After developing a business concept and starting up a business, many small business owners decide that to grow and move to the next level it is necessary to hire employees. This is a big step for young businesses and there are key items these business owners should consider in the process, such as whether the existing business structure still makes sense and how to properly document employment relationships. By addressing these important issues early in the process, a business owner lays an important foundation for success in the future and mitigates the risk of certain pitfalls along the way.
Many small business owners with no employees choose to start out as sole proprietorships, single-owner LLCs or “S” corporations. The decision to add employees warrants reconsideration of the existing structure for liability and tax reasons. Business owners should be aware that depending on the type of business they intend to run, different company structures may be more appropriate. For example, if a company intends to offer employees equity participation in the business at a future date, restructuring as a “C” corporation may be worth considering, because “C” corporations as opposed to “S” corporations are not as limited with respect to shareholders or future transfers. Offering equity interests to employees also raises tax, securities and/or ERISA issues that should be explored with legal counsel.
Conversely, when a business owner plans to keep a business closely held and just add additional employees to the workforce, an LLC or “S” corporation may be preferable. These alternatives limit the owner’s liability, while providing flexibility for tax and management purposes.
Some business owners mistakenly believe that all agents who provide services to the business can be classified as independent contractors as a means of avoiding cumbersome tax and legal obligations that arise from hiring employees. In many situations, however, this desire for expediency leads business owners to misclassify employees as independent contractors, resulting in legal exposure for unpaid wages, overtime pay and business expenses, meal and rest periods that were never provided, workers’ compensation claims for which there is no insurance, unpaid tax withholdings, and substantial fines and penalties.
Although numerous factors are used to determine whether a worker is an employee or independent contractor, the primary factor is whether the company has the right to control the work details, meaning the manner and means in which the work is performed. In S.G. Borello v. Department of Industrial Relations (1989) 43 Cal.3d 341, the California Supreme Court identified the following additional factors as significant:
1. Whether the person performing the service is engaged in an occupation or business distinct from the principal; 2. Whether the work is part of the regular business of the principal; 3. Whether the principal or the agent supplies the instrumentalities, tools and place of work; 4. The agent’s investment in equipment or materials required; 5. The skill required for the particular occupation; 6. The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the principal or by a specialist without supervision; 7. The agent’s opportunity for profit or loss depending on his or her managerial skill; 8. The length of time during which the service is performed; 9. The degree of permanence of the relationship; 10. The method of payment, whether by time or by the job; 11. Whether the relationship can be terminated “at will” and without cause; and 12. Whether the parties believe they are creating an employer-employee relationship or an independent contractor relationship.
Business owners and their agents cannot contract around these factors and every situation must be separately assessed. Before classifying an agent as an independent contractor, business owners are well-advised to seek legal advice from employment counsel.
Documentation is Key
Corporate Structure. Upon formation of an entity, it is important to document how the business will be run. For corporations, bylaws must be adopted and buy-sell agreements can be put into place to set the ground rules for future transfers of ownership interests. For an LLC, the operating agreement documents how the LLC will be run, including who will make day-to-day decisions and what consent is required for major events, such as mergers or amendments to the articles of organization. While a business may start out with a handshake, no one knows what will happen down the road, so complete, well-prepared governing documents are critical to safeguard against legal exposure in the future.
Job Descriptions. Companies should prepare detailed and accurate job descriptions which describe important individual job duties. Job descriptions should be updated and revised when duties change or expand from time to time. Well drafted and maintained job descriptions can assist employers in complying with numerous operational and legal requirements, including setting guidelines for performance, supervision, discipline and termination, providing equal pay for substantially similar work without regard to gender, and providing reasonable accommodation to employees and applicants with disabilities.
Employment Agreements. California Labor Code section 2922 creates a presumption that employment for an unspecified term is at-will and can be terminated at any time with or without cause. When the at-will nature of a relationship is challenged, however, the employer bears the burden of proving that the relationship is at-will.
In the absence of an express, written agreement for at-will employment, employees in California acquire implied contractual rights over time based upon the totality of the circumstances surrounding the employment. Such implied contractual rights including the right to termination only for good cause. Similarly, in the absence of an express, integrated employment agreement, oral promises of “employment for as long as you would like to work for us” can become binding oral employment agreements. For these reasons, it is important for a business to document the actual terms of executive and upper management employees in written employment agreements, and to document the “at-will” status of all other employees in express, written at-will employment agreements.
Every agreement should be tailored to the specific employment position or employee, but some key provisions are important in governing the employees’ obligations, as well as providing protection if the employment relationship grows sour. For instance, companies should include provisions restricting employees from disclosing confidential and/or trade secret information, such as customer lists, data compilations, personnel information and pricing information. Failure to protect this information can result in a loss of the intellectual property rights for the company. Appropriately drafted confidentiality provisions can protect the company’s proprietary and/or trade secret information both during the employment and after the employee is terminated or resigns. Arbitration clauses also provide a useful mechanism for business owners to mitigate their legal exposure, but given the continually-evolving legal requirements for such provisions, carefully drafted and up-to-date provisions must be used.
Employee Handbooks. One of the best ways to document at-will employment is with a well-prepared employee handbook that includes an at-will employment agreement in the sign-off sheet that employees sign to acknowledge receipt and understanding of the handbook’s provisions. Employee handbooks are also an important way to regulate employee conduct and provide clear rules with which employees must comply. In addition to basic provisions regarding rest periods, benefits and vacation policies, employee handbooks should contain discrimination, harassment and retaliation policies as required by state and federal law, which include a mechanism for employees to make internal complaints if they believe they have been mistreated. Recent amendment to regulations promulgated by the California Department of Fair Employment and Housing include detailed, specific provisions which must be included in such policies to be compliant with California law.
Provisions governing employee use of computers, personal digital assistants and other electronic sources, including the fact that such information is company property, are also imperative to limit employees’ use of these items to legitimate business purposes.
Companies should abide by all corporate formation documents, agreements and policies once they are prepared. An operating agreement or an employee handbook is not much help (and may be a source of potential liability) if no one monitors and ensures compliance with it. Companies should update and revise policies, handbooks and other documentation as laws continue to change and impose additional obligations on employers, and as business operations continue to evolve. Finally, companies should consult trusted advisors, including legal counsel and CPAs, not only upon inception, but also when changes to the business are made.
Starting or expanding a business is an exciting time in a business owner’s life, but it warrants caution and careful planning. Even
the best relationships can sour and business owners are well-advised to set up workable structures with appropriate documentation
to protect and preserve their businesses as they expand and evolve.