In its early states, a startup normally relies on its founders to perform the work needed to move the startup toward launch. But at some point along the way, additional expertise may be needed, or simply help with administrative tasks. Startup corporations often reward early employees with stock options or, in the case of LLCs, with profits interests, for work in lien of cash which the startup lacks. But however tempting it may be, the startup should avoid providing employees services as a payroll deduction to defray the cost of hiring an employee unless the startup is willing to keep strict track of the deductions. A recent Oregon Supreme Court case shows why.

Rich Jones and the Rod and Gun Club

The Four Corners Rod and Gun Club, located in Salem, Oregon, found itself in need of a maintenance worker and groundskeeper. The Club also had an unoccupied mobile home on its grounds. Rich Jones, for his part, was willing to maintain the Club’s facilities and keep up the Club’s grounds in exchange for the right to live in the mobile home with utilities, including cellphone service, paid by the Club. The parties agreed to offset the services rendered by payroll deduction which in practice amounted to a wash.

The arrangement lasted three years. At the end of that time, the Club evicted Mr. Jones. Mr. Jones then sued the club for violation of Oregon Revised Statutes section 652.610(3), which states that under these arrangements, payroll deduction is permitted only if the employer obtains the employee’s written authorization in advance and keeps a record of the deductions it has taken from the employee’s pay, at the fair market value of the lodging or services rendered. If the employer fails to do so, the employee can sue the employer for the unpaid wages the employee should have been paid. In Mr. Jones’ case, the parties did not specify the value of the wages, so the courts applied Oregon’s minimum wage.

To make a long story short, Mr. Jones sued the Club. He won a judgment for his wages over the three years. Ultimately, Mr. Jones suffered a net loss because a jury found that the value of letting him live in the mobile home rent-free, and that of the cellphone, exceeded the amount the Club owed him.

How is a Rod and Gun Club Like a Startup?

It isn’t, really, but the payroll deduction law could apply to a startup, subject the startup to liability and cause the startup to incur substantial attorneys’ fees and litigation costs at a time in the life of the startup where every dollar is important. Suppose a startup hires an employee who contributes their expertise to the startup in an amount well in excess of the minimum wage that the court applied to Mr. Jones’ case. Because the startup is cash-poor, but runs a small canteen on its premises, it allows the employee to eat their meals there without paying for them. Also, the startup furnishes the employee with a cellphone that the employee must pay for but pays the bill for the employee. Instead of taking cash payments from the employee for meals and the cellphone, the startup uses payroll deduction so that the employee receives a net amount that is less than the amount stated in the employment contract.

Don’t Use Payroll Deduction

Let’s suppose further that the startup fails to get the employee’s prior written consent to use payroll deduction for meals and the cellphone. Further, the startup does not keep records of the individual cost to the employees. Then the employee quits or is fired and sues for the difference between what the employee’s contract said they should be earning and the amount actually paid. Without the employee’s consent or records, the employer faces liability, fines and an award of attorneys’ fees. Of course, the startup could argue, as did the Club in Mr. Jones’ case, that the fair market value of the services rendered exceeded the value of the unpaid payroll deduction to the employee. But the employee’s contract no doubt called for much higher wages than the minimum wage so that even after deduction, the startup would owe money to the employee, perhaps a substantial amount of money.

What To Use Instead

If a startup wants to hire an employee but wants to pay as little as possible because money is tight, the startup could grant the employee stock options in the case of a corporation or profits interests in the case of an LLC. These compensation methods are well recognized and also might carry tax advantages over pay or payroll deduction. Further, they allow the employee to prosper if the startup does, yet protect the startup’s founders from having to lay out so much money at a young point in the startup’s life.