HRMN 408 Week 8: Considerations for HR Professionals

The Employment Relationship

CHAPTER 1

• Overview

• Employees, Independent Contractors, and Agents

• Statutory Employees and Nonemployees

• Joint Employers

• The Employment-at-Will Doctrine

• Employment Contracts

• Indemnity Obligations

• Arbitration Agreements

• Business Owners’ Employment Status

C o p y r i g h t 2 0 1 7 . S o c i e t y F o r H u m a n R e s o u r c e M a n a g e m e n t .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Book: The SHRM Essential Guide to Employment Law : A Handbook for HR Professionals, Managers, Businesses, and Organizations. Author: Charles Fleischer Date: 2017

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The SHRM Essential Guide to Employment Law2

OVERVIEW The employment relationship is a mutual, voluntary arrange- ment between two parties. The employer—which may be a corporation, some other entity, or an individual—voluntarily agrees to pay the employee in exchange for the employee’s work.

The employee—who is always an individual—voluntarily agrees to work for the employer in exchange for pay.

The relationship is voluntary in the sense that the law does not force anyone to work for a particular employer. The 13th Amendment to the U.S. Constitution declares that “neither slavery nor involuntary servitude … shall exist within the United States.” As implemented by the Congress, the 13th Amendment prohibits forced labor through use of physical restraints, threats of physical harm, or threats of legal action. The prohibitions against forced labor also protect persons from compulsory work to pay off a debt—sometimes called peonage or indentured servitude.

The United Nations International Labour Organization (ILO) has adopted the ILO Declaration on Fundamental Prin- ciples and Rights at Work, to which the United States subscribes. The declaration states that all member nations have an obliga- tion to respect four fundamental rights:

• “freedom of association and the effective recognition of the right to collective bargaining;

• the elimination of all forms of forced or compulsory labour; • the effective abolition of child labour; and • the elimination of discrimination in respect of employment and occupation.”

Although the employment relationship is voluntary from the employer’s viewpoint, in that the employer usually has no obli- gation to employ anyone in particular, in limited circumstances an employer can be forced to hire or re-employ a particular individual as a remedy for discriminating against that individ-

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The Employment Relationship 3

ual or violating that individual’s rights under a protected leave law, such as the Family and Medical Leave Act (FMLA).

The employment relationship is often thought of as a contract between employer and employee. However, it usually does not take the form of a typical bilateral (or mutual) contract, in which each party makes a promise to the other, such as, “I promise to deliver goods to you next week if you promise to pay me $1,000 in 30 days.” Instead, the employment relationship usually takes the form of a unilateral contract, in which only one party (the employer) makes a promise, such as, “If you come work for me, I will pay you $12 per hour.” The employee usually does not promise to work. He or she just shows up, works, and becomes entitled to the promised pay. Mutual employment contracts are discussed in more detail on the following pages.

EMPLOYEES, INDEPENDENT CONTRACTORS, AND AGENTS An employer’s workforce can be classified broadly as employees and independent contractors. An employee and an independent contrac- tor may or may not be an agent of the employer, depending on the authority given by the employer to obligate the employer to contracts.

Employees An employee is someone whose manner of work the employer has a right to control, even if the employer does not actually exercise that control. An entry-level file clerk will likely be subject to close, daily, or even hour-by-hour supervision and is therefore an employee. So, too, is the president of a large corporation, not because he or she is closely supervised, but because the corporation’s board of directors has the right to control his or her work. This right to control is illustrated by the outdated legal terms master and ser- vant used historically to describe the employment relationship.

True employees (as distinguished from independent contractors) are sometimes known as W-2 employees, referring to the Forms W-2 issued to them for federal income tax purposes.

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The SHRM Essential Guide to Employment Law4

Vicarious Liability As a matter of public policy, the courts hold employers vicariously liable for injuries or property damage caused by their employees if the injury or damage occurred during the course and scope of the employee’s employment. This is sometimes referred to as the doctrine of respondeat superior—a doctrine requiring the superior (the employ- er) to respond (by paying damages) for the conduct of its employee.

Normally, such liability is imposed when the employee acts neg- ligently, such a causing a car accident while driving on the job. But vicarious liability may be imposed even if the employee intentionally causes the injury, so long as the employee acted with the intention to benefit his or her employer and the employment relationship enabled the employee to cause the injury. An example might be a store clerk who physically restrains a customer wrongfully suspected of shoplifting.

Negligence and intentional misconduct that cause injury or damage are referred to in the law as torts—French for wrongs.

Independent Contractors An independent contractor, in contrast to an employee, is someone you engage to perform a certain task, but whose manner of work you do not have a right to control. Good examples are professionals, such as outside lawyers or accountants, and trades persons such as electricians and plumbers. In each of these examples, the independent contractor’s work is governed by professional standards, state and county codes, and the like, with which you are probably not familiar. Your lack of familiarity is precisely why you engage an independent contractor instead of doing the work yourself or having one of your employees do it.

Certainly you can tell your independent contractor what it is you want done, and you remain free to dismiss him or her if you do not like the work. But it is the result you are interested in; the manner in which that result is accomplished is up to the independent contrac- tor and is not subject to your control.

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The Employment Relationship 5

Unlike an employee, an independent contractor generally cannot impose vicarious (tort) liability on his or her employer.

ALERT! Whenever a worker’s status as an independent contractor could reasonably be ques-

tioned, the safest course is to treat that worker as an employee.

Independent contractors are issued Forms 1099 to report income for federal tax purposes, as opposed to Forms W-2 issued to employees. Unlike employees, independent contractors are not subject to income and payroll tax withholding.

Employers sometimes try to classify their workforce as inde- pendent contractors, rather than employees, in an effort to avoid being subject to laws and regulations that apply to employees. In response, the various regulatory agencies, such as the Internal Rev- enue Service (IRS), the U.S. Department of Labor (DOL), the Equal Employment Opportunity Commission (EEOC), the Occu- pational Safety and Health Administration (OSHA), state wage and hour departments, workers’ compensation commissions, and unemployment insurance administrators, have adopted complex tests—that differ from agency to agency—to distinguish employ- ees from independent contractors. These tests tend to be biased in favor of an employer-employee relationship—that is, in favor of finding that the person is covered by the particular employment law or regulation the agency is charged with enforcing. (Tax issues relating to independent contractors are discussed in Chapter 7. See “Contingent Workers” in Chapter 20 for more details about the independent contractor relationship.)

The consequences of misclassifying an employee or a group of employees as independent contractors can be expensive. For exam- ple, the employer might be held liable for income taxes that should have been withheld, but were not, wage and hour violations, retro- active coverage under employee benefit plans, back pay, penalties, statutory damages, and interest.

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The SHRM Essential Guide to Employment Law6

QUICK TIP Some workers are required by law to work under another’s supervision. This is true,

for example, in various health care professions. Even though the worker may otherwise

qualify as an independent contractor, the duty to be supervised may convert the worker

into an employee.

Agents An agent is someone you authorize to make contracts on your behalf and to bind you to those contracts. Employees can be agents, but employees do not automatically become agents; it depends on what, if any, additional authority you give them. For example, if you told your employee to take a computer to the shop and make arrangements to have it repaired, you have given your employee authority to act as your agent. When he or she signs a work order in your name, you as the principal, not the employee, will have to pay the repair bill.

Similarly, an independent contractor can be, but is not necessarily, an agent. When you engage a landscape architect to prepare a design for the grounds around your new office building, the architect is an independent contractor but not an agent. However, when you then authorize the architect to buy plantings, he or she becomes your agent as well and has the power to obligate you in contract to the nursery.

STATUTORY EMPLOYEES AND NONEMPLOYEES Some laws classify workers as employees or independent contrac- tors regardless of the employer’s right of control or lack of control over the manner in which the work is done.

For payroll tax purposes, the Internal Revenue Code classifies the following four categories of individuals as statutory employees even though they could be independent contractors under the common-law test:

• a delivery driver (other than one who delivers milk) • a full-time life insurance agent • an individual who works at home on materials or goods supplied by the employer

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The Employment Relationship 7

• a full-time salesperson who sells merchandise for resale or for use in the buyer’s business operation

The Internal Revenue Code classifies the following individuals as statutory nonemployees for all federal tax purposes:

• direct sellers of consumer products in the home or a place of business other than a permanent retail establishment

• licensed real estate agents • companion sitters who are not employed by a companion sitter placement service

Workers’ compensation statutes, unemployment insurance stat- utes, and other laws also state who does or does not qualify as an employee for purposes of the statute.

JOINT EMPLOYERS In a number of situations the law considers an employee to be joint- ly employed by two or more employers. As a result, both employers may be liable for discrimination or unfair labor practices, obligated to pay overtime and withhold and remit payroll taxes, or provide workers’ compensation or other benefits.

A common example of joint employment is the staffing firm that leases an employee to another business. If the business directs the staffing firm to replace the leased employee based on the employ- ee’s race or age and the staffing firm does so, both the business and the staffing firm will be liable for discrimination.

In another example, suppose a nurse’s aide works for two sepa- rate nursing homes that are owned in part by the same individuals. The total hours she works for both nursing homes may be aggre- gated in determining whether she is entitled to overtime.

In the construction industry, a prime contractor may engage a subcontractor, who in turn provides employees to the job site. If those employees perform work both for the subcontractor and the prime contractor, they may be deemed jointly employed by both

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The SHRM Essential Guide to Employment Law8

entities. Similarly, franchisers may be considered as joint employers of their franchisees’ employees.

In the 2015 decision in Browning-Ferris Industries of Califor- nia, Inc., the National Labor Relations Board (NLRB) expanded its definition of joint employment in determining what constitutes an appropriate bargaining unit for union representation purposes. According to the NLRB, in evaluating whether an employer pos- sesses sufficient control over employees to qualify as a joint employ- er, the board considers whether an employer has exercised control over terms and conditions of employment indirectly through an intermediary or whether it has reserved the authority to do so. As of this writing, the case is on appeal to the U.S. Court of Appeals for the D.C. Circuit. (Unions and labor relations are discussed in more detail in Chapter 24.)

In Salinas v. Commercial Interiors, Inc., the U.S. Court of Appeals for the 4th Circuit (headquartered in Richmond, Va.) ruled that joint employment exists when two or more entities “share, agree to allocate responsibility for, or otherwise co-determine—formally or informally, directly or indirectly—the essential terms and conditions of a worker’s employment.” The Court went on to list a number of factors to be considered in determining that question.

As these cases indicate, joint employment remains a developing legal area and is becoming more common given the growing variety of business models and labor arrangements. It should also be noted, however, that the DOL under the Trump administration has with- drawn a 2015 administrator’s interpretations that offered an expan- sive view of joint employment.

THE EMPLOYMENT-AT-WILL DOCTRINE Most employment is at will. That means there is no fixed period of time that the employment relationship will last, and either party is free to terminate the relationship at any time, with or without cause. In other words, the employer may fire, or the employee may quit, for any reason or for no reason at all.

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The Employment Relationship 9

In almost all states, there is a presumption that any particu- lar employment relationship is at will. The presumption applies unless it is shown that employment for a specific period of time, such as two years, was intended. The fact that the employer and the employee intended the relationship to last a long time or for an indefinite period does not overcome the presumption of at-will employment, since in almost all cases the parties hope (at least at the outset) that the relationship will last a long time or indefinitely. An employer’s promise of work for as long as the job exists and for as long as the employee wants it is nothing more than indefinite, at-will employment. Even so-called perma- nent employment is still employment at will (although employ- ers should not use the term permanent when intending only an at-will relationship).

An important corollary of the at-will doctrine is the implied covenant of good faith and fair dealing. In most states, every contract is presumed to contain that implied covenant, requir- ing parties to the contract to act reasonably toward each other. However, the covenant is generally not implied in the normal at-will employment arrangement, since the covenant depends on the existence of an employment contract with a definite term. (A handful of states do recognize the covenant in an at-will employ- ment relationship.) It follows, at least in theory, that an employ- er may treat at-will employees unreasonably and may fire them without cause, although it is seldom good practice to do so.

The at-will employment doctrine has five important exceptions: • the employment contract exception (discussed later in this chapter)

• the abusive discharge exception (see Chapter 4) • the exception for protected leave (see Chapter 8) • the discrimination/retaliation exception (see Chapters 14 through 17)

• the exception for collective bargaining agreements (see Chap- ter 24)

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The SHRM Essential Guide to Employment Law10

When one of these exceptions applies, discharging an at-will employee may result in a lawsuit, an award of money damages against the employer, or an order that the employer reinstate the employee.

EMPLOYMENT CONTRACTS An employment contract (more accurately, a mutual employment contract) is an agreement between the employer and the employee that the employment relationship will last for a fixed, definite period of time or that the relationship can be terminated only for cause or under specified conditions. Employment contracts should be in writing, since oral contracts that cannot be performed within one year are generally unenforceable according to the statute of frauds. Even if an oral contract of employment is enforceable, it can give rise to misunderstandings, and its provisions are difficult to prove.

The contents of any particular employment contract depend on the circumstances. A typical contract might include provisions dealing with the following:

• job description, including employee duties and authority • whether the position is exempt or nonexempt under the Fair Labor Standards Act

• beginning date and term of the contract and any extensions • compensation arrangements • bonuses and equity, such as stock options • health and other benefit plans • other fringe benefits, such as a company car or an expense account

• exclusivity, such as no moonlighting or no conflicts of interest during term

• vacation and sick leave arrangements • grounds for early termination, such as death, disability, revoca- tion of a required license, or dishonesty

• confidentiality and trade secrets • ownership of intellectual property, such as copyrightable and patentable works or inventions

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The Employment Relationship 11

• noncompetition and nonsolicitation of customers and fellow employees after termination

• liquidated damages for breach by employee • waiver of jury trial or arbitration of disputes, along with prohibi- tion on participating in class or collective actions

• indemnification • choice-of-law provision • choice-of-forum provision • abbreviated statute of limitations

In most cases, the employer wants to preserve an at-will employ- ment relationship and avoid being bound by an employment con- tract or by any implied covenant of good faith and fair dealing. This would be true, for example, in the case of lower-level employees who can be replaced fairly easily. However, in a tight labor market in which qualified employees are difficult to find, the employer may want the protection of an employment contract. The employ- er might also want contract protection for employees in whom costly training is being invested, for employees who have access to closely guarded company secrets, or for employees who have unusual or complicated compensation arrangements.

An employee may want the security of a contract when, for example, the employee is resigning from a stable position to take a job with a start-up company or making a costly move to the new employer’s headquarters. Whether the employer gives a contract in those circumstances depends on the employee’s bargaining power and worth to the new employer.

Choice-of-law and choice-of-forum provisions are particularly helpful to large, multistate employers, which might otherwise be subject to conflicting state laws. They allow the employer to specify which state law will govern the employment contract and which court will hear any disputes that arise under the contract. The employer might, for example, specify the law of the state and the courts of the state where its headquarters are located or where most of its employees work. So

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The SHRM Essential Guide to Employment Law12

long as the employer’s choices are reasonable and do not impose an undue burden on the employee, most courts uphold these provisions.

Some employment contracts also seek to shorten the time within which an employee may bring suit against the employer. If state law specifies a three-year statute of limitations, the contract might short- en that time limit to, say, 18 months. While these types of provisions are controversial, some courts have upheld them.

Fill-in-the-blank contract forms are available from commercial publishers. Electronic forms can even be purchased or downloaded from the Internet. But if the employment relationship is important enough to justify a contract in the first place, it should be important enough to justify a consultation with employment counsel to be sure the contract fits the particular circumstances and conforms with state and local law.

Implied Contracts Although the parties may not have explicitly intended to enter into an employment contract, the employer’s actions can inad- vertently bind the employer to the same extent as if there were a written, signed agreement. Some courts have found, for example, that an employee handbook amounts to an employment contract, even though no contract was actually intended. Even the wording of a simple employment letter can create a contract if it implies that a specific time period is contemplated. Consider this letter:

We are pleased to offer you the position of sales manager beginning January 1. Your base salary will be $50,000 per year, increasing to $60,000 your second year, and $70,000 your third year. You will also earn an override commission of 2.5 percent on all sales.

We have already made definite plans to expand our market into the southeastern states over the next three years. By the end of the third year, sales should reach $1.5 million, which translates to a commission to you of $37,500. We are counting on you to take the lead

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The Employment Relationship 13

in these expansion plans, and we have every confidence that, with you at the helm of our sales department, we will reach our goal.

While the letter does not exactly promise a three-year arrange- ment, it certainly implies that the sales manager should expect to stay that long. Couple that with the sales manager’s own testi- mony that he was indeed promised three years, and the employer might find itself bound to such a contract.

Breach of Contract When employer and employee have agreed that the employment will last a fixed period of time, or that the employment can be ter- minated only for specified reasons, the courts generally enforce such an agreement by awarding money damages for its breach. If the employer breaches, it may be liable not only for the compensation the employee would have earned but also for fringe benefits such as health insurance, pension plan contributions, and stock options.

If the employee breaches, damages are more difficult to measure, since it is not easy to quantify just how a particular employee’s performance would have affected future profitability. Absent a liq- uidated damages provision (a provision that specifies in advance the amount of damages to be recovered), the employer’s claim might be limited to employment agency fees, employee relocation costs covered by the employer, and any license or similar fees paid by the employer on the employee’s behalf. Remember that a court will not order the employee back to work since such an order would violate the Constitution’s involuntary servitude clause.

ALERT! Even in employment-at-will situations, the employer may be held liable for misrepre-

sentation if an employee is induced to accept work based on false or incomplete repre-

sentations as to the conditions of employment. (See Chapter 2 for more on fraud and

misrepresentation during the hiring process.)

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The SHRM Essential Guide to Employment Law14

INDEMNITY OBLIGATIONS In an indemnity agreement, one party agrees to protect the other party from claims by third parties. For example, a physi- cian employed by a hospital might agree to indemnify the hospital from malpractice claims by the physician’s patient. Or a business corporation might agree to indemnify its senior management from claims by shareholders or other employees. Such an agreement serves, in effect, as private insurance between the parties.

Whether an indemnity provision will be included in an employ- ment contract and, if so, who will be indemnifying whom, are mat- ters of negotiation between the parties. A highly desired candidate, for example, might insist on being indemnified as a condition to accepting a job offer. On the other hand, a candidate with little bargaining power may have no choice but to agree to indemnify his or her employer to get the job.

Even absent an indemnity provision in an employment contract, the employer may have an indemnity obligation to some or all of its employees under state corporation law or under provisions of its corporate charter or bylaws.

ALERT! An indemnity provision in an employment contract or in corporate documents exposes the

employer to a risk of substantial liability. The employer should therefore carry adequate lia-

bility insurance and be sure that the potential indemnity obligation is covered by the policy.

ARBITRATION AGREEMENTS Arbitration of disputes is often viewed as preferable to litigation. Arbi- tration is generally faster and cheaper; it involves only limited pretrial discovery, the proceedings take place in private, and the results are usually final and unappealable. Since arbitration means no jury trial, an employer that fears a runaway jury and a runaway damage award may view arbitration as a highly desirable alternative to litigation.

Both the Federal Arbitration Act (FAA) and its state counter- parts say that a contract provision for resolution of future disputes

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The Employment Relationship 15

by arbitration is valid and enforceable. The courts have gone so far as to rule that the law favors arbitration and that when a contract contains an arbitration clause, a presumption arises that all disputes relating to the contract must be arbitrated. These principles have been applied to labor disputes under collective bargaining agree- ments and to employment disputes in the securities industry, in which arbitration clauses have been common for years. Arbitration provisions are now finding their way into more and more con- tracts, including routine employment agreements.

QUICK TIP A pre-dispute arbitration agreement—that is, an agreement to arbitrate made at the

outset of employment or at some other time before a dispute has arisen—should

be distinguished from an agreement to arbitrate made after a dispute has arisen.

Courts almost always enforce a post-dispute arbitration agreement that is entered

into knowingly and voluntarily. Enforcement of a pre-dispute arbitration agreement,

however, may be open to a variety of objections, such as unfairness or lack of true

consent.

For some time, there was a question whether an employee could be forced to submit federal statutory claims to arbitration. Suppose an employer routinely requires employees, as a condi- tion of employment, to sign an agreement that subjects all future employment-related disputes to binding arbitration, including discrimination claims based on the various federal nondiscrimi- nation statutes. Under the principle that statutory rights cannot be waived in advance, some federal courts initially ruled that an employee would not be bound by such an agreement, made in advance of any dispute.

The Supreme Court, which is the ultimate authority on interpre- tation of federal law, resolved the question in March 2001. In a deci- sion involving an employee of an electronics store in California, the court ruled that an agreement to arbitrate discrimination claims was valid and enforceable under the FAA. The court went on to praise

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The SHRM Essential Guide to Employment Law16

arbitration agreements in the employment context, because of the smaller sums of money normally involved.

The EEOC, which opposes binding arbitration of discrimina- tion claims, will not stay its own hand in investigating or attempt- ing to resolve a discrimination charge just because the parties have entered into an arbitration agreement. In a 2002 case, an employ- ee of a chain restaurant was fired from his short-order cook job when the restaurant learned he suffered from seizures. In response to the EEOC’s suit for violations of the Americans with Disabilities Act (ADA), the restaurant argued that the employee had signed a pre-dispute arbitration agreement that barred the EEOC’s suit. The Supreme Court upheld the EEOC’s suit, saying the EEOC has an independent statutory right to pursue whatever remedies it feels appropriate that included not only injunctions against future violations but also victim-specific relief such as reinstatement and back pay.

Nor can an arbitration agreement, or any other agreement for that matter, prevent an employee or former employee from filing a charge of discrimination with the EEOC or a state fair employment practices agency.

Arbitration may not always be cheaper than litigation. There are often significant filing fees just to initiate arbitration. And while judges are provided by the government without charge, arbitrators typically charge substantial hourly rates payable by the parties.

Some employers have tried to shift the burden of arbitration costs to the employee, so that the employee ends up paying far more to arbitrate than he or she would in a court suit. Other employers have drafted arbitration agreements that are so one-sided in favor of the employer as to be fundamentally unfair to the employee. Decisions by a number of federal appellate courts have refused to enforce such agreements, ruling that any attempt to burden an employee with excessive costs or to give employers unfair procedural advantages is a denial of the employee’s statutory rights.

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The Employment Relationship 17

QUICK TIP For companies that require employees to sign noncompetition or nonsolicitation con-

tracts, an arbitration agreement should have an exception allowing the employer to go

to court for an injunction to bar an employee’s or former employee’s violation of the

contract.

Arbitration provisions should not be placed in the employee handbook, since the employee handbook is not intended to be a contract of employment. (However, the handbook may mention the fact that an employer has an arbitration-of-disputes policy.) For those employees with whom the employer has a formal contract of employment, the arbitration provision would be included there. For at-will employees, the employer should use a separate written doc- ument, dated and signed by the employee, that contains both the desired arbitration provision and a disclaimer to the effect that the arbitration provision is not a contract of employment and does not change the at-will status of the employee.

Despite the Supreme Court’s blessing, legal issues involving pre-dispute arbitration agreements continue to arise, particularly in the area of fairness and cost-shifting. To help ensure their validity, arbitration agreements should do the following:

• contain a clear and unmistakable waiver of the employee’s right to go to court and specify that arbitration is final and binding

• specifically identify the types of potential claims that the employer intends to submit to arbitration—claims under Title VII of the Civil Rights Act, the ADA, the Age Discrimination in Employment Act (ADEA), the FMLA, state human rights and fair employment practices acts, county and local nondiscrimination laws, claims for abusive discharge, pay disputes, etc.

• provide for a neutral arbitrator, not one who is affiliated with the employer or who regularly hears disputes involving the employer

• allow at least minimal discovery • not burden the employee with costs in excess of those he or she would incur in court

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The SHRM Essential Guide to Employment Law18

• be balanced, fair to both sides, and not attempt to give the employer any procedural advantages

• be binding on the employer as well as the employee (that is, it should not obligate the employee to arbitrate while giving the employer the option of arbitrating or not)

• not attempt to take away any of the employee’s substantive statu- tory rights or limit an employee’s statutory remedies

• require the arbitrator to issue a written award

With increasing frequency, employers are including class- and col- lective-action waivers in arbitration agreements in an effort to pre- vent employees from participating with a large group of plaintiffs. Class and collective actions allow individual plaintiffs to aggregate their claims into one lawsuit or arbitration proceeding when each individual claim may be economically too small to pursue.

In AT&T Mobility LLC v. Concepcion, the U.S. Supreme Court held that class-action waivers are enforceable in the context of a dis- pute between a business and a consumer. However, the National Labor Relations Board takes the view that in the employer-employ- ee context, such waivers violate employees’ rights under the Nation- al Labor Relations Act (NLRA). (See Chapter 24 for more on the NLRA.) As of this writing, the issue is before the U.S. Supreme Court in NLRB v. Murphy Oil USA, Inc.

BUSINESS OWNERS’ EMPLOYMENT STATUS Business can be conducted in a variety of forms, from the sole proprietorship to the publicly held, multinational corporation. In between are general partnerships; small or closely held corpora- tions that have elected S status for federal income tax purposes (S corps), limited liability partnerships (LLPs), limited liability companies (LLCs), and professional corporations (PCs).

The right choice of business entity goes beyond the scope of this book. This section is concerned with the status of business owners who also work for the entity they own. Are they con-

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The Employment Relationship 19

sidered employees of the entity? And what liability do they have for entity obligations or the negligence of other employees? The answers depend on the specific type of entity involved and on certain tax elections available to those entities.

Sole Proprietorships A sole proprietorship is a business owned by a single individual in his or her individual name. While a sole proprietor can have employees, he or she is considered self-employed and can never be an employee of the business. Sole proprietors report their business income and expenses on Schedule C of Form 1040 for federal income tax purposes.

Sole proprietors are personally liable for their own negligence, and, as employers, they are vicariously liable for the work-related negligence of their employees. They are also personally liable for the business’ obligations, such as wages, lease payments, business loans, and vendor invoices. For liability reasons, a sole proprietor- ship is usually not a recommended form for doing business.

General Partnerships A general partnership is a group of individuals who share profits and losses of the partnership’s business. Partnerships are treated as separate entities for some purposes and as pass-through entities for other purposes. For example, a partnership can have employees (other than the partners themselves), and it files its own income tax returns. However, partnerships generally do not pay any income tax. Instead, any net income or loss shown on the partnership return is allocated to the partners according to the partnership agreement. Partners pay tax on their allocated share (as shown on Schedule K-1 (Form 1065) that the partnership issues to them) whether or not net income has actually been distributed to them in cash. Partners are considered to be self-employed.

Partners are personally liable for partnership obligations, just like sole proprietors. Also, each partner is considered the agent of each other partner and is personally liable for the negligence and

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The SHRM Essential Guide to Employment Law20

contractual obligations of each partner. (Think of a partner as a sole proprietor with multiple personalities.) This is the main reason for the popularity of S corps and, more recently, LLPs and LLCs.

S Corporations An S corporation, or S corp, is just like any other corporation formed under state law, but it has elected S status for federal income tax purposes. (The S refers to the Internal Revenue Code subchap- ter that permits the election.) As a result, it is treated much like a partnership for federal income tax purposes, yet it retains the limited liability features of a corporation. An owner of an S corp is considered self-employed and gets a Form K-1, just like a part- ner in a partnership. However, there is no personal liability for corporate obligations or for the negligence of other employees or co-owners. Because they have characteristics of both corporations and partnerships, S corps (along with LLPs and LLCs) are some- times called hybrids.

S corp status is available only to small business corporations with one class of stock and fewer than 100 shareholders. Only individu- als, decedent’s estates, and some types of trusts can be shareholders. Partnerships and other corporations cannot own stock in an S corp.

Limited Liability Partnerships and Limited Liability Companies Owners of an LLP (who are called partners) and owners of an LLC (who are called members) are the equivalent of partners in a general partnership for tax purposes. Therefore, they are normally considered self-employed and they get year-end K-1 forms show- ing their taxable shares of LLP or LLC profits. However, LLPs and LLCs (or any other entity treated as a partnership under state law) may take advantage of the IRS’s check-the-box rule and elect to be taxed as corporations. Worker-owners would then be treated as employees, as with any other corporation.

Regardless of an LLP’s or LLC’s status for tax purposes, its partners or members have no personal liability for obligations of

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The Employment Relationship 21

the LLP or LLC, or for the negligence of other partners, mem- bers, or employees.

QUICK TIP Small businesses with only a few owners may find it advantageous to organize as LLCs

and then elect to be taxed as S corps. This arrangement enjoys simplicity of organization,

pass-through tax status, and protection of owners from personal liability. In addition, it

allows an income tax deduction for the employer’s portion of FICA due on compensation

paid to owner-employees. Had the LLC not elected corporate taxation status, all compen-

sation to owner-employees would have been subject to self-employment tax for which

no deduction is available.

Professional Corporations Traditionally, professionals like doctors, lawyers, and accountants were only permitted to practice as sole proprietors or as partnerships. The fear was that if they practiced in corporate form, their profes- sional judgment would be compromised by being subjected to the wishes of a corporate board of directors. At the same time, however, federal income tax law (particularly regarding pension plans) strong- ly favored corporations over partnerships. So professionals brought pressure on state legislators and licensing boards to allow them to incorporate. The result was the professional corporation (PC).

QUICK TIP Depending on a variety of factors, owners of a professional corporation may or may not

be counted as employees for federal nondiscrimination law purposes. In Clackamas Gas-

troenterology Associates, P.C. v. Wells, the Supreme Court applied the common-law test

of whether the employer controls the means and manner of the workers’ performance in

determining whether the physician-shareholders in a medical practice should be counted

as employees.

PCs are in every respect true corporations under state law. An owner who works for the PC is usually classified as an employee for tax purposes and receives a Form W-2 at year-end, just like employ-

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The SHRM Essential Guide to Employment Law22

ees of other corporations. (PCs can elect S corp status in which case owners are treated as self-employed for federal tax purposes.) How- ever, only licensed members of the particular profession for which the PC was organized can be shareholders, directors, and officers.

Professionals who work for a PC are personally liable to their cli- ents for professional negligence, regardless of their status as employ- ees for other purposes. But the good news is that they are not personally liable for the negligence of their fellow professionals—a liability they would have if they had organized in partnership form.

C Corporations Large businesses have little choice in their type of entity. To participate effectively in capital markets they must organize in corporate form. They also cannot qualify as S corps under the Internal Revenue Code because they have a broad shareholder base, and perhaps several classes of stock. C corp shareholders may work for the corporation but they have no special status as shareholder-employees. Both the president who owns 10,000 shares and the janitor who owns 10 shares get Forms W-2, and neither is generally liable for corporate obligations or the negligence of fellow employees.

QUICK TIP Although sole proprietors and partners are considered self-employed, many workers’

compensation statutes allow them to opt in and obtain coverage. Conversely, while

members of LLCs and corporate officers are covered by workers’ comp statutes, they are

often permitted to opt out of coverage. (Workers’ compensation insurance is discussed

in Chapter 11.)

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