Disclaimer: OLLIE is a free educational resource that provides general legal information for entrepreneurs in California. It does not provide legal advice. Please engage a licensed attorney for advice on your particular situation.

Hiring employees, independent contractors, and interns

Worker Classification

Worker arrangements are where most new businesses get into trouble, so we want to make sure you're well-equipped to prevent common mistakes early on.

The government will classify your workers into three buckets:

1. Independent Contractors;
2. Employees; or
3. Volunteers/Unpaid Interns.

Even if you don't categorize your workers a certain way, the government will. Thus, it's very important for you to correctly classify your workers, both to properly protect your IP, and to avoid penalties and fees from the Department of Labor.

Independent Contractors

Hiring independent contractors can be a very efficient way to get what you need done. They'll perform a service for you and you don't need to pay them minimum wage/overtime, give them benefits, or go through the hassle of withholding part of their wages for Social Security/Medicare contributions. However, you do need to make sure you actually treat them like independent contractors—otherwise, the government will classify them as employees, and you might owe a hefty sum in backpay and penalties. Generally speaking, in the government's mind, an independent contractor is an expert hired for short-term, clearly defined projects, who is engaged in their own independent business. The more the relationship looks like one where the worker has a specialized set of skills and the employer lacks control of how the work is actually being done, the more likely a court is going to rule that the worker is, in fact, an independent contractor.

The ABC Test

In California, courts will apply the ABC test to determine whether a worker is an independent contractor or an employee. The ABC test puts the burden on the employer to show that the worker:

1. is free from the control and direction of the hiring entity in the performance of the work, both under the contract for the performance of the work and in fact;
2. performs work that is outside the usual course of the hiring entity's business; and
3. is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity

(A) Free from Control and Direction

This prong focuses on the independence of the worker in performing the work. For example, if the employer has the power to set the working hours and direct the procedures for completing the tasks, this indicates that the relationship is more like that of an employer and employee.

Note that a court would also look at which party has necessary control over the work performed. If the task can only be performed one way, a court will not consider a lack of supervision over the task to be meaningful to the question of whether the contractor is free from the control or direction of the employer. For example, if an employer controls all of the other operations of a farm, but contracts with workers to harvest crops and pays the workers based on the amount of crops received, a court would still consider the employer to have all of the necessary control over the job. See S.G. Borello Sons v. Department of Industrial Rel, 769 P.2d 399, 345 (Cal. 1989).

Other instances where an employer would not satisfy this prong include:

• Knitters and sewers who work at home on their own machines at their own pace to produce children's clothing based on patterns provided to them by the employer. See Fleece on Earth v. Dep't of Employment, 923 A.2d 594 (Vt. 2007).
• A truck driver who was required to keep their truck clean, obtain the employer's permission before transporting passengers, go to the employer's dispatch center to receive additional assignments, and could be terminated for tardiness, failing to contact the dispatch center, or violating any of the employer's written policies. See Great N. Constr., Inc. v. Dep't of Labor, 2016 Vt. 126, (Vt. 2016)

(B) Outside the Usual Course of Business

This prong addresses the question of whether the worker would be reasonably viewed as "working in the hiring entity's business." The classic example would be when a retail store calls in a plumber to work on a leaky pipe. The retailer's usual course of business is far removed from the plumber's repair services, so a reasonable person would not view the plumber to be an employee of the retail store.

In contrast, courts have found that the following situations fail this prong of the ABC test:

• Seamstresses who work from home to create dresses using cloth and patterns supplied by the employer, that will then be sold by the employer. See Silent Woman, Ltd. v. Donovan, 585 F. Supp. 447 (E.D. Wis. 1984).
• Cake decorators at a bakery who work on a regular basis on the bakery's custom-designed cakes. See Dole v. Snell, 875 F.2d 802 (10th Cir. 1989)

(C) Independently Established Business

Lastly, this prong requires that the worker has independently chosen to go into business for themselves. Factors that would weigh in favor of a contractor relationship include:

• forming an entity (like an LLC or corporation);
• obtaining a business license;
• advertising/marketing activity; and
• regularly offering services to the public or other customers;

Examples where courts have found that the employer did not satisfy this prong include:

• Construction workers who used their own tools, but the employer presented no evidence that they had business cards, business licenses, business phones, business locations, or other clients. See Brothers Const. v. Va. Employment Com'n, 494 S.E.2d 478, 288 (Va. Ct. App. 1998).
• Bicycle courier who was contracted to deliver letters and packages for a same-day pickup and delivery service, but the employer presented no evidence that the courier advertised to other potential customers, had their own business cards, had their own clients, or maintained a separate place of business or telephone listing. See Boston B. C. v. D. D., Div., Emp, 778 N.E.2d 964 (Mass. App. Ct. 2002).

Setting Up an Independent Contractor Relationship

Template Forms

• New Business Community Law Clinic: Template - Independent Contractor Agreement
• Orrick: Startup Forms Library - Consulting Agreement
• Nolo (via SF Law Library: Nolo Legal Information Reference Center - Consultant & Independent Contractor Agreements

Employees

At-Will Employment vs. Employment Contract

While we would always recommend having a written contract between you and your independent contractors, you probably don't want to enter into an employment contract with your employees. California, like most states, is an at-will employment state, where the default case is that both the employer and the employee are allowed to terminate the relationship at any time, for any (lawful) reason. 1

Instead, what you would want to provide is an offer letter, detailing the terms of the employment while leaving open-ended its length. Otherwise, termination prior to the end date of the contract may result in damages. 2 However, this might be an intended result if you're looking to recruit a highly skilled and highly compensated worker (e.g., a CEO).

Legal Compliance Checklist

From the Insight Center for Community Economic Development

All employers should regularly assess their compliance with legal requirements, including the following:

1. The employer has applied for and been assigned a federal employer identification number by the Internal Revenue Service (IRS).
2. The employer has registered with the California Employment Development Department (EDD) and secured an EDD account number. See “How to Register with the EDD” and “Employer Payroll Tax Account Number” here.
3. The employer withholds federal and state income taxes and federal social security, (FICA) taxes from taxable wages paid to employees, pays the employer share of FICA taxes, and deposits all such funds in a timely manner and with the appropriate IRS and EDD forms. For information on California payroll taxes, click here.
4. The employer withholds state disability insurance from taxable wages paid to employees, and deposits all such funds in a timely manner with EDD, or establishes a state-approved private disability insurance plan. For information on California disability insurance, click here.
5. The employer purchases workers’ compensation insurance through an authorized insurance company or from the State, or secures consent to self-insure. If the business has volunteers, the leadership has declared that the business’s volunteers are employees for workers’ compensation purposes, and the business has so notified its insurance carrier. For information on California workers’ compensation insurance, click here
6. The employer pays state unemployment insurance or elects the reimbursement method.
7. The employer pays any local city-imposed payroll tax.
8. The employer obtains a completed federal Form I-9 from all new employees.
9. The employer reports all newly hired employees to the EDD.
10. The employer notifies employees about the Earned Income Credit.
11. The employer obtains a completed IRS Form W-4 and state Form DE 4 from each employee.
12. The employer furnishes each employee with a completed IRS Form W-2 by January 31 for the previous calendar year.
13. The employer posts or provides to all employees the required employment notices.
14. The employer complies with wage and hours laws, workplace safety laws, and nondiscrimination laws.
15. The employer complies with all employee benefit plan requirements.
16. The employer complies with all written personnel policies and procedures.
17. The employer prepares proper documentation of all independent contractor arrangements, and reports compensation to independent contractors on IRS Form 1099 MISC and California Form DE 542 .
18. If it employs greater than 50 employees, the employer offers affordable health care or pays a fee. For additional help with employer legal compliance, click here.

Setting Up an Employee Relationship

Template Forms

• Orrick: Startup Forms Library - Employee Offer Letter
• Nolo (via SF Law Library: Nolo Legal Information Reference Center - Human Resources
• Clerky: 83(b) Elections
• Clerky: 83(b) Elections (Step-by-Step)

Interns or Volunteers

Nonprofit Organizations

It is generally accepted that most nonprofit organizations cannot operate without the help of volunteers. Additionally, as you might remember from the Entity Formation module, nonprofit organizations must adhere to rules against providing a substantial private benefit—nonprofits must work toward public or charitable purposes that benefit society as a whole, and not to the benefit of just a few particular individuals. Based on these reasons, unpaid interns or volunteers in a nonprofit organization generally wouldn't raise red flags among the employment authorities.

One exception, however, is in the context of the limited commercial activities that a nonprofit organization may perform. For example, if the nonprofit runs a gift shop, the workers who staff the gift shop cannot be volunteers.

For-Profit Organizations

Because for-profit companies, by definition, work toward maximizing profit for their shareholders, volunteers and unpaid interns working within for-profit businesses are viewed as more exploitative than beneficial. As a result, unpaid worker relationships (volunteers and unpaid interns) in for-profit businesses are highly scrutinized by the Department of Labor.

In fact, the guidelines put forth by the Department of Labor are designed to make interns more trouble than they're worth in a for-profit business. This is to ensure that the internship is primarily operated as an educational program for the benefit of the intern trainee. Some key highlights from the guidelines include:

• The training is similar to that found in a vocational school;
• The intern does not displace regular employees; and
• The employer derives no immediate advantage from the activities of the intern.

Given these requirements, most early stage start-up companies would probably be hard-pressed to design and implement a compliant unpaid internship program. One avenue that might be helpful is to engage with an academic institution to set up a system where interns receive course credit for participating in the internship. This would require additional coordination with the school/university, but often helps ensure that the internship is primarily focused on benefiting the intern.

Setting Up an Intern/Volunteer Relationship

Template Forms

• New Business Community Law Clinic: Template - Unpaid Internship Agreement

Footnotes

1. For example, terminating someone due to their race is unlawful, and would not be allowed, even in an at-will employment state.
2. An employee who breaches an employment contract could be liable for the cost to cover (the $ spent by the employer to find and hire a replacement), while an employer could be liable for the remaining amount owed under the contract.