You’ve successfully navigated the web of startup legal formation issues, obtained initial financing (or bootstrapped), and are now in a position where you need additional talent for your business. What’s next? This series of blog posts will take you through some of the principal legal-related decisions facing founders as they look to enhance the intellectual capital of their team. This first post addresses categorizing someone as an employee or an independent contractor.

Many startups are now finding out that the classification of a service provider as an independent contractor (IC) is not as simple as checking a box. A quick Google search will yield a significant number of recent cases involving startups allegedly misclassifying service providers as ICs. For example, startups such as Uber and Handy are the subject of class action lawsuits alleging violations of applicable labor laws for improperly classifying service providers as ICs rather than as employees. Your ability to properly classify a service provider as an IC is subject to a multi-pronged, fact-intensive inquiry (i.e., it’s not a bright line test). By being cognizant of this calculus before you engage a service provider, you can better insulate your company from misclassification-related labor lawsuits.

Companies try to classify service providers as ICs because the potential economic benefit to a company can be significant. By classifying service providers as ICs, companies can avoid significant payroll tax obligations, health care and other benefit requirements, and workers’ compensation obligations. The counterweight, however, is that there are legal guidelines of which every company needs to be aware that govern how a service provider can be properly characterized as an IC.

While the factors considered can vary, and while no one set of factors is dispositive, the following are generally considered when determining whether an employment relationship exists under the Fair Labor Standards Act:

  • Importance of the Scope of Work to the Business. The more the services provided are critical to your company’s business, the greater the chance that the provider of such services will be classified as an employee.
  • Scope of Authority. Does the service provider exercise supervisory or managerial authority? The greater the authority, the greater the likelihood of classification as an employee.
  • Independent Business Judgment and Control. Does the service provider exercise independent judgment and operate independently (e.g., with his or her own deadlines, equipment and legal entities)? ICs generally exert control over their particular project or function.
  • Duration of Relationship. The longer the service provider is tied to the company, the greater the likelihood of classification as an employee.

Note that having a signed agreement from a service provider acknowledging his or her status as an IC has no bearing on the propriety of the classification.

Ultimately, this inquiry and your analysis is important, as penalties for misclassification can be severe, including reimbursement for unpaid wages, back taxes, employee benefits (such as health insurance), and workers’ compensation benefits.

No matter the nature of your startup’s business, when the time comes to bring on additional talent, don’t just assume that any service provider can be classified as an independent contractor.