Employee Classification

IRS re-characterization, 83(b) foot-faults, milestone gamesmanship, and “I thought I was an employee” litigation.

Types of Employment	characteristics
Full-time employees	Full-time employees are typically hired for a permanent position and work a standard number of hours per week. They may be eligible for benefits such as health insurance, retirement plans, and paid time off.
Part-time employees	Part-time employees work fewer hours per week than full-time employees, and may not be eligible for the same benefits. They may be hired on a seasonal or temporary basis, or may work part-time hours as a long-term employment arrangement.
Contract workers	Contract workers are hired on a temporary or project basis and are not considered employees of the organization. They may work for a specific length of time or until a specific project is completed, and may receive a set fee or hourly rate for their work.
Freelancers	Freelancers are self-employed individuals who offer their services to clients on a project or contract basis. They may work for multiple clients at the same time, and are responsible for their own taxes and benefits.
Remote workers	Remote workers work from a location outside of the organization's physical office, such as from home or a coworking space. They may work full-time or part-time, and may be classified as full-time employees, part-time employees, contract workers, or freelancers.
Contingent Workforce	A contingent workforce refers to a group of workers who are not traditional full-time employees of an organization, but who are hired on a temporary or contractual basis to perform specific tasks or projects. Contingent workers can include independent contractors, freelancers, temporary workers, and consultants. Contingent workers are typically hired to help organizations meet short-term needs, such as for a specific project or to cover a temporary staffing shortage. They are often hired for their specialized skills or expertise, and may work on a part-time or full-time basis. One of the benefits of using a contingent workforce is that it allows organizations to be more flexible in their staffing needs. They can quickly ramp up or down their workforce as needed, without the long-term commitment and expense of hiring full-time employees. Contingent workers can also provide a cost-effective way to access specialized skills or expertise that may not be available in-house. However, there are also potential drawbacks to using a contingent workforce, such as a lack of loyalty and commitment to the organization, and potential legal and compliance risks if workers are misclassified as independent contractors instead of employees. As such, organizations need to carefully evaluate the pros and cons of using a contingent workforce, and ensure that they have appropriate policies and procedures in place to manage this type of workforce effectively.

classifying a worker who is paid only sales performance revenue share as an independent contractor in New Jersey is highly risky, especially if the sales activity is the core of your business.

This is a high-stakes compliance question. You are correct to be worried: Worker misclassification is the single biggest legal risk for early-stage startups.

If you get the ABC Test wrong (especially in strict states like California, Massachusetts, or New Jersey), you could be liable for years of back taxes, unpaid overtime, and penalties—even if everyone "agreed" to be a contractor.

Here is the unvarnished truth: Phantom Equity does not inherently "destroy" the ABC test, but a poorly drafted Phantom Equity agreement WILL.

To make this work, you must structure the Phantom Equity as a "Success Fee" for a business-to-business transaction, NOT as a "Retention Bonus" for an employee.

---

1. The Danger: Why "Time Vesting" Kills the IC Status

In a standard employee relationship, equity vests over time (e.g., 4 years). This creates a "long-term indefinite relationship."

• The ABC Test Trap: Under the "A" (Control) and "B" (Course of Business) prongs, an indefinite, time-based relationship looks like employment. It implies you are paying them to "be available" (Control) rather than paying them to "deliver a result."
• The Risk: If your Phantom Equity agreement says, "You get 2% if you stay employed for 4 years," a labor board will read that as: "This is an employee. You are controlling their time for 4 years."

2. The Solution: Structure as "Performance Milestones"

To align Phantom Equity with Independent Contractor (IC) status, you must strip away the "time" component and replace it with "deliverables."

• Employee Logic: "I pay you because you show up every day." (Time-based vesting).
• Contractor Logic: "I pay you because you delivered a finished product." (Milestone-based vesting).

How to Draft It: Instead of "Vesting Monthly over 24 months," your Phantom Equity agreement should say:

• 0.5% vests upon delivery of the Marketing Go-To-Market Strategy.
• 0.5% vests upon completion of the MVP Front-End Codebase.
• 1.0% vests upon the Company achieving $50k in Gross Revenue (attributed to the Contractor's advice).

Why this protects you: This argues that the equity is a contingent transaction fee (a "kicker" or "success fee") for a completed business service, not wages for ongoing labor.

3. The "Passive Member" Defense (The "B" Prong)

You mentioned these are "passive members." This is your strongest shield against the ABC Test, specifically Prong B: Is the worker performing work that is outside the usual course of the hiring entity’s business?

• High Risk: If you run a Software Dev Shop and you hire a Software Developer as an IC and give them Phantom Equity, you will likely FAIL the B-Prong. Developing software is your business. They are likely employees.
• Low Risk: If you run a Software Dev Shop and you hire a Sales Advisor or Financial Consultant (your passive members) and give them Phantom Equity.
  • Argument: "My business is writing code. This person is providing strategic financial advice. That is outside my usual course of business."

If your "Passive Members" are doing core work (coding/marketing): You cannot use the IC defense easily. In this case, Phantom Equity doesn't hurt you, but it doesn't help you either. You are misclassifying them regardless of how you pay them.

4. Contract Language "Red Flags" to Avoid

To protect your IC defense within the Phantom Equity agreement, you must scrub "Employment" language:

Toxic Term (Do Not Use)	Safe Term (Use This)	Reason
"Employee"	"Participant" or "Service Provider"	Never admit employment status.
"Termination"	"Cessation of Services"	"Termination" implies firing an employee. "Cessation" implies a contract ending.
"Salary" / "Wages"	"Fees" / "Retainer"	Wages are for employees. Fees are for businesses.
"Duties"	"Scope of Work"	Duties imply obedience; Scope implies a negotiated contract.
"Retention"	"Successful Completion"	You retain employees; you complete contracts with vendors.

Summary

Phantom Equity creates a Contractual Debt (a promise to pay cash later), not an Employment Relationship.

It does not destroy the ABC test if:

1. The "Passive Members" are truly Advisors/Consultants (not doing core daily coding/design).
2. The vesting is tied to Milestones (Success Fees), not just a calendar (Time).
3. The agreement includes a "No Control" Clause stating they can work for other clients and control their own hours.

If these 8-15 people are actually junior developers sitting in your Slack channel 9-5 building your core product, Phantom Equity won't save you. You should classify them as employees or true partners (Class B), or accept the risk that the Phantom Equity agreement could be used as evidence of misclassification in an audit.

Contract differences

Yes, both employees and independent contractors (ICs) can be subject to IP (Intellectual Property) Non-Disclosure Agreements (NDAs) and non-solicitation clauses in their legal contracts. However, the legal and practical considerations for each worker classification are distinct.

IP Non-Disclosure Agreements (NDAs)

An IP NDA is a legal instrument that prevents a worker from disclosing confidential information, including trade secrets, proprietary business plans, customer data, and intellectual property. The objective is to protect the company's competitive advantage. This is a standard and highly recommended practice for both employees and ICs.

• For Employees: IP ownership is often the default, a "work-for-hire" doctrine under U.S. copyright law. If an employee creates IP within the scope of their employment, the employer generally owns it. An NDA in an employment contract serves to clarify this and to protect other sensitive information. It's a fundamental part of the employer-employee relationship.

• For Independent Contractors: IP ownership is not a default. Unless specified in a written contract, the IC retains ownership of the IP they create. Therefore, an IP assignment clause is a critical component of a contract with an IC. This clause legally transfers ownership of the IP from the IC to the client. An NDA for an IC is crucial to ensure that confidential information shared with them (e.g., source code, client lists, project designs) is not disclosed to third parties.

---

Non-Solicitation Clauses

A non-solicitation clause is a restrictive covenant that prohibits a worker from soliciting the company's clients, customers, or employees after the working relationship ends. The goal is to prevent a former worker from "poaching" valuable relationships.

• For Employees: These clauses are very common and are generally enforceable, provided they are reasonable in scope, duration, and geographic area. The clause must be tailored to protect a legitimate business interest and not place an undue burden on the former employee's ability to earn a living.

• For Independent Contractors: Non-solicitation clauses can be more difficult to enforce for ICs, especially if they are overly broad. Because ICs often work with multiple clients and are, by definition, separate business entities, a broad non-solicitation clause can be seen as an illegal restriction on their trade. Enforceability often depends on the specifics of the clause, such as its reasonableness, and the laws of the state. Some states, like California, are particularly restrictive on such agreements.

1. Fatal Flaw: Misclassification of Employee as Independent Contractor

• The Problem: The first agreement explicitly labels the worker as an "Independent Contractor," while the second (and the consolidated) agreement is an "Employment Agreement" with terms utterly inconsistent with contractor status (e.g., duty of loyalty, restrictive covenants controlling how work is done, potential equipment provision). New Jersey and the IRS use multi-factor tests (behavioral control, financial control, relationship of the parties) to determine status.

• Why It's Unenforceable: A court or regulatory agency will almost certainly classify this worker as an employee. The commission-only pay does not automatically create contractor status. By misclassifying, the Company exposes itself to massive liability for:

  • Unpaid minimum wage for all hours worked (a huge risk with a $0 base salary).
  • Unpaid overtime premiums.
  • Failure to pay employer-side payroll taxes (FICA, unemployment).
  • Penalties and interest.

• Recommendation: This is the most critical issue. The Company must choose: either structure a true independent contractor relationship (with less control, a project-based fee, and no restrictive covenants like non-compete) or properly hire them as an employee. The current hybrid model is legally perilous.

Software Dev Contract

Important provisions

Some provisions impact software engineers more than others. While the totality of the contract should be carefully examined, in particular, be sure to keep an eye out for provisions related to the following:

• Non-competition
• Non-solicitation
• Non-disclosure
• Work Product Ownership
• Moonlighting
• Arbitration

ICs (Independent Contractors)

you have to be able to produce results with little to no structure classifying workers as independent contractors

independent contractor - control, compensation, results

• negotiate compensation
• FLEXIBILITY: control over your own time
• no payroll deductions:
  • social security
  • disability taxes
  • medicare
  • state withholding
  • unemployment
• no employee benefits
  • overtime
  • health insurance
  • pension, profit sharing, and bonuses

IRS determination

instructions	suggestions
evidence the worker is an employee	may not be followed = independent contractor

Misclassification of employee vs independent contractor (IC)

Most states have a multi-factor statutory test used to make the IC/employee determination, but generally a state labor board will look at the level of control the employer exercises over the IC. Are there set work hours determined by your company? Is the IC using materials provided by you company to perform his/her job? Is the IC working exclusively for your company? If the answer to these “yes,” it’s likely that your IC is an employee for WC purposes.

old school analysis

• control
• primary business purpose
• tools
• similar skill sets
• efficiency
• duration of employment
• job vs project
• payment schedule

New Jersey LLC Compliance for Independent Contractors

The ABC Test

The crux of compliance for New Jersey LLCs engaging independent contractors lies in correctly classifying workers. New Jersey employs the stringent "ABC Test" to determine if a worker is an independent contractor or an employee. If a worker doesn't meet all three criteria of the ABC Test, they're likely an employee, not an independent contractor.

1. Control: The worker must be free from control or direction over the performance of work, both under contract and in fact.
2. Usual Course of Business: The work must be outside the usual course of the business for which the service is performed.
3. Independent Establishment: The worker must be customarily engaged in an independently established trade, occupation, profession, or business.

Consequences of Misclassification

Misclassifying employees as independent contractors can lead to severe penalties, including:

• Back taxes
• Penalties
• Interest
• Potential lawsuits

Compliance Best Practices

To ensure compliance, consider the following:

• Thorough Assessment: Carefully evaluate each worker's relationship to your LLC using the ABC Test.
• Written Contracts: Clearly define the relationship as independent contractor in written agreements.
• Tax Compliance: Issue Form 1099-NEC to independent contractors and report payments to the IRS.
• Worker Benefits: Avoid providing employee-like benefits such as health insurance or paid time off.
• Control: Refrain from dictating how the work is performed.
• Business Structure: Ensure the worker has their own business structure and operates independently.
• Federal Regulations: While New Jersey uses the ABC Test, federal regulations may also apply.
• Professional Advice: Consult with an attorney or tax professional for specific guidance.
• Industry Standards: Be aware of industry-specific regulations and best practices.
• Documentation: Maintain detailed records of your classification decisions and interactions with workers.

Helpful Resources:

• New Jersey Department of Labor and Workforce Development: [Image of New Jersey Department of Labor and Workforce Development website]
• IRS Information on Independent Contractors: [Image of IRS website]

ABC Test

A

1. is the worker free from constant control and direction of the employer?

• contracts & results oriented end product >> IC
• Updates, Direction, monitoring >> employee

B

1. Is the employee performing services in the same industry as the employer?

IC Relationship

CONFLICT OF INTEREST:

1. The Partner warrants that at the time of signing this Agreement no conflict of interest exists or is likely to arise in the performance of its obligations under this Agreement.
   1. If a conflict of interest arises or appears likely to arise during the duration of this Agreement, the Partner shall:
2. immediately notify the UNDP;
   1. make full disclosure of all relevant information relating to the conflict; and
   2. take such steps as the UNDP reasonably requires to resolve or otherwise deal with the conflict.

New Jersey, like most states, distinguishes sharply between employees and independent contractors.

Misclassifying an employee as an independent contractor can lead to serious legal and tax consequences, including back taxes, penalties, and even lawsuits. The "ABC test" is often used to determine worker classification, although New Jersey often uses a similar multi-factor test, which is crucial to understand.

Independent Contractor Status in New Jersey: New Jersey courts will scrutinize the relationship between the LLC and the individual. Factors considered include:

• Control: Does the LLC exert significant control over how the work is performed, or just the result? More control suggests an employee relationship.
• Economic Realities: Does the individual invest in their own business, bear the risk of loss, and profit from their own efforts? Independent contractors typically do.
• Permanency of the Relationship: Is the relationship ongoing and indefinite, or project-based and temporary? Long-term relationships lean towards employee status.
• Integration: Is the individual's work an integral part of the LLC's core business? If so, it points towards employment.

Tiered Commissions: Tiered commission structures are generally permissible for independent contractors. The key is that the tiers must be clearly defined in a written contract. The contract should address:

• Performance Metrics: What specific actions trigger each tier? (e.g., number of sales, value of contracts, etc.)
• Commission Rates: What percentage or fixed amount is earned at each tier?
• Payment Schedule: When are commissions paid? (e.g., monthly, quarterly, upon completion of a project)
• Draws (if any): If the contractor receives advances against future commissions, the contract must clearly outline the terms, including how and when the draw is reconciled. Be extremely careful with draws, especially in a pre-revenue startup. They can create the appearance of an employer-employee relationship if structured improperly.
• Expenses: Who is responsible for business expenses? Independent contractors typically bear their own expenses.