Employment Law Issues for Startups Classification of Workers By Tifani Sadek Sadek Bonahoom PLC Detroit, MI

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1 Employment Law Issues for Startups Classification of Workers By Tifani Sadek Sadek Bonahoom PLC Detroit, MI Start-up companies often grapple with the issue how to classify their workers. Often having limited capital they may have, pre-revenue startups may try to save money by classifying workers as independent contractors rather than employees, or by setting up an internship program to take advantage of free labor. The penalties for misclassification can be severe, and the guidelines for determine employee versus contractor, and intern versus worker are anything but concrete, so it is important that legal counsel for startups be aware of changes in this area. Rising Use of Unpaid Internships The number of unpaid internships has climbed in recent years, so much so that in 2010, the Department of Labor ( DOL ) issued Fact Sheet 71 to educate employers about unpaid interns and to dissuade their use. The Fact Sheet listed six factors that must be satisfied for interns to be excluded from the Fair Labor Standards Act: 1. The internship, even though it includes actual operation of the facilities of the employer, is similar to training which would be given in an educational environment; 2. The internship experience is for the benefit of the intern; 3. The intern does not displace regular employees, but works under close supervision of existing staff; 4. The employer that provides the training derives no immediate advantage from the activities of the intern; and on occasion its operations may actually be impeded; 5. The intern is not necessarily entitled to a job at the conclusion of the internship; and 1

2 6. The employer and the intern understand that the intern is not entitled to wages for the time spent in the internship. The fourth factor was the most troublesome. As most employers derive some benefit from the internship, the DOL s rule effectively precluded almost all employers from using unpaid interns. In the wake of the Fact Sheet, interns initiated a wave of class action lawsuits across the country. Employers settled many of these lawsuits out of fear that they would not be able to satisfy the DOL s six-factor test. For example, in 2014, Conde Nast and NBCUniversal settled class action lawsuits involving thousands of interns for $5.8 million and $6.4 million, respectively. However, there has been some recent pushback against the DOL s rigid rules. On July 2, 2015, the Second Circuit issued a decision that specifically rejected the DOL s six-factor test and instead adopted a primary beneficiary test, holding that the proper question is whether the intern or the employer is the primary beneficiary of the relationship. Glatt et al. v. Fox Searchlight Pictures Inc. et al., Nos and , 2015 WL (2d Cir. July 2, 2015). To help lower courts apply the new test, the Second Circuit listed seven non-exclusive factors to consider in determining whether an intern or employer is the primary beneficiary of an internship: The extent to which the intern and the employer clearly understand that there is no expectation of compensation. 2

3 The extent to which the internship provides training that would be similar to that which would be given in an educational environment, including the clinical and other hands-on training provided by educational institutions. The extent to which the internship is tied to the intern s formal education program by integrated coursework or the receipt of academic credit. The extent to which the internship accommodates the intern s academic commitments by corresponding to the academic calendar. The extent to which the internship s duration is limited to the period in which the internship provides the intern with beneficial learning. The extent to which the intern s work complements, rather than displaces, the work of paid employees while providing significant educational benefits to the intern. The extent to which the intern and the employer understand that the internship is conducted without entitlement to a paid job at the conclusion of the internship. The Second Circuit s primary beneficiary test is decidedly more advantageous to employers than is the DOL s test. Additionally, the fact that the primary beneficiary test requires an individualized evaluation of whether a specific intern benefits more from an internship than does the employer means that class actions may be more difficult to certify. Indeed, in Glatt, the Second Circuit vacated the district court s class and conditional collective class action certifications. 3

4 While the Glatt primary beneficiary test is currently only law in the Second Circuit, which covers Connecticut, New York, and Vermont, this alternative to the DOL test is likely to start a discussion regarding when an intern should be a paid employee. Legal counsel for startups that utilize unpaid internships should evaluate those programs under both the test announced in Glatt as well as the traditional DOL test. It may be prudent to either strengthen the educational factor or restructure the internship as a paid program to avoid liability for unpaid wages and benefits. Employee versus Contractor in the Gig Economy Workers can be classified as either employees or independent contractors. The distinction between the two is important, as employers do not have to provide worker s compensation insurance, unemployment compensation, or pay employment taxes such as Social Security and Medicare for independent contractors. Classification as an employee or independent contractor is governed by the federal Fair Labor Standards Act and specific state laws, and broadly involves balancing the relative importance of three primary criteria. First, one must consider the extent to which the business has the right to direct and control the worker. This may include control over when and where to do the work, what tools or equipment to use, and what order or sequence to follow when performing the work. Second is the extent to which the business has the right to control the economic aspects of the worker s job. Independent contractors are more likely to have a significant investment in the equipment he or she uses, are more likely to have unreimbursed expenses, and have the possibility of incurring a loss in the work. Finally, the type of relationship between the business and the worker is important, including whether there is a written contract, the permanence of the 4

5 relationship, and whether the worker is free to seek out other business opportunities. The DOL s Fact Sheet 13, released in May of 2014, noted that most workers [who are economically dependent on the business of the employer] are employees under the Fair Labor Standards Act s broad definitions. A number of high-profile tech startups, such as Uber, Handy, and Lyft, rely on the lower costs provided by the independent contractor status of their workers as a key part of their business models. The classification of workers as independent contractors in the so-called gig economy has come under scrutiny as an increasing number of those workers have filed lawsuits seeking minimum wage compensation, reimbursement for business expenses, and overtime. In June of 2015, a pivotal ruling came from the California Labor Commission that classified a former Uber driver as an employee, ordering Uber to reimburse her for the costs incurred while driving for Uber. The Commission relied on the multi-factor test spelled out in S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations, 48 Cal.3d 34 (1989), including whether the worker s occupation is distinct from the company s business; whether the work is part of the company s regular business; and whether the work requires special skill. The Commission noted that, from a big picture perspective, Uber retained control by obtaining the clients who needed its services and then supplying the workers who provided the services. On the individualized level, the Commissioner rejected Uber s argument that it was merely a platform that connected drivers and passengers, and found that it was involved in every aspect of the operation. For example, Uber vetted prospective drivers with background checks, 5

6 controlled the drivers tools such as the age and condition cars, monitored drivers approval ratings, and provided the smart phone app that was essential to the work. All these factors pointed to individual control over the worker. That same month, FedEx reached a $228 million agreement to settle a class action suit by its California drivers after a 2014 Ninth Circuit ruling against FedEx on worker misclassification. A month later, in July of 2015, the Seventh Circuit Court of Appeals upheld a Kansas Supreme Court decision that FedEx workers were misclassified as independent contractors under Kansas law. The DOL addressed the issue of misclassification in July of 2015 when it outlined a new economic realities test, whose factors include: The extent to which the work performed is an integral part of the employer s business Whether the worker s managerial skills affect his or her opportunity for profit and loss The relative investments in facilities and equipment by the worker and the employer The worker s skill and initiative The permanency of the worker s relationship with the employer The nature and degree of control by the employer It is important to remember that, in addition to these new federal guidelines, many state laws use their own tests. However, under most tests, the classic model of utilizing individual independent 6

7 contractors as primary service providers will often produce rulings that these individuals are employees, and not independent contractors. Minimum Wage Requirements Upon finding that a worker classifies as an employee instead of as an independent contractor or an intern, many startups find that they do not have the cash flow to pay an employee a standard hourly wage or salary, and choose to offer equity instead. This raises several concerns. First, as a general matter, wage and hour laws apply to startups and stock and options do not count for purposes of minimum wage calculations under those laws. Currently, federal minimum wage is $7.25 per hour, and many cities and states have minimum wages that are significantly higher. For example, the minimum wage in San Francisco is $12.25 per hour. Where there are conflicting requirements, the employer must follow the stricter standard. By offering subminimum wage rate, many startups are violating wage and hour laws, even when wages are supplemented with stock or options. And while, under the newly formed business owner exemption found in 29 C.F.R , workers who own at least 20% of the company and are actively engaged in managing the business are exempt from federal minimum wage laws, similar exemptions may not exist under applicable state and local laws. For example, New York and California both have different standards for this exemption, and Illinois does not allow it at all. Legal counsel for startups should be aware of all state and local laws as they pertain to minimum wage requirements. 7