Startup Law · Salaries

Is working for a startup without pay illegal?

Rand Strauss

January 15th, 2016

My attorney says she's wary of using the Slicing Pie model, that I should find a securities lawyer. Workers must be paid. I searched on-line and it seems that for-profit companies can't have volunteers. Or they can, but they might run afoul of The Fair Labor Standards Act (ehow.com/facts_7464428_can-business-volunteers-isn_t-nonprofit_.html ).

So is my corporation running an illegal operation because I'm working without pay? Must I give or lend my company enough to pay me minimum wage plus the employer 7% of social security and medicare and have the company pay me?

And now someone is joining me. Maybe I should pay him $1/month as a contractor, plus give him the right to his Slicing Pie portion?

Or should I dissolve the corporation and have it be a partnership?
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Susan Lyon Managing Director | Film Producer at LYON, focused on marketing mission-critical science and technology.

January 19th, 2016

If you're not making any money, you don't need to pay yourself. Once the company is making money, as the owner of a corporation in which you work, you need to pay yourself fair and reasonable wages for the job you are doing (to the extent the corporation can afford to do so). The government doesn't want owners actively working in small businesses claiming no salary and all income as profits, thereby dodging FICA, unemployment, and Medicare taxes. If you own a sandwich shop in which you do not work (you have a manager, a bookkeeper, etc.), you could legitimately take all profits as profits just as a shareholder in a large company does.

Anyone who isn't an owner has to be paid. Interns can avoid being paid only if you are using them through a program at their school and they are getting academic credit in some fashion. If that's the case, the school will make it clear to you and will typically have specific requirements you must meet--if only some kind of an agreement as to what things they will learn and a report back on their performance. If you're not being required to do anything, it's probably not a legitimate academic internship in the eyes of the government.

To be an independent contractor there is, as previously explained, a many-point test and in California it differs somewhat from the federal rules. Having passed a 2014 EDD audit with a clean slate approving our procedures and classifications, the clearest indication they are a true IC is that they have other clients and there is evidence they are running an ongoing business. A painter who works on your office is clearly an IC, although you may provide supplies and definitely direct the work and the timing of the work. While we direct a makeup artist on a shoot and provide the time and some direction in her work, they bring their own supplies, choose to accept the job or not, and have a lot of other clients, a website, etc. so it's acceptable to classify them as an employee. (Our shoots are 1-3 days, not a months of feature or TV filming, so the duration of the gig can override everything else in a review. In that case the makeup artist would need to be an employee, as it's not clear that they are actively running a true business at that point, but are instead rather working a series of temporary jobs.)

If someone is incorporated as an s-corp or c-corp they are clearly a business entity, not an individual, and it gets much easier. None of the tests are required because just the fact they are incorporated means you're not hiring an individual, you are hiring a company which is free to negotiate whatever terms it likes. 

If you want a true co-founder either make them a corporate owner with you, or have them incorporate. It's not unusual for a business to have to do a little bit of free work as part of the pitch/proposal or to choose to do pro bono work because you believe in the cause or the relationship is valuable or perhaps for two small companies to team up on a big project--although in that case, I would expect their corporation would want part of your corporation or share ownership in the final work product. 

Good luck!

MaxBlox/Founder Institute Director, Chennai Area at The Founder Institute

January 18th, 2016

I went through this two years ago. Someone wanted to work with no pay for a while for an equity stake on completion of specific deliverables. He really wanted to be part of a startup. I was very specific that we didnt have cash to pay. A few months later and the deliverables weren't met. I felt concerned and started paying a flat amount to make sure that he at least had some money to take home. After about 9 months it was clear that the deliverables werent going to be met and he would not be a fit. I terminated him.
I was surprised when he sued in California State Labor Court. He wanted something like $150k or something. The court ruled that i owe minimum wage on the time minus whatever i had provided.  The arbitrator was apologetic and understood that this meant that every startup owed every employee ( even if no formal employment agreement) minimum wage: in the state made famous for bootstrapped startups. I paid.

Max Avroutski

January 15th, 2016

It is illegal not to pay people who are legally employees no matter if you call them contractors and no matter if they agree. There is a legal definition of an employee in each state, find it in yours. In most states except in CA & NY there is a way out by assigning bonafide 20% of the company to employee and then you don't have to pay them, but SlicingPie would not work because if any of them get less then 20% at solidification they can sue for unpaid wages. In CA & NY even 20% is not possible. Solution is pay or run from another state. It's pretty stupid situation to pay yourself your own money & to be taxed again on after-tax money. Don't forget to pay Income tax. I haven't researched partnerships. Only if stock is worth a lot where investors bought it and you pay with it to employee and that is more than minimum wages only then there maybe a way out, but if you have investors that buy your stock then you should have money to pay minimum wages.

MaxBlox/Founder Institute Director, Chennai Area at The Founder Institute

January 18th, 2016

Mr. Eberhart. I completely agree with you that people deserve a fair pay. I think the minimum wage protections do a lot of good and we need to support it. In my company, with less than 10 people, it was possible to provide extremely generous packages with multiple healthcare options and even 401k.  The issue here is really about the special case of early startup employees, even co-founders. They are taking special risks for special rewards and foregoing all pay is one of them: because at that point the company needs that to get going. 
Let us imagine a startup with four co-founders working for a year on a product: the minimum wage commitment for that startup is going to be around $100k. Most startups would not start if they knew they had liability up front.

Rob G

January 22nd, 2016

@ Christopher B; as to your earlier question: "Is it worth pointing out that these seem to be issues relevant only if someone decides to sue? That unless someone brings the issue to bear, it isn't overly a concern?  Not trying to encourage naivete, but just looking to understand the parameters of the discussion" .  My answer is 'not exactly'.  Rand's original question seems pretty benign and few would even think to ask the question. Of course he doesn't have to pay himself minimum wage, but what about a co-founder?  what about an independent contractor?  And as crazy as the question may seem (no offense to Rand) there are plenty of attorneys in this world who could make his life miserable arguing otherwise in court.  If his co-founder works more than 40 hrs/wk is s/he entitled to overtime pay? Even when we get an answer from an expert - a lawyer who practices employment law in CA the answer is "follow the IRS regulations..." ("that will be $300 please") which is really a non answer.  As i mentioned earlier, where money and/or lawyers are concerned anything can happen.  You may be lifelong friends with your co-founder(s) and trust them with your life and you 'know' that they would never sue, but sh*t happens and as much of a waist of your precious time as it may seem now it is good practice to simply be aware of the possibilities and potential consequences.  One simple example, of many, is divorce.  Let's say you and your cofounder each own 50% of your company stock. Your cofounder's spouse files for divorce. Now all of a sudden you have 2 cofounders who are at the very least 'at odds' with each other and potentially headed to trial with attorney's looking for money wherever they can find it.  Even though your cofounder would never dream of suing you or the company all of a sudden s/he has no choice and you have an adverse 3rd party with a paid pit bull who can sign subpoenas.  The moral of the story is just to keep your wits about you at all times and keep things clean and documented - follow accounting rules, keep your books clean, pay your taxes, treat your employees well and get in the habit of playing devil's advocate. 

Colin Vincent TEDx Speaker | Co-Founder at Equity Directory

January 17th, 2016

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Peter Weiss President at American Outlook, Inc.

January 19th, 2016

Wow!  What a spirited discussion.

A couple of useful summary points:

Federal and State laws do not necessarily align and you must comply with both. Some states are tighter than the Feds, some are looser.  This applies to minimum wage, employee vs. independent contractor, benefits qualifications, overtime rules, etc.  

The IRS has some strong views about independent contractor status driven principally by questions of who is remitting payroll taxes and withholding.  In Washington we have a business gross revenue tax rather than personal or corporate income taxes but for unemployment, workman's compensation and wage and hour classifications the first question is whether the "independent contractor" is licensed as a business with the Department of Revenue.  This is not a bad test wherever you are - if your consultant has a business license you've passed the first screen on independent contractor status.

Founders who own a big piece of the company generally do not have to receive cash compensation but I remember the instructor in a contractor law class asking us "when does your partner become your employee?".  The answer:  halfway through his fall from the scaffold to the ground.  Pay everyone at least minimum wage as soon as you can; if someone does not own a big piece of the company this needs to be a priority.  (In some states officers and directors have personal liability for unpaid wages.)

Directors are not employees because of their Director status although they be employees because they are employees.  Directors are compensated under their contracted agreements and are not covered by employment law.

The LLC member vs. employee question is tricky.  If someone is a member of the LLC they are not an employee for IRS purposes but for most other purposes in many jurisdictions they are considered employees.  This includes health insurance coverage, unemployment, wage and hour, etc.  Again, the exception is if they own a very big piece of the business.

I'm not a big fan of not paying people currently even if they are willing to defer.  At the least pay minimum wage - it's a safe harbor in case someone decides to come after you in the future.  If you are not able to keep paying someone at the rate you've agreed you need to rework and document a new arrangement which addresses what happens if you end up not being able to pay.

Start-ups are tough.  It can be frustrating enough trying to get investor capital but it's a not a good idea to finance our companies by having our employees float the payroll.

Rob G

January 20th, 2016

@ Mr. Eberhart, the question was whether working for a startup without pay is illegal and, more specifically,  whether the founder has to pay himself at least minimum wage and thus federal and state employment taxes as well and by extension, how does employment law apply to cofounders.  This is a site for startups and founders to discuss founder issues. I don't think anyone here is advocating that startups pay unfair wages. The issue is, in the early stages before a startup brings on its first "employee", how does the company function and stay 'legal' re employment law.  Few early stage (pre-funding) startups can afford to pay even minimum wage, let alone 'prevailing' wages and the inherent red tape that goes along with payroll, so the alternatives are: 1) sweat equity and 2) independent contractors.  The issue at hand is how to structure the equity and or contractor relationship so one can grow to the point of revenue and/or funding at which point hiring employees and paying fair wages and payroll taxes is a reality. 

Rob G

January 22nd, 2016

@ Irwin S; as to your statement: "Mr. Strauss' attorney sent him to a securities attorney for a question that required employment law expertise and the result has been a spirited discussion without any real value. If we are going to help each other on FD, it would be good to stay within our own areas of expertise." (emphasis added). I would argue that this discussion is quite valuable and it the value is enhanced precisely because we have input from multiple experts from multiple fields with different experiences. Case in point; if the only input to this discussion had come from the CA employment-law attorney you spoke to we likely still would not have a satisfactory answer. 1) "follow the IRS regulations..." may be good advise, but is far from a satisfactory answer. Mr. Mattel provided similar advice and provided a real-life example as to how that was less than adequate. That's valuable input. It appears Mr. Mattel followed the IRS regs AND had a signed independent contractor agreement and still he ran into trouble because the CA labor board decided they knew better.  The fact that their salaries and benefits likely are paid from employment taxes is a topic for another discussion - one that perhaps Rand's company will get to address someday.  You, as an attorney, should know that lawyers get paid, handsomely i might add, to argue and they get paid win, loose or draw. It rarely matters which side of the argument as long as it's the 'other' side. Even a situation that seems clearly black and white, logical, reasonable and rational and has a 21 point checklist in the IRS manual still is, apparently, open to argument. 2) lawyers can be wrong. I'm not sure i can count the number of times i've received conflicting advice on the same subject from different attorneys, or just plain bad advice.  For years i never considered getting a second or third opinion after talking to 'the attorney'.   Now i typically looks for additional input from attorneys AND experienced entrepreneurs when it's an important subject.  If i were Rand i would have thought a securities lawyer would be a good source of advice too... and an employment attorney or 2 AND 3 or 4 experienced entrepreneurs - you get a bunch right here.  The real stickler when it comes to banking on 'expert' feedback from an attorney is it is rarely in writing, is rarely clear cut and almost always includes disclaimers longer than the answer. So the moral here is 1) seek advice from multiple sources to see where the trends lie and 2) understand that you must manage attorneys - subject for another time.  
There are many snake pits along the startup trail. sometimes you need a snake expert and sometimes you need the local guy who knows the trail and often times you need 2 or 3 of both who have simply walked the trail before you.

Rob G

January 20th, 2016

every member of FD should be following this thread. does this crap help us build companies? no, but it can help them survive. This is one of the mundane conversations that we hate to waste valuable time on, but it has to happen sooner or later. my best advise (and i'm no lawyer and given that i tend to point fingers at lawyers a lot i feel compelled to state that this is not legal advice) is use your head and document everything, within reason. If you are having conversations with potential cofounders it's a good idea to document not just your end agreement but also include key points of the 'conversation' as you go along so that later you can deconstruct intent and understanding. It is a sad commentary about our judicial system and, yes we should all be spending time focusing on more important things like products and customers, and revenue, but the reality is lawyers make a living when there is conflict. It doesn't matter if it's right or wrong - conflict means billable hours. remember, stirring up conflict = business development for law firms. I can tell you from experience that when money gets tight or when money and assets are plentiful sh%t will happen. Someone gets fired or pushed out and calls an attorney and that sh%t then hits the fan. The important lesson here is to be aware, use your head and document everything within reason - no need to get covert, just get things out in the open and in writing or at least email.

The original question here was does the founder have to pay himself at least minimum wage and therefor also have to pay state and federal employment taxes, workers comp, etc. One would certainly hope the answer is 'no'. The same SHOULD go for any co-founders. Their compensation comes later (theoretically) and is earned in the form of sweat equity. You know that's what you are thinking and you presume that's what 99% of the potential cofounders you are talking to are thinking. Talk about it openly with cofounders to be sure everyone is on the same page and document the salient points of the conversations and the understandings so when you get that summons or subpoena it is clear what everyone's understanding and agreement was at the time.

Contractors is another matter, but the above advice applies (again, this is not legal advice), do your homework and document everyone's understanding and intentions. It's a good idea to have more than just an Independent Contractor Agreement, it's a good idea to be sure the contractor is incorporated and has a history of paying their own taxes. If they don't, guess who the state and federal authorities will look to to pay those past due taxes and wages? This is especially important, and prevalent in the US, if the individual who performs the work (especially SW dev work) is here on a visa. If his/her employer does not pay their wages and taxes you could be next in line. back to work.