We are often asked, “Is it OK not to pay ourselves until we obtain funding?” or “I don’t have to pay someone who wants to volunteer for my company just for the experience, right?” We've also been told, “I don’t have to worry about overtime, payroll taxes or benefits because I only use contractors!” Each assumption is risky.
Considering the advantages, disadvantages and consequences of how you classify workers is critical for emerging companies striving to hold down start-up costs. But any company hoping to manage compensation outlays must also be aware of the risks involved when classifying someone other than as an employee. The money you think you may be saving can all be lost, and additional costs and penalties incurred, if you don’t classify workers correctly from the start.
Is It a Good Idea to Use "Volunteers"?
There is no recognized legal authority that allows a “for profit” business (as opposed to a charity or government employer) to use unpaid “volunteers.” So if someone wants to gain experience by working for your company without pay, be forewarned. If the relationship sours, you could face a claim for unpaid minimum wages and even overtime pay. You may also be liable for unpaid Social Security, unemployment and workers’ compensation payroll taxes, as well as failure to withhold income tax.
When the tech bubble burst earlier in this decade, many former volunteers who “hosted” chat rooms or online communities made claims that they had been misclassified, that they were really employees and were entitled to be paid at least the minimum wage, and in some cases overtime, for the hours spent in such volunteer activities.
What About Using Student Interns?
There is a very limited exception under the federal and state wage and hour laws governing when companies may use unpaid student interns. These individuals should only be “shadowing” or “observing” a regular employee, or doing make-work assignments.
Employers must meet the following five conditions to safely categorize someone as an unpaid intern:
- The intern must receive on-the-job training similar to that which would be provided through a school;
- The primary benefit of the internship must be for the intern;
- The intern must not displace regular employees;
- The employer must reach an understanding up front with the individual that the intern is not entitled to pay or benefits during the internship or a job at the end—savvy companies require interns to sign a statement documenting their status and acknowledging that they are not entitled to compensation or a job at the end of an internship;
- The employer gets no immediate advantage from the intern’s activities—in fact their presence is supposed to impede your operations on occasion, based on the assumption that you are spending time training them.
How Should I Classify Founders and/or Business Owners?
Is it safe to have an agreement at the earliest stages that no one will be paid until the company secures a certain level of funding or achieves a positive cash flow? Generally, there is less risk of employment claims with this type of arrangement during the earliest stages while a nascent unincorporated business is being run by a sole proprietor or common-law partners who have contributed their own funding to start the company.
The risks increase significantly, however, when a company is legally formed, adds executives or officers, and allocates equity (stock, options or LLC interests or units) among individuals who are called officers or directors, or who are given titles typically associated with employees.
The risks of not paying any compensation were underscored in an unpublished (nonbinding) decision by the Washington State Court of Appeals in 2007. In Edenholm v. Flytrap Network Security, Inc. et al., a founder of the company, who was also a corporate officer, was held personally liable for failing to pay any compensation to the startup’s vice president.
The founder, as an officer of the company, had entered into a written “employment” agreement that provided the vice president would not be paid any salary until the company closed an initial equity financing round. The court held that if there was a enforceable contract not to pay a salary prior to securing funding, Washington’s Minimum Wage Act required that the vice president be paid at least the minimum wage for each hour worked, as well as overtime (at the rate of 1.5 times the state minimum wage) for all hours worked beyond 40 in one week. The state minimum wage is currently $8.55 per hour. Considering the long hours worked within startups, and a three-year statute of limitations for unpaid minimum wages and overtime, this exposure can add up quickly.
Consequently, the safer practice, once a business is legally formed, is to pay exempt employees at least the minimum salary required to claim the federal overtime exemptions for white collar workers (currently $455 per week) and to pay nonexempt staff at least the minimum hourly wage and overtime for time worked beyond 40 hours in a workweek, rather than relying on questionable agreements to defer or waive pay. It is also critical to obtain advice from human-resource professionals and others knowledgeable in current employment law as to whether a job’s duties qualify the salaried worker as exempt from overtime.
Also, remember that when forming a business there are certain steps that can be taken to opt out of unemployment and workers’ compensation payroll taxes for corporate officers and board members. If you don’t take the required steps promptly, you may miss the opportunity to claim such payroll tax exemptions.
What’s Involved If I Use Contractors?
It is very risky to directly engage individual contractors who do not have a business license, a state Unified Business Identifier (UBI) number, their own place of business, their own equipment, and who are solely dependent upon your business for their livelihood.
Bona fide “independent” contractors meet the following criteria:
- They are in business for themselves;
- They typically have multiple clients;
- They determine whether they will do the work themselves and/or use employees or subcontractors;
- They pay income and business and occupation (B&O) taxes on business revenues and payroll taxes on employee compensation.
Even self-employed sole proprietors should have (and provide to you) a UBI number (used for paying B&O taxes to the state) and an investment in their own business equipment, even if it is for a home office-based business. In short, independent contractors should not be working full time at your business, using your equipment and supplies, and doing the same work as your employees.
When contractors are obtained through staffing firms or temporary-help agencies, the contractor’s (e.g., temporary employee’s), primary/payroll employer should be considered the staffing firm or temp agency, not the employer using such services.
Classifying individuals as non-employees is tricky. Whether you’re an emerging company or a longstanding organization looking to lower costs, be sure to consider the legal ramifications of misclassifying an individual. Interns need careful attention. Volunteers may appear to be an inexpensive alternative, but in reality, few employers can use them without running into significant issues. Owners and founders may be able to work for minimal compensation, providing good employee agreements are in place, but problems can still arise. Contractors come in all shapes and sizes; the ones you hire directly should be bona fide contractors with established business credentials.
If you have any questions regarding employee staffing or classification, please contact Mary Drobka, Mike Killeen or your Davis Wright Tremaine employment law attorney.
For more information of interest to emerging companies please visit Davis Wright Tremaine's Startup Company blog. Startup employers in Washington state may wish to visit the Washington Technology Industry Association's (WTIA ) Web site.