1099 form if he earns less than $600 from a company in a year, for one thing. In addition, he noted, contractors can write off expenses that traditional employees can't.
Fast-growing startup companies are drawing particular attention from government officials cracking down on misclassification, says Jaime Klein, founder of Inspire Human Resources, a provider of outsourced HR services with an office in Manhattan.
“When they see a high-growth company receiving a lot of press, they will start to look a little bit deeper into that company and how it staffs its talent,” Ms. Klein said. “When they see it grew 200% in one year, they will ask, 'How did it staff up so quickly?' “
Often, what triggers an investigation is an unemployment claim by a former contractor who thinks he or she is eligible to collect, says Megan Moran, a human-resources specialist at Insperity, an HR provider with an office in Manhattan.
“This raises a red flag to the Department of Labor when it checks with the employer of record and finds out [the contractor was] not an employee,” Ms. Moran said. After asking investigative questions, labor officials may say, “This worker thought [he was] an employee.” That can trigger a full-fledged investigation into how the worker should have been classified — which may result in the employer owing wage penalties, back taxes and other employment costs.
Jeannette Boccini was taken by surprise when the state Department of Labor contacted her small public-relations firm, LVM Group—acquired in February by Didit, a digital marketing and advertising agency—with questions about a young woman who filled in for an employee on medical leave six years ago. State officials said LVM, now operating as part of the bigger company, owed several thousand dollars in back taxes and unemployment insurance contributions.
Thinking they were doing the right thing, Ms. Boccini and her business partner had paid the woman as a contractor and filed a 1099 form at year's end. “She didn't have to work 9 to 5,” said Ms. Boccini. It was only when the woman filed for unemployment after taking another job that didn't last long--and listed LVM as a former employer—that the state Labor Department came calling.
With the help of LVM's accountant, Ms. Boccini's business partner convinced officials that they had made an innocent mistake and negotiated a reduction in what they owed, but the experience left them wary.
“When you're a small business, a few thousand you don't expect to pay is a headache,” said Ms. Boccini.
Elaine Pofeldt writes for Crain's New York Business, a sister publication of Business Insurance.