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Contractors vs. Employees: The Benefits and Risks of Hiring Outsourced Workers

Insight Thomas M. White Thomas M. White · January 20, 2015

This article, co-authored by Thomas M. White and Mark Rosenman, was originally published by Chief Executive. It can be viewed at the original source here.

Alternatives to direct employment are flourishing, as businesses have come to believe they should keep in house only “core” functions and outsource other activities like IT and HR to specialized service providers. This “employee light” model shifts labor costs from fixed to variable, enhancing a business’s flexibility to adapt to market changes.

At the same time, a new kind of organization, the Professional Employer Organization (PEO), provides “leased” employees that function day-to-day like employees but are on the books of the PEO. Businesses are engaging independent contractors to perform specific functions. They should realize, however, that there are risks and hidden costs—both strategic and legal—in the “employee light” model.

Major, sophisticated businesses, such as Microsoft and FedEx, have been determined by courts to have mischaracterized a significant portion of their workforces, leading to legal and public relations troubles. Decision makers need to consider the following.

  1. Build your HR base first. A successful business requires an engaged workforce and a vibrant culture. It’s hard to do that with a talent base consisting almost entirely of contractors and leased employees. You need a base of employees who see the possibility of a long-term future with the business and a single-minded devotion to their work.

  2. Consider the risks of outsourcing. Outsourcing major activities like IT requires that management understand its activities well enough to specify them in a contract and monitor service delivery—and address changes in requirements that arise after the contract is signed. A well known professional services firm that outsourced its recruiting had to bring it back in-house after it struggled to communicate to service providers the nuances of its human resource needs.

  3. Decide whether to go with independent contractors or employees. Decision makers who think they want to go the “employee light” route need to consider that employee outsourcing may give rise to complex issues under tax and benefit laws. If workers are misclassified as independent contractors rather than employees, the business may be responsible for tax withholding, FICA, FUTA, state unemployment taxes and worker compensation contributions.

  4. Discuss benefit issues with leased employees. All businesses under common control must be aggregated to determine whether benefit plans discriminate against employees. Businesses considering leasing employees that have plans should consult tax and benefits counsel.

  5. Understand laws that govern the contract. Local laws can render terms of an outsourcing contract inoperative or make it hard for the recipient to protect its rights. Litigating a dispute in a foreign forum is difficult and you may not be able to collect a judgment. The recipient needs to control the location where work is performed.

  6. Measure geopolitical risk. Negotiate terms that will permit you to terminate the relationship on short notice in case of disrupted communications or bad working conditions due to political instability. After the terror attack in Mumbai, India in 2008, a number of companies announced they would diversify the countries to which they outsource IT development, adopting a policy of “India plus one.”

  7. Know that there are no intellectual property guarantees. Local regulations governing ownership of intellectual property may provide less protection to service recipients than U.S. law. Several years ago it was estimated that American firms lost nearly $48 billion due to Chinese violations of U.S. intellectual property. This may be a significant risk for certain businesses.

Businesses today can have the best of both worlds: develop a core of talented, dedicated permanent employees, while using outsourcing and “variable cost” workers to achieve cost savings and flexibility. Smart companies will see the advantages of steering a middle course between a traditional organization and the “employee light” model.

Mark Rosenman is Chief Knowledge Officer of Newport Board Group, a national professional services firm of CEO’s and senior executives.

Thomas M. White is a partner with Rimon, a national law firm. He is based in Chicago and specializes in benefits law.