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SO YOU THINK YOU WANT TO HIRE: INDEPENDENT CONTRACTORS

Continuing our series about hiring, we look at the ins and outs of hiring independent contractors to work with your business.  Hiring contractors is a very popular way for small businesses and startups to get the work done without the paperwork and expense of hiring employees.  However, many “independent contractors” do not really fit the description and this can cause problems in the long run for the businesses that hire them.

There are several criteria that the federal government looks at to decide whether someone working for you is an independent contractor or an employee:

1) The extent to which the services rendered are an integral part of the principal’s business.

2) The permanency of the relationship.

3) The amount of the alleged contractor’s investment in facilities and equipment.

4) The nature and degree of control by the principal.

5) The alleged contractor’s opportunities for profit and loss.

6) The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.

7) The degree of independent business organization and operation.

     Per http://www.dol.gov/whd/regs/compliance/whdfs13.htm

This is not a checklist and there is no requirement that the contractor fit every criteria, but this is what needs to be examined to determine if the person providing services is truly an independent contractor. 

For example, a founder who has no programming experience hires a software developer to create his product.  The services rendered are an integral part of the principal’s business but once the product is developed, the developer’s relationship with the business is over, unless the founder negotiates a separate contract for maintenance support.  The developer uses his own equipment at his own home office to develop the product and is paid a fee, negotiated with the founder, to develop the product.  The founder does not direct the developer’s day-to-day work and the developer handles his own taxes and withholding. This would most likely be found to be an independent contractor – employer relationship.

However, if we change a couple of conditions, the relationship is completely changed.  For example, the founder hires a rising senior computer science major to create the product over the summer and has her working in the founder’s office, using her computer.  The founder pays her an hourly rate for the work which she does on her own schedule.  The founder doesn’t direct her day-to-day work but expects her to show up several days a week.  She handles her own taxes and withholding.  In this situation, the developer would most likely be classified as an employee.  She does not have an independent business structure and is dependent on the employer to provide a place to work.  The employer has not contracted her for a fee but an hourly wage and expects her to show up for work.

Why would the government examine independent contractors’ relationship with their employers?  It is unlikely that the government will evaluate these relationships without an invitation from either the contractor or employer, often in the form of the contractor filing for unemployment benefits.  At that point, it is up to the employer to prove to the state that both employer and contractor understood that this was an independent contractor-employer relationship.   (The first evidence that the contractor did not understand this is that he filed for unemployment benefits.) If there is a written contract, the employer must show it contains the magic words about the contractor being responsible for his own income taxes and withholding.  The contractor will be given the benefit of the doubt because it is almost always assumed that the employer is the more sophisticated actor in the relationship.

What are the consequences of an independent contractor being found to be an employee?  There are several, depending on which part of the government makes that finding.  The Georgia Department of Labor could award unemployment benefits, requiring some additional payments from the employer for unemployment insurance.  The Georgia Department of Revenue could require the employer to pay back withholding for state income tax.  The IRS could require the withholding taxes for income tax, Social Security and Medicare for the entire time the contractor was employed and the U.S. Department of Labor could require additional payments of wages if what was paid was less than minimum wage.  Any or all of the demands for money can kill a startup or small business before it even gets going.

The best way to avoid problems:  hire companies or established freelancers as independent contractors and sign a contract that explicitly defines the work and nature of the relationship, including the magic words requiring the contractor to be responsible for their own taxes and withholding. Also, negotiate a fee for the project.  There can be contingency clauses for additional requirements, overruns, and maintenance but paying on a per project basis goes a long way toward establishing independence. 

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SO YOU THINK YOU WANT TO HIRE: INTERNS

At some point in the life of your business, you are going to think about getting someone to help you with some aspect of the business.  Among startups, this could take the form of recruiting interns, granting equity in return for work, bringing in an independent contractor, or hiring an employee.  How these paths differ and the considerations and decisions you will need to make will be the topics for the next few blog entries here.

Our first topic is interns.

To clarify, when I talk about interns, I mean unpaid interns.  Paid interns are subject to the same rules as any other employee regardless of what you call them.

Many business founders I have met look to college students who want experience as a pool of free labor by offering internships.  However, the law says that individuals who are “suffered or permitted” to work must be compensated for the services they perform for an employer.  There are a couple of very narrow exceptions to this rule, of which private sector interns are one, but they should not be considered free labor and the recruitment and use of interns must follow certain guidelines.

The rule of thumb is that an unpaid internship must benefit the intern more than the business and it must provide some sort of educational experience for the intern.  A safe way to make sure this is the case is to reach out to the intern’s major department to find out their guidelines to grant credit for outside internships.  However, this takes time, which is usually at a premium for founders.

In the alternative, there are guidelines for interns as established by the Department of Labor:

—  The internship, even though it includes actual operation of the facilities of the employer, is similar to training which would be given in an educational environment;

—  The internship experience is for the benefit of the intern;

—  The intern does not displace regular employees, but works under close supervision of existing staff;

—  The employer that provides the training derives no immediate advantage from the activities of the intern and on occasion its operations may actually be impeded;

—  The intern is not necessarily entitled to a job at the conclusion of the internship; and

—  The employer and the intern understand that the intern is not entitled to wages for the time spent in the internship.

        Fact Sheet #71: Internship Programs Under The Fair Labor Standards Act, Department of Labor, April, 2010 

These are not hard rules for internships but guidelines that will be considered in any evaluation of your intern’s program by the DOL. Your efforts to comply with these guidelines will serve as mitigation should your intern complain to the DOL or file suit.

The educational environment and benefit to the student specifically addresses the complaints of the interns from the fashion and magazine industries who sued a few years ago because their responsibilities were mostly menial tasks such as getting coffee, filing, running errands, etc. with no relationship to the business or industry for which they were interning.  Essentially, interns are not go-fers and their participation in your business should not be the same as an entry level employee of your business.  They need to have some meaningful work that teaches them about your business and should be supervised by someone from whom they can learn.  They cannot replace an employee that you would otherwise hire.  While they can perform work that benefits the business, the primary purpose of the internship is for their education and experience, not to move your business forward.

So, what happens if you do not abide by the guidelines?  Most likely nothing except you will get a reputation for being a lousy option for internship opportunities.  However, if you do have an intern who is unhappy and decides to sue for wages, there is a good chance that you will not only have to pay that intern for the time they were with you but you will also likely have a visit from  the DOL leading to penalties beyond the wages owed.  In other words, it could end up costing a lot more than any benefit you will have gained by using the intern.

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Entity Choice Considerations

Imagine for a moment, a group of three friends who have been tossing around an idea for a couple of weeks. They are super-excited about it, but cautious, even trying to talk themselves out pursuing it. But they can’t shake it. So they succumb to that deeply primal urge to create stuff, and decide to move forward. They decide to start a business.

And what better way to kill all the enthusiasm of this momentous decision, than to be forced to sit down and talk about myriad implication of their legal entity choice.

What could be more tedious.

Yet, this is the common course of events, and even where it’s tedious, this analysis is also pretty necessary.

For most companies there are really only two options: the limited liability company (LLC) and the corporation (often called a C-Corp, because they are governed by Subchapter C of the Internal Revenue Code). “Two options, you say? Sounds to me like a problem that can be solved with a coinflip.” And maybe sometimes it can; there are certainly situations in which the ultimate difference between operating as an LLC or a C-Corp are negligible. But there are also situations in which one entity type is clearly the better choice, so it’s wise to understand some of the factors that affect this analysis.

Possibly the most substantial is what has come to be known as double-taxation. When a C-Corp turns a profit, it pays income tax on that profit. If it then distributes some of that profit to its shareholders, as a dividend, the shareholder also pays income tax on that distribution. This regime is contrasted with that of Subchapter K, which governs LLCs. Under Subchapter K, the company is never taxed at the entity level, and the tax passes through to the member who receives a distribution.

Almost entirely for this reason, the popularity of the LLC has increased substantially in the past few decades. But for other reasons, C-Corps do remain a viable, if not more attractive, option in many situations. This question can be a complex one, so best practice is to discuss it with an attorney or accountant (or both). But here are a couple of questions to consider as you begin this analysis.

1. Why type of capital do you anticipate raising?

If you plan on raising venture money, then it is probably important to know that venture capitalists (VCs), by and large, prefer to invest in C-Corps for a number of reasons. (a) If an LLC generates a profit, the member will be required to pay taxes on that profit whether or not they had otherwise received a distribution. The company typically distributes enough to cover the tax liability, as a work-around. But it’s still annoying, and it’s still a hassle for people who want to give you money. (b) VC’s like option pools. They may want you to set aside 20%, give or take, of the equity of your company, to use in attracting the kind of talent you need to succeed. And it’s much easier to use shares of a C-Corp as equity compensation than to use LLC membership units. Creating a functional equivalent in an LLC can really muddy up the cap table. (c) For the VC’s own taxes, a 1099DIV may be easier to deal with than a K-1. Certainly be aware that this “VCs prefer C-Corps” rule isn’t without exception, but it is pretty common.

2. How do you plan to reward your equityholders?

Getting back to double taxation, this is the reason a lot of lawyers and accountants will really push the LLC form. And where double taxation applies, it is certainly a problem. If a C-Corp is making a profit and distributing that profit via a dividend, the IRS will take a hefty slice at the entity level and then another nice slice at the shareholder level. But for startups, double taxation rarely applies. First, they rarely make a profit that they intend to distribute. Whatever excess revenue is generated is generally invested back into the company, not issued as a dividend. The company pays the founders a reasonable salary, which is conveniently tax deductible for them, and neither founders nor the investors expect an issuance of a dividend. The typical plans to build, to scale, and to exit, either by acquisition or IPO. So, again the question: how do you plan to reward your equityholder? If your plans primarily involves a big pay off at a liquidity event, then the benefit of the LLC’s pass-through taxation is less substantial. But if you plan includes distributions throughout the course of the growth of your company, then the LLC form can provide substantial tax savings.

And one last point, to reiterate, this a short post cover a few issues.  Your specific situation may involve facts and issues that I haven’t discussed here, which is why it’s always best to talk to an attorney and/or a tax professional.

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Viva la Crowdfunding!

At its core, crowdfunding is an extremely democratic idea. Congress and the SEC, along with the equally paternalistic state regulators, have made investing in startups a relatively difficult, if not impossible, process for those who do not meet the elitist requirements of the “accredited investor.” Crowdfunding stands poised to become the beacon of equality for those who have the desire to brave the waters of startup investing, without the “accredited investor’s” means.

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