Recent years have seen employers increasingly use “independent contractors” in lieu of employees, believing that these relationships simplify payroll administration, afford the opportunity to “try” a worker before hiring on a “regular” basis, and provide a barrier to employment-related liability. This explosion in independent contractor relationships is especially evident in the dot-com and start-up world, where it is common for a majority of workers to function under some form of alleged independent contractor relationship.

There can be substantial risks associated with these relationships, however. For example, if a company incorrectly characterizes certain workers, it can face IRS fines for failing to withhold payroll taxes, greater liability to third parties for worker conduct and lawsuits by individuals for employment-related claims such as workers’ compensation, health and welfare benefits, compensation, breach of contract, discrimination, harassment and wrongful discharge.

It is critical, therefore, to recognize that self-generated labels and written agreements do not bind the courts or the IRS in reviewing whether a worker is an employee or independent contractor. Instead, the IRS and the courts to a lesser and more inconsistent degree will review more than 20 factors to determine an individual’s correct status. The bottom line always will be the degree of control the employer has over the way the worker accomplishes relevant tasks or duties. The greater the control over day-to-day activities, the more likely the individual will be characterized as an employee rather than an independent contractor.

Another common trap is the misclassification of an employee as “exempt” (and, thus, not entitled to overtime) under the Fair Labor Standards Act (FLSA) or California’s state law equivalent. Most often, particularly with start-ups, every employee is “salaried,” no one is being paid overtime, and even the file clerk is someone’s “executive assistant.” Many employers mistakenly believe that overtime liability can be avoided simply by labeling an employee “salaried” or “exempt.” This simply is not the law.

To be exempt from federal and state overtime and minimum wage laws, an employee must satisfy both a duties and salary requirement. The salary requirement that the employee’s monthly remuneration be at least $1,993.33 is generally not difficult to satisfy because most “salaried” employees are paid at least this minimum level.

Exempt classifications

It is the duties requirement where most employers fall short. In determining whether an employee satisfies this requirement one must refer to the three recognized exempt classifications of employees professional, executive or administrative and the criteria required to satisfy each. An executive employee is one who, among other things, supervises at least two employees. Very few start-ups have more than a handful of key employees that satisfy the executive test. The administrative exemption essentially requires the employee to exercise independent discretion in fulfilling his or her duties.

However, simply following a predetermined policy or practice to decide among several options in a particular situation is not exercising “discretion” as defined by the FLSA or California law, and most employers only have a few truly administratively exempt employees.

Despite obvious misclassifications, most employers fail to focus on this issue until they are served with a wage claim for unpaid overtime (which, for a class of employees over a three-year period, can accrue to hundreds of thousands of dollars), waiting time penalties (up to an additional 30 days of wages) and interest for all the improperly classified exempt employees who have not received overtime or minimum wage.

California law presumes that an employment relationship for no specified term is at-will, i.e., either the employee or employer may terminate the employment at any time without notice or reason. At-will employment is particularly advisable for start-up companies because it allows employers the freedom to make quick adjustments in the workforce.

Even though most employers believe their employees are at-will, they often do not realize that the at-will presumption can be invalidated by express or implied representations/promises, conduct reflecting continued employment and other “fluff” that tends to run rampant in recruiting literature, offer letters and other language used by start-up companies. It is important to remember that the at-will presumption only operates in contracts for an unspecified term, so any contract for a definite term should either specify that the employment relationship remains at-will notwithstanding the term, or it should properly define cause for termination.

Protecting property

For most startups, property rights to the computer programs, codes and systems developed by employees represent the company’s largest and perhaps most important asset. Accordingly, the employer should take steps to protect this precious commodity when an employee is first hired. Put another way, while the intellectual property rights to works of authorship are to a great degree vested in the employer by law, the value of these rights forces an employer to take steps to protect them.

It is important to note, however, that under the California Labor Code, an employer cannot require an employee to give the company rights to an invention that the individual developed entirely on his or her own time without the employer’s equipment, supplies, facilities or trade secrets, unless those inventions are either: (a) related at the time of conception or implementation to the employer’s actual or anticipated research or development; or (b) the result of work performed by the employee for the employer.

Finally, because of the extremely competitive environment in which many start-ups operate, employees tend to jump frequently from one company to another. Start-ups therefore should limit employee mobility, prevent disclosure of trade secrets and other confidential information, and prohibit employee raiding to the extent the law allows.

To prevent employees from engaging in such behavior a start-up should obtain written agreements signed by each employee.

Framroze Virjee is a partner and Timothy McCaffrey is an associate in O’Melveny & Myers LLP’s labor and employment practice group where they represent high tech start-ups, emerging growth companies and major corporations in a broad range of industries.

Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.