Cut Costs With Independent Contractors?

Q: I recently learned that a very successful competitor -- who always seems to be undercutting my pricing -- employs very few of his staff directly. Most of his work is done by people he defines as independent contractors. (I hear that some of them used to be his employees, but he laid them off and promptly hired them back as "freelancers.") He apparently saves all the money that I pay for my staff's Social Security, unemployment insurance, worker's comp, health care and vacations, not to mention my HR administrative costs. Am I being a chump, or is he unethical?

It is not unethical for a business owner to try to reduce costs and lower prices to his customers, especially if it can be accomplished through efficiency, economies of scale and innovation. That's working smart. But fattening the bottom line at the expense of one's employees is not ethical. The most respected employers offer good benefits to full-time employees.

Maybe your competitor's workers are bona fide independent contractors. If so, in addition to his savings in taxes and benefits, he also enjoys the flexibility of reducing his labor costs without having to lay off real employees.

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But your competitor might be one of thousands of employers who are breaking federal law by misclassifying long-term, full-time employees as freelancers and independent contractors. This is the subject of heightened scrutiny by the IRS and the Department of Labor. The IRS has a multipart test for this classification, and it requires a surprisingly high degree of autonomy on the part of these workers. True independent contractors typically work for more than one client at a time, set their own hours, and don't receive training or close supervision from their clients.

In addition to the risk of government audits, employers who don't heed the accepted rules of independent contracting could be vulnerable to whistle-blowing by disgruntled workers and former employees.

Knight came to Kiplinger in 1983, after 13 years in daily newspaper journalism, the last six as Washington bureau chief of the Ottaway Newspapers division of Dow Jones. A frequent speaker before business audiences, he has appeared on NPR, CNN, Fox and CNBC, among other networks. Knight contributes to the weekly Kiplinger Letter.