Business owners often lack clarity on when to classify a worker as an employee and when to classify a worker as an independent contractor. Classification of a worker as an independent contractor may initially save the business money and benefits such as group health and retirement benefits, workers’ compensation coverage, as well as Social Security and unemployment insurance taxes. In most cases, the only tax form employers have to complete for an independent contractor is a Form 1099-MISC.
 
Classifying workers as employees, on the other hand, requires that the business undertake several tax-related actions. This includes: withholding federal, state, and local income taxes; paying half of the Social Security and Medicare Taxes; paying the full tax required under the Federal Unemployment Tax Act and any amount required under State unemployment insurance tax laws; paying for workers’ compensation; filing a number of returns during the course of the year with the various tax authorities; and providing Form W-2s by January 31. The employee may also have rights to any employee benefits offered, such as health insurance, paid vacations and holidays, and retirement plans. In addition, the employee is eligible for any Federal or State mandated entitlements, such as family medical leaves of absence, etc.

Despite the savings a business may accrue by classifying a worker as an independent contractor, it is critical to ensure that workers are classified correctly. Misclassification can result in significant liability down the road.
 
EMPLOYEE OR INDEPENDENT CONTRACTOR?
The IRS has issued guidelines to help businesses determine worker status. In the past, a list of 20 factors compiled by the IRS had been used as guidance to determine whether workers are employees or independent contractors. The IRS has now focused the analysis in three areas: 1) behavioral control; 2) financial control; and 3) the type of relationship between the individual and the business.
 
Behavioral Control
If the business has significant control over the individual’s work, that fact weighs in favor of classification of the worker as an employee. Facts that show whether the business has a right to direct and control how the worker does the tasks for which the worker is hired include the type and degree of the following:
  • Instructions the business gives the worker; and
  • Training the business gives the worker.
Financial Control
Much like behavioral control, if the business has significant financial control over the individual’s work, this also weighs in favor of classification as an employee. Facts that show whether the business has a right to control the business aspects of the worker’s job include, but are not limited to the following:
  • The extent to which the worker has unreimbursed business expenses (independent contractors are more likely to have unreimbursed expenses than employees); and
  • The extent of the worker’s investment (an independent contractor often has an investment in the equipment he or she uses in performing services).
 
Type of Relationship
The nature of the relationship between the worker and the business can also point toward the classification of a worker as an employee or independent contractor. Factors that determine the type of relationship between the parties include, but are not limited to:
• Written contracts describing the relationship the parties intend to create; and
• Whether the business provides the worker with employee-type benefits, such as insurance, a retirement plan, vacation pay, or sick pay.
 
Assumptions to Avoid in Classifying Workers
A business should not assume it is safe to classify a worker as an independent contractor simply because:
  • The business owner thinks it is a free and open choice.
  • The worker wants or asks to be treated as an independent contractor.
  • The worker signs a contract that states they are an independent contractor.
  • The worker does assignments sporadically, inconsistently, or is on call.
  • The worker is paid commission only.
  • The worker does assignments for more than one company.
 
Risks When Individuals are Misclassified
The stakes for failing to classify workers as employees are high.
 
For Federal income tax purposes, if the misclassification as independent contractor was intentional, severe Federal tax penalties result. If the classification was unintentional, the Federal tax penalties are less severe, but still significant.
 
The Federal tax penalty for failure to withhold Federal income tax from a worker’s paycheck is 100% of the amount of the unwithheld tax. In addition, interest is charged on the unpaid amounts. Likewise, the individual responsible for the misclassification within in the business is personally liable for the employer portion of the Social Security. Business owners are also generally personally liable for any unwithheld Michigan income tax.
 
In addition to the tax penalties and personal liability, misclassifying individuals as independent contractors can result in liability for failure to provide health and retirement benefits to the individuals. Failing to provide Federal and State mandated entitlements to family medical leave, COBRA, etc. can also lead to significant liability on the part of the business.
 
Another very substantial liability that can result from failing to properly classify individuals as employees is for worker’s compensation. Michigan law provides that if someone should have been covered by worker’s compensation and was not, and the person suffers a work related injury or illness, the employer becomes the worker’s compensation carrier and must pay the scheduled benefits directly. This can well exceed $100,000 per instance, depending on the injury or illness.
 
PLAYING IT SAFE
When in doubt about how to classify a worker, the most conservative approach would be to classify him or her as an employee. It is always advisable to seek professional advice from your attorney when these issues arise. As a matter of law, the business has the burden of proving a worker is an independent contractor. It is also important to note that when a former worker files an unemployment insurance claim, an investigation is automatically triggered by the IRS to determine the status of the worker.
 
The IRS uses the above guidelines to determine proper classification. It will also look to a written contract for independent contractor classification. Any such contract would generally set forth the terms of the relationship between the employer and the individual, and may include:
  • A statement that the independent contractor is not entitled to employee benefits programs;
  • A joint severability clause stating that if part of the contract is struck down, the rest of it survives; and
  • Acknowledgment that the independent contractor is free to work elsewhere at any time.
A contract between the employer and the worker may be immaterial, however, depending on the facts and circumstances of the relationship between the employer and the individual.
 
ACTION STEP:

 

If you are currently engaging independent contractors and are unsure if they are classified correctly, contact us for assistance in sorting through the issues. The IRS has a partial amnesty program for businesses that voluntarily disclose classification issues.

Often, we have clients in our office who tell us that they have a purchase agreement in place, whether it is for a business, a building, or something else.  Naturally, we want to review such agreements for our clients, so we will then ask them for a copy of the agreement.  That is usually when we hear something to this effect:  “Well, we don’t have anything in writing.  We talked about it and shook on it.”  Regrettably, a handshake does not a purchase agreement make.
 
It is always better for our client if they have us prepare the purchase agreement, rather than reviewing a purchase agreement prepared by someone else.  To quote Benjamin Franklin, "[an] ounce of prevention is worth a pound of cure."  This is especially true if the drafter of the agreement is not an attorney.  There is a lot that goes into the substantive preparation of a purchase agreement, no matter what item or asset is being purchased.  There are many considerations and terms that need to be included. A layperson is typically not aware of the key subtleties.  This includes provisions that address items like Small Business Administration requirements, arbitration clauses, venue, default, taxes, and warranties, to name just a few.
 
Another dangerous and often costly mistake made by clients is using form contracts.  Every transaction, especially when dealing with real estate, is highly individual.  Form contracts where the parties simply need to “fill in the blanks” do not work.  They are never specific enough, rarely properly address state law, and often contain extraneous provisions, while missing necessary ones.
 
A lot of times, people are very eager to buy or sell something and they are willing to sacrifice a lot in order to make it happen.  We always warn clients against this line of thinking.  Something that may seem small or trivial now could become extremely problematic in the long run.  We do not want our clients to open themselves up to liability that could come back to bite them years down the road.  An example of this is property tax prorations.  Property tax prorations are quite complex and are capable of shifting the value of the transaction to the seller or the buyer. A client may say, “I will just pay the taxes” without realizing it may be a $10,000 swing.

 

Purchase agreements properly memorialize a transaction and also help to protect both the buyer and the seller.  If a proper purchase agreement is not in place the ramifications for both parties could be extraordinarily costly.

Though you may have heard the phrase “net neutrality” tossed about throughout the past few years or while browsing the Internet, last week’s FCC approval of its network neutrality plan has brought this phrase back to the realm of practical relevance for all Americans.  Net neutrality is the concept that Internet Service Providers (ISPs) should enable access to all content regardless of the source and without favoring or blocking particular products or websites. The first thought that may come to mind as a small business owner is, why should I care about a small drop in the sea of regulatory rules created by a federal agency?  What quickly follows is the realization - I use the Internet and my business relies on it. The question then becomes, how does the FCC’s network neutrality plan affect me and my business?
 
What Net Neutrality Does
As a way of reassurance, individual consumers and small business owners will not likely notice a change from their current Internet service. The idea behind the FCC’s network neutrality plan was more to prevent what could have been, rather than to change the existing Internet framework. Currently, just about every person receives the same access to all lawful content on the open Internet through various ISPs. Almost always, providers stuck to this framework. In some cases, however,providers have prioritized their bandwidth to large companies such as YouTube, Netflix, or Hulu. This meant slower internet speeds for consumers browsing other content and for smaller businesses that did not pay the ISPs to prioritize their data.
 
The network neutrality plan implemented by the FCC prohibits this practice and purports to regulate the Internet as a public utility. This means that consumers have a public right to Internet access once they purchase it, and, much like with electricity and other public utilities, have the ability to complain to the FCC if they suspect abuse by their ISP.
 
What this Means for Small Businesses
In short, net neutrality means that large companies will not be able to prioritize access to their data over that of smaller businesses or other lawful web users who have not paid off ISPs for priority. By way of example, this ensures that your business’ website will be no less accessible than Wal-Mart’s or Microsoft’s and that all lawful content on the Internet receives equal bandwidth from ISPs. In addition, given the Internet’s status as a public utility, the plan also gives the FCC the regulatory power to punish ISPs who are “not acting in the public interest” such as price gouging for services or arbitrarily discriminating in providing their service to customers.
 
This plan is not without opposition, however, and the FCC is likely to be challenged on net neutrality by companies such as Verizon in the not so distant future. By no means is the continued “openness” of the Internet as an inherently equal public space a certainty, however, the FCC’s net neutrality plan is a step in the direction of assuring it stays that way.

Whether the purpose of an agreement is to retain work done by an employee, to protect confidential company information, or to preserve the business of customers, non-compete agreements are an important tool used by many businesses to protect themselves from the actions of a former employee or independent contractor. There is no doubt that a non-compete agreement can be a practical way to protect the interests of your business; however, the protection a non-compete can provide loses its benefit and can potentially harm the company if it is deemed unenforceable. Under Michigan law, a non-compete agreement must:
 
  1. Protect a reasonable competitive business interest;
  2. Be reasonable in duration, geographical area, and type of employment or line of business;
  3. Not be specifically injurious to the public; and
  4. If it contains a liquidated damages clause, that it be reasonable.
 
What Constitutes a Reasonable Competitive Business Interest?
The first objective of a valid non-compete agreement is to identify the business interest that needs to be protected. This means that “cookie cutter” non-competes will rarely work. Instead, the agreement should be narrowly tailored to protect the specific business interest, whether this be a trade secret, customer relationships, or something else specific to the business. Drafting specific non-competes that are tailored to specific circumstances will ensure that the non-compete is not overbroad, which would render it unenforceable.
 
Duration, Distance, and Scope of the Agreement
The duration, geographical area, and type of employment restricted under the non-compete must also be narrowly tailored to protect the business interest mentioned above. Reasonableness depends entirely upon the industry and the nature of the interest. Generally speaking, reasonable duration is somewhere between six months to years; however, if the business interest that is being protected warrants additional duration, it can extend to several years. Similarly, distance and scope are dependent on the industry and the interest seeking protection. For instance, it would be reasonable to restrict a doctor from practicing in pediatric care within Livingston County, but it will almost definitely be unreasonable to restrict a doctor from practicing at all within the state of Michigan. Again, reasonableness dictates an assessment on a case-by-case basis.
 
Non-Competes and Public Injury
Non-competes can be considered unenforceable even if they are reasonable as to the interest to be protected and as to the duration, area, and scope. This occurs when a non-compete, if enforced, would cause detriment to the public. For example, a non-compete that prohibits an oncologist from practicing in Livingston County for six months may be unenforceable for reason of public injury. It may be impractical or impossible for patients needing a very specific type of medical care to see another doctor in the area or to switch doctors in the middle of treatment. This is not true for most agreements; however, it is another pitfall to be aware of when drafting a non-compete.
 
Should I use a Liquidated Damages Clause?
Liquidated damages are an amount the parties designate during the formation of a contract if one of the parties breaches the contract.  A liquidated damages clause, while not a necessary component of a valid non-compete, is a completely valid option if used properly. Liquidated damages clauses are often misused and are thus struck from the non-compete. First, a liquidated damages clause must be a reasonable assessment and not excessive given the injury suffered. Another way to put this is the purpose of the liquidated damages clause must not be to act as a penalty, but rather to be a reasonable assessment of damages to the business in the event of a breach. Additionally, these clauses have been enforced by Michigan courts only if damages are uncertain, difficult to ascertain, or purely speculative in nature. These provisions are most likely valid in employment situations, where the damage of an employee violating the non-compete is almost impossible to quantify.
 
The proper use of a non-compete agreement still remains an effective tool that a savvy business owner has at his or her disposal to protect the interest of their business. It is of great importance, however, to ensure that the document is prepared by a competent attorney. A non-compete is useless if it is unenforceable.

One of the most interesting and amusing cases on the docket for the U.S. Supreme Court this coming term has some fishy implications. In Yates v. United States, the Supreme Court will contemplate the application of 18 U.S.C. § 1519, a provision of the Sarbanes-Oxley Act, to the alleged destruction of evidence in violation of this provision by a commercial fisherman.
 
What is the Sarbanes-Oxley Act?
The Sarbanes-Oxley Act or “SOX” was enacted in late 2002 in the wake of several large-scale accounting fraud scandals in the early 2000s, which involved high profile corporations such as Enron, Tyco, and WorldCom and the Arthur Andersen Accounting Firm. SOX was enacted with the broad purpose of protecting investors from the fraudulent acts of accounting firms and businesses. The act requires these companies and firms to adhere to stricter standards regarding their financial information and documents. One of the many ways this goal is achieved is the broad prohibition against the knowing destruction of any tangible objects with the intent to impede an investigation under §1519 of SOX.
 
Why does SOX matter?
While largely in place to regulate public companies, SOX has several provisions that apply to private companies as well. Section 1519 of the Act, regarding liability for the destruction of records, documents, or tangible objects is one of these provisions. Thus, §1519 is applicable to every company, whether public or private, large or small.
 
How does SOX apply to Yates?
Yates, a commercial fisherman and boat captain was issued a citation by a Florida wildlife deputy for catching fish that were smaller than legal size. Upon receiving a citation for the undersized fish and being directed to return to shore, Yates ordered his crew to throw the fish overboard in an attempt to thwart the investigation into the violation, and for all practical purposes, to destroy the evidence. At trial, Yates was found guilty under §1519 of SOX for destroying or concealing a “tangible object with intent to impede, obstruct, or influence” the government’s investigation into his catching of undersized fish. On appeal, the 11th Circuit affirmed this conviction, stating that a fish is, in fact, a “tangible object” under the plain meaning of §1519. Thus, the ultimate question for the Supreme Court is whether, under the plain meaning of §1519, a fish is a “tangible object”, or if §1519 simply applies to tangible objects relating to recordkeeping materials, such as computers or storage drives.
 
What are the Implications of Yates?
Due to the importance of SOX from a regulatory standpoint, the outcome of Yateshas implications for businesses of all types and sizes, not just those who happen to be commercial fishermen. If the Supreme Court affirms the ruling of the 11th Circuit, it would strengthen the overall power of SOX and, in turn, increase its regulatory power over public and private businesses. More narrowly, if throwing away fish is deemed equivalent to shredding a document, businesses will need to be much more careful with what they throw away.