PLEASE BE ADVISED: THIS POST IS OUTDATED AND CALIFORNIA'S INDEPENDENT CONTRACTOR LAW HAS CHANGED! READ MORE ABOUT THE NEW LAW HERE.
We are often approached by startups/founders who ask us to draw up an “independent contractor” agreement for their CEO/CFO/President/etc to sign. Having key positions, such as officers/general managers, retained on independent contractor agreements presents a number of potential risks for the company, such as IRS penalties for failure to properly withhold taxes or penalties under the Fair Labor Standards Act (FLSA) for failure to pay proper wages or provide proper breaks.
There are many advantages to using the independent contractor relationship over an employer-employee relationship, including but not limited to: financial savings, increased flexibility, and limited liability. Companies can save money with an independent contractor because they are not required to make the standard employer contributions such as payroll taxes, unemployment and disability insurance, and social security and worker’s compensation taxes. Moreover, businesses do not have to provide fringe benefits (insurance, vacation, sick leave, or retirement plans). Flexibility is increased because independent contractors are typically used for specific projects, and allow the business to dedicate different resources for different projects without taking on additional employees with advanced skill sets. Finally, liability is limited because the laws designed to protect employees (e.g., anti-discrimination and wrongful termination laws) do not apply to independent contractors.
Before you understand why you shouldn’t classify your executive officers as independent contractors, you must fully understand what an independent contractor is and how it is determined whether your worker is an employee or independent contractor.
An independent contractor is a person or business entity that provides goods and/or services to another person or entity under terms specified in a contract or within a verbal agreement. Unlike an employee, an independent contractor does not work regularly for an employer but works as and when required and are usually paid on a freelance basis. Contractors often work through a limited liability entity that they themselves own. The distinction between independent contractor and employee is an important one in the United States, as the costs for business owners to maintain employees is significantly higher than independent contractors due to the need to pay Social Security, Medicare and unemployment taxes on employees.
The IRS considers a number of factors when determining whether a worker is an employee or an independent contractor. The IRS is more likely to classify as an independent contractor a worker who:
can earn a profit or suffer a loss from the activity
furnishes the tools and materials required for the work
is paid by the job or project
works for more than one person or company at a time
invests in his or her own equipment and facilities
pays his or her own business and traveling expenses
hires and pays assistants, and
sets his or her own working hours.
On the other hand, the IRS is more likely to classify as an employee a worker who:
can be fired at any time
is paid by the hour
receives instructions from the company
receives training from the company
works full time for the company
receives employee benefits
has the right to quit without incurring liability, and
provides services that are an integral part of the company’s day-to-day operations.
The U.S. Department of Labor also cares about this important distinction: If a worker is an independent contractor, then he or she is not covered by the Fair Labor Standards Act (FLSA), the primary federal law concerning wages and hours. In other words, the worker is not entitled to minimum wage or overtime.
The United States Supreme Court has classified the following factors as significant when determining whether a worker is an independent contractor or employee under the FLSA:
whether the worker’s services are a significant part of the business (this favors employee status)
the permanency of the business relationship (the more permanent, the more likely it is that the worker is an employee)
whether the worker has himself or herself invested in facilities and equipment (if so, this points to independent contractor status)
how much control the company has over the worker (the more control, the more likely it is that the worker is an employee)
whether the worker has opportunities to make a profit or suffer a loss (rather than always earning a set amount of money no matter what happens, like an employee)
whether the worker does or can compete in the open market (if so, this points to independent contractor status), and
the extent to which the worker operates a truly independent business for him or herself (the more independence, the more likely the worker is an independent contractor).
The Supreme Court has also said that the following considerations have no bearing on this distinction:
The location that the worker performs his or her duties
the absence of a formal employment contract, and
whether the worker is licensed by a state or local government.
Considering this information, it would be difficult, if not impossible, to properly classify an officer as an independent contractor under either the IRS requirements or the Supreme Court factors. This is because officers are responsible for, among other things, the day-to-day operations and management, they are directed by the business in such decisions and they interact in a managerial capacity. It would be nearly impossible for an officer to handle these duties independently and while fitting within the confines of the above requirements.
Again, in a very general way, independent contractors are self-employed people who operate their own business and are able to carry out that business independently of the other businesses with whom she contracts. On the other hand, an employee is a person who is not in business for him or herself, but works for a company and is primarily dependent on that business for the terms and conditions of his employment and for his continued employment.
California law also has something to say about this distinction. Under Section 621(a) of the California Unemployment Insurance Code (CUIC), a statutory employee includes any officer of a corporation or an LLC that is treated as a corporation for federal income tax purposes.
Obviously, the advantages of using independent contractors for a startup with limited resources and funding is highly attractive. It is important to understand and remain cognizant of the risks of misclassifying your workers, particularly your officers.
Feel free to reach out to us here at Verhagen Bennett LLP to speak with one of our experienced employment law attorneys for assistance in properly classifying your workers and drawing up the proper legal documents to reflect your compliance.
About the Author:
Dallas P. Verhagen is a business attorney and a partner at Verhagen | Bennett LLP. To learn more about Dallas, please click here.
For questions or comments about this post, please email Dallas directly at: Dallas@VerhagenBennett.com
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© 2017 Dallas P. Verhagen — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.