The Letter of the Law: September 2012
IN THIS ISSUE:
As an employment lawyer representing employers, this is one of the most frequently asked questions I get from my clients.
The short and safe answer is, “No.” California has a strong public policy not to impede its residents’ ability to work and make a living. California Business and Professions Code section 16600 provides that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”
To that end, California courts consistently rule that covenants not to compete are unenforceable. A covenant not to compete can be worded a million different ways, but the intent of the clause is that if an employee leaves his employment, he or she cannot go work for an employer’s competitor. Many times these clauses put mileage restrictions, such as the employee cannot work with a competitor within 100 miles of the business; or time restraints, such as two years. Regardless, just because you may think that the restrictions are not oppressive, a California court of law will most likely invalidate the provision.
With covenants not to compete being unenforceable in California, it goes without saying that employers may not force their employees to sign non-compete agreements. If employers make signing such an agreement a condition to continued employment, they face liability for wrongful termination and suits from subsequent employers for unfair competition.
There are several exceptions to the general rule against enforcement of covenants not to compete. California Business Code section 16601 permits a buyer of a business interest to enforce a covenant not to compete against the seller. Specifically, any person who sells the goodwill of a business or any owner selling or otherwise disposing of all of his ownership interest or operating assets in that business, may agree with the buyer to refrain from carrying on a similar business within a specified geographic area, so long as the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business in that area.
The second and third exceptions involve the dissolution of a partnership or limited liability corporation (“LLC.”) Generally, a partner leaving the partnership, or a member of an LLC, can voluntarily agree not to compete with the existing partnership or LLC if the entity is going to continue to conduct business. The departing partner or member can agree to time and geographic constraints. This agreement has to be entered into voluntarily. (Bus. & Prof. Code sections 16602 and 16602.5)
For those employers that are panicking right now because you have an employment agreement or employee handbook that has a covenant not to compete provision in it, do not fret. Most courts will not invalidate the entire agreement if there is a non-competition clause. The best course of action is to remove the provision from any existing contracts or employee handbook. You can do this via an addendum or some other writing that makes it clear that the covenant not to compete is no longer a provision to the handbook or contract.
Does including a covenant not to compete in an employee handbook invalidate the entire handbook? No.
Contractors routinely face a number of liability threats as a cost of doing business. One that is occasionally overlooked is the threat of “alter ego” liability. Are you the alter ego of your company? And what does that mean exactly? Under the law of most states, it means that you could be held personally liable for the debts or liabilities of your corporation or limited liability company if a plaintiff is able to satisfy certain legal requirements. Most likely, your intent in setting up a separate corporation or LLC was to avoid that kind of responsibility. It pays, therefore, to know a bit about the law of alter ego liability.
Under California law, alter ego liability will be imposed where two conditions are met: (1) there is such a unity of interest and ownership that the separateness of the individual (or another entity) and the business entity has ceased; and (2) recognizing the business entity as being separate from the individual (or other entity) would, under the particular circumstances, “sanction a fraud or promote injustice.”
The meaning of the above standard is subject to considerable judicial interpretation and, as is often the case in litigation, the courts assess a variety of factors in deciding whether to impose liability on an alleged alter ego. The factors are numerous and the case law is not always consistent. Moreover, alter ego liability can be imposed where some of the factors, but not others, are present. Nonetheless, most alter ego cases have at their core an allegation that the defendant has failed to maintain proper separation between his or her personal affairs (or the affairs of another owned business entity) and those of the company being sued.
Here are a few simple guidelines for contractors and other business owners (including members of a California limited liability company) seeking to avoid the prospect of a personal judgment for the obligations of a corporation or LLC:
- Observe all corporate formalities. Devote the necessary time and attention to this task. It will be well worth it in the long run.
- Never commingle assets (or liabilities) . Maintain separate bank accounts and keep them separate. Always avoid commingling the funds of separate corporations or LLC’s, and always keep personal and corporate funds separate from corporate funds. Never pay the debts of one using an account maintained by the other. (Contractors in California should also be aware of the potential civil and criminal penalties for diverting funds from one job to another-which is a topic for another update.)
- Never use corporate funds to purchase services or items for personal use . Pay yourself first, then use your own personal funds for your purchases.
- Never hold yourself out as being responsible for the debts or obligations of your company .
- Have adequate capitalization for your intended operations and purchase adequate insurance .
Following the basic guidelines above will not protect you from an alter ego judgment in all circumstances; every case is unique and calls for individualized legal advice and attention. If you have questions about avoiding alter ego liability, or if you are sued as an alleged alter ego, seek prompt legal advice.
Employers often misclassify employees as independent contractors so that they can avoid paying payroll taxes, minimum wage or overtime, and complying with other employment laws, such as providing meal and rest breaks and workers’ compensation coverage. Misclassifying an employee as an independent contractor without a reasonable basis can lead to steep penalties and other significant legal consequences. Thus, it is critical that employers properly classify their workers.
What’s the Difference?
The distinction between an independent contractor and an employee is not always clear. Numerous factors are considered in determining the status of a worker. Generally, if the employer has the right to control how the work will be done, and not just the result of the work, the worker is an employee. The following are some general guidelines.
An independent contractor typically:
- is engaged in a distinct occupation or business
- operates under a business name
- is a specialist who works without supervision
- has his or her own employees
- provides his or her own tools and place of work
- sets his or her own hours
- advertises his or her business services
- invoices for work done
- has more than one client
Typical examples of independent contractors include lawyers, doctors, dentists, engineers, architects, accountants, chiropractors, contractors, and subcontractors.
An employee typically:
- performs duties dictated or controlled by others
- receives training for work to be done
- uses company-provided equipment, tools, and materials
- works hours or days dictated by a company
- gets paid on an hourly, weekly, or monthly basis
- works for only one employer
There is no set definition of an “independent contractor” for all purposes, and not one single factor is determinative. The determination must be made on a case by case basis. Additionally, depending on the state or federal agency involved, the factors that get considered vary.
The existence of a written agreement purporting to establish an independent contractor relationship is not determinative. Nor is the fact that a worker is issued a 1099 form rather than a W-2 form.
Why is it Important?
If you misclassify your workers as independent contractors, you could be liable for many years of back taxes and penalties for unpaid federal and state income taxes, Social Security and Medicare taxes, and workers’ compensation and unemployment insurance premiums. You may also be liable to the worker for overtime pay, meal and rest period violations, reimbursement of business expenses, plus interest and penalties. The costs of misclassification can be extremely high and potentially devastating for some businesses, especially those highly reliant on independent contractors.
The U.S. Department of Labor as well as state task forces have been cracking down on businesses misclassifying their employees as independent contractors. The IRS has also been actively seeking what is estimated to be billions of dollars in lost tax revenues due to misclassification of independent contractors.
Under California labor law, there is a presumption that workers are employees, and the burden is on the employer to demonstrate that the workers are employees. Thus, employers should thoroughly research and analyze a working relationship before it is established. Employers should also diagnose whether current independent contractors are properly classified. If you are uncertain about whether a worker is an employee or an independent contractor, we advise that you contact an attorney or the appropriate government agency for guidance.
Kring & Chung Newport Beach Triathlon
Registration is now open for the Kring & Chung Newport Beach Triathlon, which is scheduled to take place on October 21, 2012 in Back Bay in Newport Beach, California. The course includes a 1/2 mile swim, 15 mile cycle, and a three mile run.
This year marks the 35th year of the event. Visit www.newportbeachtriathlon.com for more information and to register.
Shane Singh Nominated for Sacramento Business Journal’s “40 Under 40” List
Shane Singh, a Partner with Kring & Chung’s Sacramento, CA office, has been nominated for Sacramento Business Journal’s “40 Under 40” list. The “40 Under 40” list honors individuals under the age of 40 who are excelling in their professional fields. The final list will be announced in December.