Potential Shut-downs for Start-ups: Worker Misclassification Minefields

New businesses, otherwise known as start-ups, face all kinds of challenges when they decide to open up their doors for business.  While I live and work in the midst of a flourishing and vibrant tech start-up scene here in New York City, this post is relevant not only to tech start-ups, but all new and existing businesses.  Obvious challenges to start-ups include formulating and financing a successful marketing plan, deciding whether to lease or purchase needed equipment, and choosing the right location within their budget.  Of interest to me as an employment attorney is the way that many of them deal with one of their biggest challenges: Securing the services of good workers.

I could well have said “securing the services of good employees”, and therein lies a hint of the problem.   Faced with serious budget limitations for the first few years, start-ups in desperate need of additional labor often opt for alternatives to hiring that come in two varieties: (1) Interns, and (2) Independent contractors.  This is especially true in today’s economy where employers find no shortage of experienced candidates for hire, and eager student volunteers desperate for work experience.  Sensitive to the fact that many start-ups are leery of the costs associated with hiring employees, both groups tend to package themselves as independent contractors and interns, respectively.  Both options are attractive to start-ups because, unlike employees, neither option requires the start-up to make federal, state, or local income tax withholdings, Social Security or Medicare contributions, or pay Unemployment Insurance and Workers’ Compensation premiums.   While these options may indeed be perfectly good solutions, start-ups need to understand that there are legal tests that must be met prior to engaging any individuals in these classifications.


What test is implicated when a company seeks to engage an individual as an intern?  Well, both the Federal and New York State Departments of Labor (DOL and NYDOL) issued documents on this issue last year.  To make a very long story short, the DOL and NYDOL both apply tests that basically require that any company that engages individuals as interns must have the relationship structured  much like that of internships established by educational institutions, wherein the intern is closely supervised, does not replace employees, shadows existing workers, does not directly benefit the employer,  occasionally impedes the employer’s business, and is not entitled to a job at the conclusion of the internship.   You can quickly see how this requirement vastly differs from how a start-up typically utilizes interns, and can lead to start-ups incurring significant legal and tax liability should they be deemed to have misclassified employees as interns. * This intern test does not apply to not-for profit organizations.

Independent Contractors

Similarly, the DOL, NYDOL, and the IRS have extensive tests for determining independent contractor status.  Boiled down, these tests require that the person have a bona fide business (typically evidenced by them having stationary and business cards, setting their own hours, working for numerous clients/customers, etc.).  This would seem to disqualify many of the self-styled “freelancers” typically found offering their services on places like Craigslist and other similar websites.  It is not enough that they be independent-minded, talented, call themselves independent contractors, and are available for engagement.  More formality is needed along the lines of showing that they operate a bona fide legitimate independent business.

In short, start-ups need to understand that simply calling someone an intern or independent contractor does not make them one.  Far from it, such ignorance or disregard of the law will more than likely expose the new business to significant liability in the form of unpaid Federal, State, and Local income tax withholdings, unmade Social Security and Medicare contributions, and unpaid unemployment insurance and Workers’ Compensation premiums.  Add interest and penalties to all of the aforementioned, and you can easily see how ignorance or disregard of these legal tests can result in the insolvency and closure of a start-up.  Other possible liabilities may include claims for employee benefits, such as pension and profit-sharing plans, medical benefits, and even stock options.

Overtime Exemptions

Other misclassification problems start-ups need to be aware of include the now infamous question of whether the employee is exempt or nonexempt with respect to overtime pay.  Simply designating the employee “salaried” doesn’t answer the question.  Getting this wrong can lead to liability for 2 to 3 years of back pay plus an additional 100% back-pay in liquidated damages under Federal law, or 6 years of back pay and an additional 25% 100% back-pay (soon to be now 100%) liquidated damages under New York State law.

While other potential pitfalls exist in the form of not properly understanding what constitutes compensable “work time” (in terms of employees using work-issued equipment (laptop, pda, blackberry, etc.) for work when they are off duty, and prep-time before starting a shift), that may be for discussion on another day.  I have already made this post longer than intended!

The bottom line, if not abundantly clear by now, is that start-ups (and any other businesses) looking to expand the ranks of their workers need to seek experienced employment law counsel prior to designating anyone as an intern, independent contractor, or exempt employee.  With all levels of government showing an increased interest in enforcement of tax and labor laws (fines and penalties raise much needed revenue), it is prudent to expect that the once lax enforcement of these laws will soon be a thing of the past.   In addition, even if your company is otherwise not on the government’s radar, all it takes is for one of your relationships with a worker to sour, and then your now disgruntled intern/contractor/exempt employee will file a complaint with a government agency.  Failure to adequately prepare for this is essentially planning to fail, because the financial cost of noncompliance can realistically deal a fatal blow to start-ups.

If you have any questions related to any of the above, leave a comment, or contact Reid Kelly, P.C., here.

DISCLAIMER: This site and any information contained herein, including this Blog, are intended for informational purposes only and should not be construed as legal advice. Seek competent counsel for advice on any legal matter.

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4 Responses to Potential Shut-downs for Start-ups: Worker Misclassification Minefields

  1. Jim Burke says:

    Shaun, This is a very fine post. I don’t know much about hiring or serving as an intern, but I don’t doubt that there are dangers waiting for those who use internship programs to rip off free or low cost services from fresh faced young workers. That’s just as well. I do, however, know something about independent contractors, both as a purchaser and a provider of independent contractor services. I understand that this arena is complex enough, and the pitfalls are dangerous enough, that a layperson (non-lawyer) should not hire an independent contractor without the necessary training and advice.

    I don’t think, though, that there is much hazard for a lawyer who wants to hire an independent contractor. Although the test has more than a couple of parts, it isn’t so multi-faceted that a competent practitioner can’t understand it. I think that as long as the independent services provider meets the basic criteria, operates a business to provide those services to others, is not available for regular employment from the hiring firm, and describes the relationship clearly in writing, I don’t see why there should be a problem.

    • Shaun says:

      Thanks, Jim. I agree with what you say regarding competent lawyers being able to navigate the independent contractor analysis. Generally, a competent lawyer is one that would research an issue that they are not familiar with, or know who to ask. So, in that sense I absolutely agree with you.

      On the other hand, like many lay people, lawyers who are unfamiliar with employment law may not even know that there is an analysis that must be done to determine independent contractor status. Like a lot of people, they may be under the mistaken impression that so long as both parties agree that the person’s status is that of independent contractor, and they draft up a contract, everything is fine. Given the renewed focus given to the issue by state and federal agencies, it would be prudent for these people to become familiar with what the law requires before they come knocking.

  2. Shaun says:

    Thanks, Nelia. Please do!

  3. Pingback: IRS Offers Employers Misclassification Amnesty: Come in to My Parlor Said the Spider to the Fly | Reid Kelly, P.C.