Owner, Volunteer, Employee or Contractor? Does it Matter?
I'm often asked – "It's okay not to pay ourselves until we obtain funding, right?" Or "I don't have to pay someone who wants to volunteer for my company just for the experience, right?" I also have been told "I don't have to worry about overtime, payroll taxes or benefits because I only use contractors!" Each assumption is risky. Here's why.
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. When the tech bubble burst earlier in this decade, many former volunteers who "hosted" chat rooms or on-line 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 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. Basically, these individuals should only be "shadowing" or "observing" a regular employee, or doing make-work assignments. Five things must be met to safely categorize someone as an unpaid intern: they must be receiving 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; they must not displace regular employees; there must be an understanding up front that they are not entitled to pay or benefits during the internship or a job at the end; and the company gets no immediate advantage from the intern's activities -- their presence, on occasion, is supposed to impede your operations, based on the assumption that you are spending time training them. Savvy companies require student interns to sign an acknowledgement of their status, and the fact that they are not entitled to compensation or a job at the end of an internship.
What about founders (e.g. owners of the business)? 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 has achieved 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, directors or given titles associated with employees.
The risks of not paying any compensation were underscored in an unpublished (non-binding) decision by the Washington 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 start-up'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 one and one-half 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 3 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 $466/week) and to pay nonexempt staff at least the minimum hourly wage and overtime for time worked beyond 40 hours in a workweek. It is also critical to obtain expert advice from HR professionals and employment law specialists as to whether a job's duties will 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.
Lastly, many start-ups flex their workforce using contractors. It is very risky to directly engage an individual contractor who does not have a business license, a state UBI number, his or her own place of business, his or her own equipment, and is solely dependent upon your business for their livelihood. Bona fide independent contractors are in business for themselves. They typically have multiple clients. They determine if they will do the work themselves, or use one of their employees or subcontractors to complete the job. They pay income and B&O taxes on their business revenues and payroll taxes on the compensation paid to their employees. Even a self-employed sole proprietor should have (and provide to you) a UBI number (used for paying B&O taxes to the state), and an investment in his or her own business equipment, even if it is a home office. 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 W-2 employees.
When contractors are obtained through staffing firms or temporary help agencies, the contractor's (e.g. temp's) primary/payroll employer should be considered the staffing firm or temp agency, not the company who contracts to use such services.
So this is why it matters – 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.