Hot topic in startup law: employment misclassification

Startup entrepreneurs have a tough job. They are constantly putting out fires. Some fires they must let burn. For example, the typical startup might not be attentive to customer service since serving existing customers would mean they do not have time to acquire new customers. On the legal side, even large companies with full time HR departments are hard pressed to keep up with California's byzantine labor laws. If a well-funded company struggles with the laws, what chance does a fledgling startup have?

As a result, many startups ignore the small fire of wage and hour laws. They do not track mandated meal and other breaks. They may be sloppy about overtime pay; their "bring your own device policy," might cause uncompensated time; and they might not get the classification of an employee as exempt or non-exempt correct (thus violating minimum wage or overtime laws). In some part, the investment and M&A markets factor in those risks of employment law non-compliance into their valuation decisions, which allows startups to let those fires burn instead of putting them out. One such uncontrolled burn is employee misclassification.

Classifying workers as contractors can be attractive. Employers can save up to 30% in costs on payroll and related taxes by utilizing independent contractors. They need not provide health benefits, retirement benefits, or paid time off. They avoid payroll taxes and withholding. The result to the worker is flexible work schedules and probably higher supplemental income, but with no benefits; paid time off; health or retirement care; workers' compensation, or wage and hour law protection. Since startups have lots of equity and little money, the temptation is almost irresistible to pay their employees in stock instead of cash. The lucky ones resist that temptation.

Misclassification has always been a burning fire for startups. For many gig economy startups, however, recently enacted Assembly Bill 5 has turned a controlled burn into a holocaust.

By now, everyone knows about AB 5, which codified the California Supreme Court's decision in Dynamex Operations West, Inc. v. Superior Court of Los Angeles and its three-factor ABC test, which presumes a worker is an employee unless the following tests are satisfied:

For a gig economy company operating a startup that matches service providers with service recipients (think Uber), the test is impossible to meet due to the third factor: that the worker is engaged in an independently established trade, occupation of business of the same nature.

For many other companies, that third prong is also problematic. For a pre-Dynamex example of how bad it can be, one need only look to the example of the startup Homejoy.

Homejoy used an algorithm to connect homeowners with contract-for-hire cleaners. The idea was a good one, as the company raised $40 million in venture funding. Predictably, Homejoy treated its cleaners as independent contractors, and not employees, at least until they became the subject of a class action lawsuit. All that remains now of Homejoy are its ashes, having run out of money and failing to attract additional funding. The CEO said its failure to raise money was dude to worker classification lawsuits.

Besides AB 5, a startup might misclassify workers for other legal purposes, such as federal and state payroll and income tax, workers compensation or federal labor laws. The area is confusing since each agency has its own test and while a person could theoretically be an employee for one purpose and a contractor for another, those are subtle distinctions to bet the company on.

As an example, the Internal Revenue Service applies a control test that looks to behavioral control, financial control and the type of relationship between service provider and service recipient. The Department of Labor under the Fair Labor Standards Act applies an economic realities test, where the focus is on the degree of control the company has over the worker performing the service. The key inquiry is the right to control, not whether the company actually exercises the control. In July 2015, the Department of Labor issued administrative guidance and explained that the test focuses on whether the worker depends economically on the hiring entity or is in business for herself/himself.

The California Employment Development Department (EDD) manages the Unemployment Insurance (UI) and State Disability Insurance (SDI) programs for the State of California and is usually the first agency to question worker classification for taxes. Anecdotally, I can report that the EDD auditors know of AB 5 and the differing standards for payroll taxes and other purposes. Given the historically aggressive positions taken by California generally and the EDD specifically, it might not matter much that they appreciate the theory of the laws. As practical matter, an EDD audit is often a death knell for a startup company.

The putative employer could end up with liability based on misclassification for: unpaid back federal, state and local income tax withholdings; unpaid back Social Security and Medicare contributions; unpaid federal and state unemployment insurance taxes; and willful misclassification penalties, just to name a few.

But it does not stop there. The putative employer could also be responsible for a plaintiff employee's attorney fees in cases involving minimum wage or overtime (Cal. Lab. Code Section 1194), nonpayment of wages or benefits (Cal. Lab. Code Section 218.5), enforcement of public interest (Cal. Lab. Code Section 1021.5) or FEHA Fees (Cal. Gov't. Code Section 12965(b). Worse, criminal penalties may apply to failing to procure workers' compensation insurance (Cal. Lab. Code Section 3700.5) or knowingly and intentionally violating Cal. Lab. Code Section 226 (failure to provide wage statements). The employer also risks a claim of insurance premium fraud if it intentionally underreports payroll or misclassifies workers to avoid workers' compensation premiums. Finally, and maybe the largest fire of all, is a Private Attorneys General Act claim.

As is apparent, with employee classification, the standards are complex and fact based, and the consequences of getting it wrong are severe. Many attorneys may decide that they simply will not advise on this issue due to the risk or may advise to take a conservative approach and treat everyone in California as an employee. If a company still desires to hire workers in California and treat them as independent contractors, they should re-evaluate their independent contractors to ensure that the status is still applicable. At a minimum, their independent contractor agreement should document and establish real independence, and the day to day work relationships should follow the independent contractor agreement and reflect actual independence. If the status of a worker or group of workers looks like a close call or falls into a legal grey area, the company should classify the worker as an employee (part-time, temporary, etc.). Many companies will consider using a staffing agency or workforce management firm, but caution is required, because an employer may have joint and several liability with the staffing agency or workforce management firm.

In conclusion, employment is one area of the law that startups in California cannot ignore. This is a potential fire that, as Smokey the Bear might say, only you can prevent. 

Roger Royse is founder of the Royse Law Firm. Roger works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries.