The Traditional Temp Agency Model

The traditional model is designed after the classic temporary employment agency. Employers routinely hire temps to perform general clerical work, take inventory, do seasonal work, or fill in when various office staff are ill or on vacation, so most people are quite familiar with the concept of temporary employment and the temporary employment agency.

What distinguishes the contract employee from other temps is this: Contract employees provide specific, advanced, technical and professional skills. Contract employees are paid more than regular temps and they tend to have longer assignments. However, in every other respect contract employees are just like regular temps, and traditional contract employment agencies operate just like regular temporary employment agencies.

Getting the Job Order. Recruiters call potential client companies to present the qualifications of individual candidates. They try to reach individual hiring authorities such as project leaders, managers, and directors. Experienced recruiters avoid calling the HR department because HR personnel have an inherent dislike for outside recruiters. The recruiter uses the candidate as bait to entice the hiring authority into giving the recruiter a job order or specific search assignment. Thus, even if the company does not need the particular candidate, the recruiter may still receive a valuable job order. When the recruiter receives a job order, he or she confirms the required skills, the duration of the assignment, and the bill rate, and quickly negotiates key elements of a contract between the agency and the client.

If the agency has previously worked with the client, there is probably an approved agency contract already on file with the client.

Getting the Talent. Contractors solicit help in locating assignments by submitting resumes directly to contract employment agencies. Unsolicited resumes are often broadcast in mass mailings, or sent individually in response to a classified ad or Internet job posting. Job seekers also submit their resume to on-line resume banks, news groups and mailing lists. Recruiters may also call potential candidates who were referred to them by other contractors. From these sources the agency assembles a database of candidates.

Making the Match. Armed with a specific search assignment, the recruiter searches the resume database for candidates who match the job order's search criteria. The recruiter then calls the best matches to see if they are available for an interview. The joint process of obtaining job orders and recruiting qualified candidates is time consuming and expensive, and contributes significantly to the agency's administrative overhead. Recruiting costs typically amount to 20% or more of the hourly bill rate charged to client companies.

The High Cost of Recruiting. Traditional agencies control their overhead by placing recruiters on a commission-based compensation plan. In this way recruiters are rewarded in direct relation to their productivity and in relation to the gross profits they generate for the agency. Like most businesses in America, contract employment agencies operate in a free market economy where one succeeds by keeping revenues high and costs low. Consequently, in any given situation, a traditional agency is likely to bill clients as much as the market will bear, and pay contract employees as little as they will accept.

Every agency has a different formula for calculating the recruiter's commission. More aggressive commission schedules are based on the spread between the amount billed to the client and the amount paid to the contract employee. When this is the case, there is a strong incentive for the recruiter to increase the spread by billing the client more than, and paying the contractor less than, the contractor's skills and experience warrant.

Whereas most high-volume regular temp agencies operate with a fixed fee schedule, traditional contract employment agencies leverage their fee schedule to produce the maximum possible profit for a given placement. Consequently, bill rates and pay rates may bear little relation to the contractor's skill and experience, relating instead to the client's gullibility or indifference and the contractor's ignorance or lack of initiative.

Bona Fide Employees with a Difference. In the traditional model the contractor is a bona fide employee of the agency. The agency is required to pay the employee on payday, usually several weeks before the client gets around to paying the agency. And, like every other employer, the agency is required to withhold State and Federal Income Taxes, Unemployment Taxes, Social Security Taxes and Medicare. Additionally, the agency pays out-of-pocket an amount equal to 10% or more of the pay rate to cover Workers Compensation, State Disability (in some states), Social Security, Medicare and Unemployment taxes. The agency must also assume the financial risks associated with slow pay or no pay by deadbeat clients. Bad debt is a significant risk factor contributing to the cost of operating a contract employment agency.

At the end of the year, the agency issues a W-2 form to the contract employee. The W-2 form reports the total compensation for the year, and itemizes withholdings for each tax category. Thus, contract workers who operate through a contract employment agency are properly referred to as W-2 contract employees.

The agency is ultimately responsible for specifying the working conditions of the contract employee, but in reality this usually means that the contract employee must do whatever the client asks them to do within the broad limits of a loosely written job description. The contract employee is paid by the hour at a rate set by the agency.

The client may decide at any time, without warning or due process, and for any reason at all (including reasons that would otherwise violate legal protections against discrimination) that they no longer want the services of a given contractor. The client simply notifies the agency, and the agency terminates the contractor "at will". Generally, a terminated contract employee has no recourse but to look for another assignment.

The Bottom Line. Traditional contract employment agencies find it difficult to operate profitably on less than a 35% cut of the bill rate. An out-of-pocket payroll burn of 10% plus a recruiting overhead of at least 20% leaves little left over to cover administrative overhead, risk of bad debt, owner's profit and franchise fees. For this reason, agency cuts of 45% are common, and some traditional agencies with especially aggressive commissioned recruiters will take 65% of the bill rate or more!

Too be sure, small one-man recruiting firms can afford to charge less than a 35% margin, but the incentive is always present to charge more.

The Small Niche Specialist Model

Knowledgeable Professionals. Niche specialists are often veteran contractors themselves with special insight into their clients' needs. They know how to evaluate a contractor's skills, and how to market those skills appropriately. Their professionalism leads to repeat business and enhanced loyalty by appreciative clients and contractors alike. Word of mouth is the niche specialist's best marketing tool.

You are likely to see the niche specialist at local chapter meetings of their professional association where they enjoy a special rapport with the members. They are also more likely to visit their clients and contractors on site. It's this personal approach that sets the niche specialist apart from the "anything that fogs a mirror" approach so often practiced by the keyword counters in more traditional agencies.

Because niche specialists tend to operate out of trust and respect, they are also more likely to freely and openly discuss their fee structure with clients and candidates.

Making the Match. Niche specialists carefully pre-qualify the candidates they are willing to work with. The more progressive agencies give qualified candidates access to a password-protected list of open assignments, and notify them by e-mail of new openings as they occur. Candidates then notify the agency of their interest, and the agency submits the best matches to the client for consideration.

The Bottom Line. By automating the job matching process, by specializing within a narrow set of skills, and by carefully selecting both clients and candidates, niche specialists are able to charge the lowest rates in the industry among full service agencies. Expect a good, ethical niche specialist to take around 30% of the bill rate to represent a W-2 contract employee.

Ethical niche specialists give W-2 contract employees more control over their contract assignments as well as a higher rate of pay, and they allow the contract worker to move even further from the traditional model toward independence and self-reliance.

Niche specialists are necessarily locked into a small agency format. For example, if they try to expand or franchise their business, they run the risk of losing their special relationship with clients and contractors. Also, by bringing on commissioned recruiters and additional marketing staff they lose their competitive advantage based on paying good contractors what they are worth and billing clients fairly.

The Pass Through Model

With the pass through model the recruiting function is eliminated entirely. Pass through agencies operate as simple employers of record in situations where the client has a policy against direct contracts with independent contractors. Because there are virtually no overhead costs associated with recruiting and job matching, rates charged by pass through agencies are very low.

The Contractor Takes Control. Contractors who locate assignments on their own earn the privilege of shopping around for a pass through agency that will give them the best deal. Here the agency truly works for the contractor and not the other way around. The pass through agency negotiates a standard contract with the client. It still performs all the functions of billing and payroll, still withholds all applicable payroll taxes, and still issues a W-2 form at the end of the year, but that's about all it does. The contractor has assumed virtually complete control over the hiring process, and has moved as far from the traditional model as possible while still operating as a bona fide W-2 contract employee.

Some pass through agencies will work with the contract employee on a 1099 basis. Essentially, the contractor becomes an independent subcontractor of the pass through agency. The agency withholds no taxes from the subcontractor's pay check, and issues a standard 1099 form at the end of the year instead of the customary W-2. In such cases, the subcontractor assumes full responsibility for paying quarterly estimated income taxes, plus both the employee's and the employer's share of Social Security taxes (because the subcontractor is self-employed).

Short of actually negotiating a direct contract between the contractor and the client, 1099 subcontracting is about as far toward independence that a contractor can move along the continuum of contracting.

As an independent subcontractor of the pass through agency the contract worker is paid when and if the client pays the pass through agency. By passing the risk of bad debt through to the subcontractor, pass through agencies reduce their administrative overhead to the lowest possible levels.

The Bottom Line. When pass through agencies represent W-2 contract employees, they typically charge about 20% of the bill rate. When they represent 1099 subcontractors, they usually charge their subcontractors a flat $4 to $6/hour to process billing and payroll, and to provide a contractual third-party presence to the client company.

The Consulting Firm Model

Consulting firms include giant corporations, specialty job shops, and solo independent contractors. Consulting firms are NOT contract employment agencies. They are vendors who consult. A large consulting firm might assign an entire team of workers to carry out a complex temporary project. A smaller job shop, on the other hand, will usually assign only one or two individuals to accomplish a relatively straightforward task. A solo independent contractor might engage the services of a subcontractor from time to time to assist in the completion of a project. But the employees and subcontractors of a consulting firm are not "leased" to the client as individuals in the sense that contract employees are. In other words, there is no third-party relationship between the client, the consulting firm, and the individual workers.

Salaried, Full-time, Permanent Employees. Employees of consulting firms are usually salaried, full-time, permanent employees who receive the same kinds of benefits received by permanent employees of other firms of similar size. When a project is completed, employees assigned to that project are reassigned to another project. The new project may be in the home office, or in another client's premises in another city. The salaried employee is assured of continued employment, but may have little say as to where that will be.

It bears repeating: Consulting firms and job shops are NOT contract employment agencies. They are, in fact, an extension of the independent contractor whose solo consulting business expands to include additional staff. Consulting firm employees are integral members of the vendor's staff.

In the early stages, the principle consultant hires 1099 subcontractors "as needed". Later, as the workload expands, the consultant hires permanent, salaried, benefited, W-2 employees. Because the modus operandi of the consulting firm resembles that of independent contractors and W-2 contract employees, the consulting firm's employees are frequently referred to as "contractors". But, make no mistake about it; they are permanent, salaried, fully benefited employees, NOT temporary, hourly, contract employees leased under separate contract to the client.

The Association Model

The association model is primarily for independent contractors who negotiate directly with client companies. The model is especially suited for road warriors, those contractors who travel far and wide for a good assignment. I include the association model in this overview, because the model also accommodates W-2 status when the client requires third-party representation.

A Computer Matching Service. The association model is a computer matching service for clients and contractors, operating literally on a global scale. In its simplest form, the association model operates as a newsgroup or e-mail service that lists resumes and job openings. For example, an industry association may sponsor the service as a benefit to its members. Association members pay nothing to post their resumes and access job listings. Clients and recruiters, on the other hand, almost always pay a fee to post jobs and access resume files.

The model has many variations. Some are highly successful commercial enterprises servicing the outside recruiting industry exclusively. Others operate as a completely free public service. All would be impossible without the Internet.

In its most sophisticated form, the association model is a fully automated keyword matching service that compares each client's requirements against a database of available contractors. The system automatically notifies individual contractors when a match is detected. The contractor then contacts the client directly and, if all goes well, the two conduct an interview.

The service may have no further involvement once a match is made. But some services extract a finder's fee from the client in the case of direct contracts, or a modest surcharge to the pay rate in the case of third-party contracts.

Caveat Emptor. Newsgroups, e-mail lists and automated matching systems help contractors, clients and outside recruiters make contact. They facilitate interaction on a global scale. They are the grease that lubricates the machinery. They are also cold, mechanical and impersonal. Properly used, the association model leverages your ability to take control of your contracting career, and move farther and farther toward independence. Used indiscriminately, the model may deliver you into the enfeebling arms of a greedy commissioned recruiter.

The Profit Center Model

Setting the Context. The profit center model arose in response to Section 1706 of the Tax Reform Act of 1986. Section 1706 singled out technical contractors working through a third-party employer of record, and excluded them from statutory protection previously granted to all independent contractors under safe harbor provisions enacted earlier in Section 530 of the Revenue Act of 1978. This exception, known as subsection 530(d), makes it easier for the IRS to reclassify as employees of the client independent contractors who provide technical services through a third party. While this does not make it illegal for third-party agencies to supply independent contractors to businesses, it certainly creates a strong incentive for businesses to avoid 1099 subcontractors in favor of W-2 leased employees.

The public rationale for this move is that it makes sure that technology workers pay their taxes, since all employers are required to withhold applicable payroll taxes from their employees' regular paychecks. The hidden rationale is that subsection 530(d) provides greater demand and higher revenues for members of the powerful staffing industry which pushed subsection 530(d) through congress with virtually no public discussion or debate.

Almost overnight, thousands of independent contractors found it necessary to convert from 1099 status to W-2 status as clients grew increasingly fearful of IRS audits that might reclassify contractors as employees of the client.

This one small amendment to the Revenue Act of 1978 was the spark that ignited the explosion of contract employment agencies in the late 1980s, and made possible the tidal wave of downsizing and organizational change that has revolutionized the structure of American labor.

The Best of Both Worlds. The profit center model addresses the issue of disenfranchised independent contractors. It gives independent-minded technical contractors almost all the advantages of 1099 subcontracting, but does so within the secure framework of W-2 contract employment. In essence, the profit center model offers the best of both worlds. Here's how the model works.

Profit center firms have no recruiters, and in this regard they are similar to pass through agencies. Contractors locate assignments on their own, using their own resources, and the profit center firm negotiates a pro forma contract between the firm and the client. Once on the job, the contractor periodically faxes completed time sheets to the firm which handles client billing, collections and payroll.

Director of One's Own Division. What makes this model stand apart from other pass through agencies is the profit center concept. All revenues and expenses are assigned to the contractor's own division which operates as a separate profit center of the parent company. The contractor is the division's director and sole employee. Revenues to the profit center are gross receipts from the client. Expenses arise from four sources: 1) wages, 2) payroll taxes, 3) benefits and 4) miscellaneous business expenses.

Wages. The contractor is paid from the net profits of the business unit, usually at a base rate equaling 30% to 50% of the gross billings. This allows a cash reserve to accumulate in the profit center, and provides a buffer against slow payment by the client and downtime between assignments. Additional wages and bonuses are paid from surplus net profits as specified by the contractor.

Payroll Taxes. In other types of third-party employer's of record, the agency pays the employer's share of FICA, FUTA, and workers compensation premiums out of pocket. The agency then covers these expenses by rolling the costs into the agency's fee. In the profit center model, these expenses are charged against the profit center.

Benefits. Profit center firms offer the standard benefits such as health, dental, vision, and life insurance. The premiums are charged as expenses against the profit center, and thus qualify as employer-paid benefits with correspondingly lower premiums.

Profit center firms also allow hefty contributions toward retirement. One firm offers a money purchase pension plan immediately upon employment with a maximum limit of $15,000 per year. After six months the contractor becomes eligible for a 401(k) plan with an annual limit of $16,000. The two plans combined allow the contractor to set aside up to $31,000 in tax deferred retirement savings each year.

Miscellaneous Business Expenses. It's a fact, traditional contract employment agencies do not issue expense accounts. Consequently, contract employees have no way to recoup expenses such as travel, lodging, conference fees, office supplies, computer hardware and software, phone calls, data lines, society memberships, training and tuition, subscriptions, books and manuals, and a host of other out of pocket expenses relating to work. Independent contractors may claim these expenses on Schedule C when they file their income taxes. But Schedule C is available only to self-employed sole proprietors, and not to W-2 employees.

The profit center model changes all that. Contractors report their expenses each month to an administrator in the profit center firm. Allowable expenses are charged against the profit center, and an expense check is issued to the contractor. Since expenses are charged against the profit center, the contractor avoids any red flags that might arise from claiming business expenses on state and federal income tax returns. Consequently, the contractor's personal tax preparation is no more complicated than for any other employee with a generous corporate expense account.

The Bottom Line. Profit center firms charge a very modest administration fee, usually in the neighborhood of 4% to 5% of gross billings. These fees are so low that many committed independent contractors are adopting the model as a viable alternative to self-employment. The profit center model greatly simplifies their accounting and tax reporting, while providing significant write-offs, plus excellent retirement and health benefits.

Not Yet Available in Most States. The profit center model was developed twelve years ago in the New York area, and is confined primarily to the mid-Atlantic states. But that will soon change. The popularity of the World Wide Web has made it possible for these firms to reach into all fifty states, and they should be operating in California by Q2 of 1998. Watch for a profit center firm coming soon to a state near you!

Full Service vs. Pass Through Agencies

Contract employment agencies fall naturally into two categories: Those that find the assignment for you, and those that don't. In the former category are traditional temp agencies and small niche specialists. In the latter category are pass through agencies and profit center firms.

Full service agencies are by far the most common type of contract employment agency, and for good reason -- They do the work most of us are disinclined to do. We hate to sell ourselves, and let's face it, job hunting is a sales job. It requires cold calling, promoting our own uncertain skills, imposing on other's time, and asking total strangers to place their confidence in us. It requires discipline, assertiveness, proactivity, and positive thinking -- traits all of us claim to have, but which few actually practice in daily life.

Hiring authorities are similarly disinclined to actively recruit contractors, either for the reasons given above, or because they simply don't have the time. Full service agencies perform a valuable and necessary function by presenting the client with qualified candidates.