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Independent Contractors and Non-Compete Agreements

November 28. 2017

By Kimberly H. Berry, Esq., www.berrylegal.com

An interesting legal question that has arisen in recent years is whether Virginia employers can use non-compete agreements with independent contractors. The answer is not entirely clear. In addition, there are many potential pitfalls for both the independent contractors that sign such agreements and the employers that attempt to enforce them. An employer may discover that its fully executed non-compete agreement with an independent contractor is unenforceable, but also subject itself to significant liability for misclassifying an employee.

The Difficulties with Non-Compete Agreements for Independent Contractors

One of the main problems with requiring independent contractors to sign non-compete agreements is that independent contractors are different types of workers. An independent contractor is essentially its own business. Generally, an employer cannot compel an independent contractor, which is a separate business, to forfeit his or her business simply because it gave the independent contractor business. Independent contractors may appear similar to employees (and many employers cross the line in terms of who they think they can classify as an independent contractor), but there are different loyalties and duties. For the most part, the more that an individual becomes a part of an employer’s business or organization, through signing such non-compete agreements and assuming duties of loyalty and the like, the more likely that the individual can be considered an employee.

Suppose that an independent contractor is paid and taxed as an independent contractor, and then the employer has the independent contractor sign a non-compete agreement.

The very existence of such an agreement likely initiated a shift of the contractor’s status from that of an independent contractor to a misclassified employee who owes a duty of loyalty to the employer. If the independent contractor has been misclassified by the employer, then the employer may risk having an unenforceable non-compete agreement, and also potentially subjects itself to serious tax, overtime, and government fine issues as a result of not paying the worker properly.

The legal issues and determinations associated with non-compete agreements for independent contractors in Virginia are in the very early stages and cannot be fully predicted. Given the large amount of government contractors in Northern Virginia alone, it appears that this issue will be fully litigated. Despite the relative uncertainty, an employer can easily run afoul of Department of Labor (DOL) and Internal Revenue Service (IRS) guidelines regarding misclassification, and end up owing significant sums to the government as well as the misclassified employee through enforcement efforts related to a non-compete agreement.

To date, there are a few interesting Virginia cases on the topic, including Reading & Language Learning Ctr. v. Sturgill, 94 Va. Cir. 94, Case No. CL-2015-10699 (Fairfax County Aug. 4, 2016) case. The Reading case involved an individual (Sturgill) who was training to be a speech therapist, but needed a clinical fellowship to obtain certification. Sturgill signed an agreement with Reading to work as an independent contractor for one year to obtain her license. In the agreement, Sturgill agreed “not to employ any contracted employee or contract with any current client of the other for a period of two years.” The language of the agreement was found to be confusing by the court.

Sturgill obtained her certification and left for full-time employment with a local charter school as a speech therapist. The local charter school had used Reading for some subcontracting work in the past. Reading then sued Sturgill in Fairfax County, claiming that she had breached her non-compete agreement by accepting employment at the charter school. Sturgill prevailed in her case on several grounds.

Interestingly, because Sturgill was still pending licensing, she was directly supervised by Reading personnel (since it had approved her schedule), and her supervisors had provided final approval on many issues associated with her work. As a result, the Reading court found that Sturgill was not an independent contractor and had been misclassified. The court determined that Sturgill was really an employee and, as a result, the non-compete agreement violated public policy. Specifically, the court found that because Sturgill was misclassified, Reading had not complied with Virginia and federal laws regarding employment taxation. In other words, the employer should probably never have brought suit as it subjected itself to other legal and tax issues. The case does not appear to have been appealed, so it is likely that the employer realized the mounting issues and decidedly walked away.

The Misclassified Employee Can Seek Damages

If an individual makes a claim that he or she was a misclassified employee, the individual can seek losses related to taxes and overtime. The DOL and other organizations can then seek fines and other penalties regarding the misclassification. The DOL has issued guidance on misclassification, at least as it relates to independent contractor entitlement to overtime.  There are several different tests by DOL and the IRS on these issues (and they differ a bit).  However, here is the test provided by the DOL in their Fair Labor Standards Act guidance:

 

“The Supreme Court has said that there is no definition that solves all problems relating to the employer-employee relationship under the Fair Labor Standards Act (FLSA). The Court has also said that determination of the relation cannot be based on isolated factors or upon a single characteristic, but depends upon the circumstances of the whole activity. The goal of the analysis is to determine the underlying economic reality of the situation and whether the individual is economically dependent on the supposed employer. In general, an employee, as distinguished from an independent contractor who is engaged in a business of his own, is one who “follows the usual path of an employee” and is dependent on the business that he serves. The factors that the Supreme Court has considered significant, although no single one is regarded as controlling are:

(1) the extent to which the worker’s services are an integral part of the employer’s business (examples: Does the worker play an integral role in the business by performing the primary type of work that the employer performs for his customers or clients? Does the worker perform a discrete job that is one part of the business’ overall process of production? Does the worker supervise any of the company’s employees?);

(2) the permanency of the relationship (example: How long has the worker worked for the same company?);

(3) the amount of the worker’s investment in facilities and equipment (examples: Is the worker reimbursed for any purchases or materials, supplies, etc.? Does the worker use his or her own tools or equipment?);

(4) the nature and degree of control by the principal (examples: Who decides on what hours to be worked? Who is responsible for quality control? Does the worker work for any other company(s)? Who sets the pay rate?);

(5) the worker’s opportunities for profit and loss (examples: Did the worker make any investments such as insurance or bonding? Can the worker earn a profit by performing the job more efficiently or exercising managerial skill or suffer a loss of capital investment?); and

(6) the level of skill required in performing the job and the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent enterprise (examples: Does the worker perform routine tasks requiring little training? Does the worker advertise independently via yellow pages, business cards, etc.? Does the worker have a separate business site?).”

 

See DOL Guidance.

 

As indicated above, if the individual was a misclassified employee, then the employer might very well be liable for multiple tax issues and payments, in addition to other potential overtime payments and damages.

Conclusion

If you need assistance with non-compete or other employment law issues, please contact our office at 703-668-0070 or at www.berrylegal.com to schedule a consultation. Please also like and visit us on our Facebook page.

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