Michael and Brad kick off season 7 by spotting the red flags in a dental deal gone (almost) wrong. Tune in as we discuss independent contractors from a legal perspective and why you should pause when you see this type of agreement.
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Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues, simplified through real client stories and real world experiences. Creating simplicity in three, two, one.
Brad: Welcome back to another episode of Legal 123s with ByrdAdatto. I’m your host, Brad Adatto with my cohost Michael Byrd.
Michael: Thanks, Brad. And welcome to a new season.
Brad: I know I’m so excited. We’re entering to our seventh season. We have a lot of fun things in store for the season, Michael, and what are we going to do this year?
Michael: Well, as a business and health care law firm, we are sometimes triggered by certain buzzwords our clients will say in conversation. We know that there is potential disaster when we hear these words and we’re immediately on high alert. This season’s theme is Red flags.
Brad: Ooh, Michael, I think we have our first vocabulary word, red flag. Now, according to my assistant Siri, who we still employ, she went [00:01:00] out and found me this great word from vocabulary.com. So very prestigious site, a red flag is either a literal warning of something dangerous like the signal flag used on a sinking ship, which is that it would be a red flag if your ship is sinking. Or a figurative warning, like the red flag a candidate’s angry outburst sends to the voters about his temperament. So there you go. That’s our vocabulary word
Michael: To be clear, we will not be talking about my dating relationships back in my single days. Our red flag season is kind of a cousin to our season three theme of dumpster fires.
Brad: Yeah. And I’m going to say on behalf of the audience, thank you for not building a season around your single days.
Michael: You’re welcome. I think we need to incorporate some fun into spotting the red flags. Our favorite radio station is a sports radio station in Dallas called The Ticket.
Brad: Yes, we do love The Ticket. You and I often have morning conversations about, did you hear that A, B or C in fact, The Ticket is so [00:02:00] beloved it was voted the number one thing about Dallas above the Texas State Fair, the Dallas Cowboys, the other sport teams or other iconic Dallas things in Dallas.
Michael: Yeah we’ve laughed many times over the years when the morning show will share a story and say they want to count the red flags. So let’s do that this season.
Brad: Yeah and the way that it works is whenever you hear a red flag, someone will say ding!
Michael: Perfect. So let’s do an example. I’ll tell a short story from our dumpster fire season as an example.
Brad: I am ready!
Michael: Very funny, Brad.
Brad: Did I go too fast?
Michael: Yeah. Thank you. You were waiting for the opportunity to ding me.
Brad: I promise to be fair. Try again.
Michael: All right. I want the audience to picture from our dumpster fire season, a dentist that was appropriately named Dr. Nose. Most dentists are not fans of coke because it’s bad for your teeth.
Michael: Dr. Nose [00:03:00] liked a different kind of coke.
Michael: Dr. Nose liked to raise money by taking his potential investors with him for weekend trips to Vegas.
Michael: Our client, an investor, started hearing about lawsuits being filed by employed dentists and vendors against Dr. Nose
Brad: There were a lot of dings in there.
Brad: Ding, ding, ding, ding!
Michael: Okay. Well that should paint the picture. I think we should jump in on today’s story.
Brad: All right. Who is our outside guest that we have brought to drop some great knowledge on our audience today, Michael?
Michael: Brad, you know that this season is mostly going to be guest free and focused on you and I telling stories.
Michael: You’re not getting it yet, Brad, but I agree. Perhaps it’s only fitting that is a red flag to do a whole season without guests.
Brad: It does give double meaning to the red flag theme, deep thoughts.
Michael: All right. Well, coincidentally Brad today’s story is also about a dentist. [00:04:00]
Michael: His story is not nearly as nefarious as Dr. Nose so you’ll have to pay attention for the red flags.
Brad: All right it sounds a little bit boring since we know how much fun we had with the Dr. Nose story, but I understand.
Michael: Yes. And it would not be good for business if all of our deals involved dentists who snorted coke and stole money from their investors. There you got it now, Brad,
Brad: I’m ready. Thanks for setting up the expectations.
Michael: Our dentist today was fresh out of school and wanted help with us reviewing and negotiating his first contract in Austin, Texas, hook ’em horns. We will call him Dr. Green.
Brad: All right. Tell the audience why Dr. Green.
Michael: Dr. Green was baby faced and a little naive about the business side of dentistry. He had big dreams, but little experience.
Brad: And you know, Michael, this is pretty common. We see this all the time, you know, we have been blessed to lecture at different dental and medical schools and it’s amazing how little education that these future [00:05:00] doctors get on their profession and the business decisions they will make and legal decisions they’ll make.
Michael: For sure. Yeah and so the first thing I wanted to explore with Dr. Green was his vision for his future practice.
Brad: We tell our clients that want to explore, the first question we often ask is what’s your plan A and plan B, because we want to understand what they plan to do with their practice.
Michael: Yeah. I mean, it’s a next level adulting conversation for sure. And something they haven’t probably really done before, but it’s kind of the ultimate, what do you want to do when you grow up conversation on a professional level.
Brad: Yeah. And the plan A is that and then plan B is if that doesn’t work out there is your plan B.
Michael: Right and so Dr. Green wanted to join a practice with a respected dentist. He wanted to work full-time with that practice and eventually buy in as a partner to the practice.
Brad: Okay that sounds like a very traditional conversation we’d have with our [00:06:00] first contract. So that’s plan A what’s plan B for him?
Michael: Well for him, he would move back to his home to a small town where he grew up. He could not afford financially to make a mistake and invest in the wrong practice. So he was either going to join and buy in to this metropolitan multi location practice or go hang a shingle back in the small town, west Texas town if it failed.
Brad: All right, so that’s his plan B. So Michael, what did his employment contract look like?
Michael: It was actually an independent contractor agreement.
Michael: Good job, Brad. We explained the red flag.
Brad: All right. You said in plan A he would work full time for a multi-location practice. An independent contractor by definition cannot be a full-time role.
Michael: Our next vocabulary word is independent contractor. The easiest way to explain an independent contractor is to talk about it in conjunction [00:07:00] with an employee. So think about it this way. When a business writes a check to an individual, the IRS is going to characterize it in one of maybe four different ways. You can characterize it as a W2 payment to an employee as a 1099 payment to an independent contractor. It could be a distribution to an owner, or it could be a loan. And it wouldn’t be taxed if it was a loan, at least at that moment in time, if you were borrowing money. And so we obviously know that that Dr. Green was not borrowing money and he wasn’t yet an owner.
Michael: And so it really comes down to one of two things. Are you going to be characterized as an independent contractor and receive a 1099 payment or are you going to be [00:08:00] characterized as an employee and be receiving this W2. And it makes a difference because in an employer, employee relationship, the employer has to pay all the payroll taxes. And if you’re an independent contractor, that responsibility falls onto the independent contractor.
Brad: Yeah. And thankfully the IRS does have a test to help employers figure out if someone’s really an independent contractor versus being an actual employee. But I think Michael, we should discuss that later in this episode.
Michael: Yes. And the risk for misclassification, so that’s the calling someone an independent contractor when they are actually an employee, is pretty significant to the employer. And it’s not as simple as the employer being able to say, I’m going to deem you an independent contractor [00:09:00] and then you move on from that. The IRS has protective measures in place, along the lines of what you just said.
Brad: Yeah, absolutely. So Michael, I think the audience is going to wonder why when we were advising Dr. Green, if there’s all the exposure on the practice, what’s his problem?
Michael: Did I mention that there were six other dentists at the practice and all were independent contractors?
Brad: No. And ding and ding and ding!
Michael: Exactly. So remember, we have to go back to Dr. Green’s plan A, he didn’t just want to go and work for a practice in Austin, Texas. He wanted to eventually buy into the practice. Well, imagine the amount of risk that was being carried by this practice if it already had six other independent contractors that were probably misclassified, they should be employees, for him, if he were to go through these steps [00:10:00] and then buy into a practice that had all this exposure. And remember he couldn’t afford to make a mistake. And so this became a big issue on his plan A.
Brad: Yeah, totally understand. So Michael, pretty crazy story. Let’s go to commercial and on the other side let’s talk more about the independent contractors from a legal perspective and what our audience needs to know when they need to hit the ding button when they see these types of agreements, but let’s go commercial.
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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my cohost Michael Byrd. Now Michael, this season theme is red flags. And we mentioned in the first half of the show the IRS test for a classification of independent contractor and so let’s talk a little bit more for our audience to really have a deeper dive understanding. I mean, we red flagged it so it’s obviously important. So let’s talk about it.
Michael: And let me just add a little bit before I go into it, there’s actually two levels of classification issues. So we always start with the IRS because that is kind of the front and center, but actually each state has its own laws on employees versus independent contractors. So I’m sure you saw all the Uber litigation in California that has been going on over the last couple of years and so it is a very real issue on a state level as well
Brad: Totally [00:12:00] agree.
Michael: From the IRS perspective, they used to use what was known as the 20 factor test to determine is this person an employee or an independent contractor.
Brad: Can I ding the fact that it was a 20 factor test?
Michael: Yes and you can ding the word IRS too.
Brad: Ding and ding!
Michael: Yes and it gets down to the fact that the IRS really cares and wants to protect people, employees, from being put in a position where they’re having to pay payroll taxes because the employers don’t want to do it. And so they will crack down on this and there’s a lot of risks to the, to the businesses. And so in an effort to clarify and simplify the criteria.
Michael: Yes, exactly. They streamlined and consolidated the 20 [00:13:00] factors into 11 main tests and organize them into kind of three main groups. The behavioral control group, the financial control and the type of relationship of the parties. And so I figure we can, at least on this episode talk about the three levels instead of going too deep and really putting our audience to sleep.
Brad: Sure. And what I love is that you’ve broken up to this three. So let’s start with behavioral control, which sounds like something that you would do as a parent or maybe this is the adulting portion of the show still, but seriously, Michael, explain to our audience the behavioral control test.
Michael: So this part of it is all about trying to figure out does the nature of the relationship make the business have some form of a right to direct control how the worker does the task [00:14:00] for which the workers hired. And so they’re really looking at this, like if you’re an independent contractor and you come in, you know what you’re doing and you do it. And if you’re an employee you’re given, you do A, B and C in this way and at a very high level. And so some of the things they look at are the instructions given to the worker. And like I said, an employee is generally subject to instructions of when, where, and how they’re supposed to work. And then they may tell them what tools I have to bring to work, or what workers to hire or assist with the work. All of these elements of control kind of will weigh in on this behavioral control element for this kind of three-part evaluation.
Brad: Okay. That makes sense. I mean, behavior, same thing about control over that [00:15:00] employee. And so again, just like we were talking on the parenting side its how you control on the kids and how you’re controlling the more authority you assert over and the more control over their behavior. Okay, that makes sense. Let’s go to that next test you mentioned, which was the financial control.
Michael: Well, this is all about looking at the degree to which the business has control over the business aspects of the worker’s job. And so things like the extent to which the worker has unreimbursed business expenses. So independent contractors are more likely to have unreimbursed expenses than an employee. And kind of an easy way to think about this is anytime you go hire an outside service, an outside business, and you’re a business, you obviously know that that’s an independent contractor relationship. In fact, they are paid on a 1099 basis, coming back to how we talked about it. It just gets muddy when you’re talking [00:16:00] about an individual that you’re trying to retain. They look at the extent of the worker’s investment. So an employee usually has no investment in the work other than their own time. And so you can’t get too hung up on any one of these things because just because you don’t meet it, doesn’t mean that you still can’t be an independent contractor. And then of course, a big one under this one is the extent to which the worker makes services available to the relevant marketer. So independent contractors are generally free to seek out business opportunities. And so what’s funny is that you will oftentimes see, and especially in the professional world for healthcare workers doctors and dentists, they’ll say here’s an independent contractor agreement and your covenant not to compete. Well now you have got like two [00:17:00] risks. One, you have a covenant not to compete that may not be enforceable because they’re going to be like, hey, this is an independent contractor relationship, how in the world can you make me have a non-compete. And then on the flip side, you have the potential misclassification, because you are saying you’re an independent contractor but are treating them like an employee. So it’s a very tricky subject, but that’s what they’re looking for there is, you know, the level of freedom does that worker have to be going out and doing other things? And then they’ll also look at like how the business pays the worker. Is it a regular wage amount, hourly, weekly, or other periods of time? The more systemized it is, the more it looks like an employee paycheck type thing. The more that weighs against the employer for potential misclassification.
Brad: Yeah. And I think Michael, the pattern you’re [00:18:00] starting to, hopefully the audiences is seeing, is they look at it from the IRS has perspective. If a business tries to hire someone, bring them on and they give them all the roles so far to explain to us and it makes them look like an employee, but they just slow, you know, hey, but we quit calling it an independent contractor label so therefore it’s okay. And so you can see how I’ve controlled the behavior. I’m now controlling basically how your financial you’re being paid and compensated and whether or not you’re being reimbursed. So hopefully the audience is seeing the light of all the different traps that are there or red flags. So, Michael, let’s talk about the third test. I believe you said it is the type of relationship.
Michael: Yeah. So the easiest one to kind of get your arms around it is what do you say the relationship is in your contract? And this is probably the least important criteria. We talk all the time about form and substance. I mean, you can’t just say to say that you’re an independent contractor.
Brad: Okay, great. [00:19:00] Thanks, I didn’t know that
Michael: It doesn’t work like that, but it is one element to the equation. So yes, if you’re actually going to treat them like an independent contractor, it’s worth having an agreement and actually labeling them that way. Its form and substance, Brad. And you know, looking at things like benefits and all that, I mean, that defines the nature of relationship. I mean, the reality is if you’re an independent contractor, they can’t get benefits because they’re not an employee. That’s only reserved for employees. So, you know, in the professional world with Dr. Green, he’s going to have to buy his own malpractice insurance as an independent contractor. Again, another thing that weighs on everything in that equation. And then another aspect of the relationship is the permanency of the relationship. If a company engages a worker [00:20:00] kind of within an indefinite time period to it, that looks more like an employer employee relationship than something that is more finite with the defined term. And so you are looking holistically at the relationship and they’re also looking at, you know, if you’re a worker that’s providing part of the core business of the business that matters too. So a dental practice hiring a dentist as an independent contractor, weighs against it, as opposed to a dental practice hiring an IT guy to come in and do a project.
Brad: Totally makes sense. And I believe I remember reading about this practical test that the IRS has to that, if it walks like a duck and quacks like a duck, that it’s a duck.
Michael: Uh, that [00:21:00] was probably what you learned when you were studying for the Louisiana bar. But you know, it’s true. I mean, you really can, if you just pause and look at, you know, is this truly an independent contractor employee relationship you can look at. I mean, a contract that requires you to work 40 hours a week and go nowhere else is a classic employment relationship. By the way, that’s what Dr. Green’s contract said.
Brad: Ding! Oh, sorry. I got caught in the moment. I think the reason why, you know, again, going back to if you have an independent contractor that is required to work 40 hours a week and that really does shift over as to how the IRS is going to view the entire relationship. And then you mentioned this earlier is who’s paying the payroll taxes? And the reason why that becomes an issue. And I think you said at the very beginning of the show, is that the IRS truly here is trying ultimately to protect the employee from the [00:22:00] costs that they would have to pay as an independent contractor and basically making sure that they’re the exposure, meaning that, you mentioned benefits all the benefits that a W2 employee receives over a 1099. So let’s pause all this IRS talk. I’m sure that the audience that’s still awake they want to know one thing, how did this turn out for Dr. Green?
Michael: Well, we tried to approach the practice to fix the model so that the risk would be mitigated in the future when he became an owner. The practice did not want to make a change and as we said, Dr. Green did not have the flexibility to make a mistake on this. So he walked.
Brad: Yeah. So the practice employed the great strategy of the head in the sand?
Michael: Yes. Oh yeah, works like a charm doesn’t it? Well until it doesn’t. So what happened to Dr. Green? Everyone wants to know now.
Michael: Well, he moved to Dallas, invested in Dr. Nose’s practice and lost everything.
Brad: I’m hoping you’re being very funny.
Michael: Yeah. I was trying to [00:23:00] put a little flair into it because you wanted a little more excitement to the story. He did really come and join a practice in Dallas and is now a partner and doing great.
Michael: Brad, as we wrap up our first episode about red flags, independent contractors, what final thoughts do you have?
Brad: You know, first off you don’t have to be a lawyer to really spot red flags, although it helps a little bit, once you spot that red flag though, you need to hit that pause button and make sure you have the right guidance to move forward. And you know, we said it already in the show is that it is really important for the form and substance to match each other. And again, we’ve talked about this in other shows because if the IRS is as best they can, they’re trying to give us clear guidance as to what a substantial to them as to a way in which they view the employer, employer relationship, you have to take it seriously. And just because you’re form says that [00:24:00] it’s not, does not make it. So keep that in mind as you venture into the employment relationship and you start trying to bring all these employees, you want to minimize those exposures of misclassification. Michael, what are some of your final thoughts today?
Michael: I think in the real application of this, it starts to get blurry and kind of taking it back to the beginning of this show, talking about my, or not talking about my single days. It gets messy pretty quickly. And so a pro tip that we use when we’re having a client, that’s an employer that’s wanting to bring someone on. It probably looks like they’re going to meet the independent contractor test, but there’s some variables to it that we don’t like is we’ll have that individual form their own professional entity and have the contract be between two professional entities instead of [00:25:00] an individual and an entity. And the thought behind that, if you go all the way back to the beginning of the episode, when I was talking about the four different ways that money can be characterized. And really what it comes down is the two, a W2 or a 1099. Well, a company or an entity by definition cannot be characterized as a W2 employee. And so we haven’t seen the IRS, or for the most part states kind of trying to pierce through that set up and say, no, you formed this to just force this into an independent contractor, but you’re not really that way. We want to use this strategy, but we want to use it for the purposes of shifting risks when it’s kind of not clear about where it would fit on the test. I think that you [00:26:00] do amplify a risk if you are clearly trying to be in an employment relationship and you just try to shoehorn it in through this kind of entity to entity strategy.
Brad: Totally agree. Great closing. Well, join us next Wednesday, we will continue with the theme of red flags. We will be talking about phantom stock and no, this is not a ghost story.
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