Going Back to Cali: The Pitfalls of Contracting for Works Made for Hire From Consultants in the Sunshine State

It is essential for start-up companies to properly characterize their service providers who are individuals (i.e., natural persons) as either employees or independent contractors (i.e., consultants).  Among other matters, a company is required to pay payroll taxes and comply with minimum wage and hour laws for its California-based employees but not its contractors.  However, distinguishing between individual employees and contractors is not a simple exercise.  The IRS has developed a three-factor test to determine whether an individual service provider is an employee or an independent contractor, and California’s employee test has both a primary test and 10 secondary factors!  (Both tests are described at http://www.taxes.ca.gov/iCorE.bus.shtml#Federal)  These tests control, despite the parties’ intent or the characterization of the relationship in written agreements among the parties.

To further complicate matters, …

California Labor Code Section 3351.5(c) provides that a person engaged to create a “work made for hire” is an employee, and California Unemployment Insurance Code Section 686 provides that a party contracting to receive “works made for hire” is an employer.

Taken at face value, California Labor Code Section 3351.5(c) and California Unemployment Insurance Code Section 686 would take an individual service provider that is otherwise properly characterized as an independent contractor and would recharacterize such service provider as an employee merely because the service provider’s consulting agreement provides that the service provider will create works made for hire.  If strictly enforced, these laws could have a debilitating financial effect on typical lean-burning start-up companies that have contracted for works made for hire from independent contractors.  Companies would be required to pay payroll taxes and minimum wages to recharacterized independent contractors prospectively and retroactively.  Also, there may be penalties with respect to such retroactive payments.

Presumably, a company contracting for works made for hire from a service provider that is an entity would not result in the entity service provider being recharacterized as an employee of the company, but is possible, albeit unlikely, that California Labor Code Section 3351.5(c) and California Unemployment Insurance Code Section 686 could reach all the way to the individuals at the entity service provider who created the works made for hire.

An initial reaction to California Labor Code Section 3351.5(c) and California Unemployment Insurance Code Section 686 might be to remove references to works made for hire from consulting agreements.  However, one of the benefits of contracting for a work made for hire is that the party who contracted to create the work made for hire is deemed to be its original owner.  If references to works made for hire are removed from consulting agreements, then companies would gain ownership of the works created pursuant to the consulting agreements only through the assignment provisions typically contained in such consulting agreements.  This is probably fine for most inventions developed under a consulting agreement, but perhaps not for copyrights.  Generally, an assignment of a copyright can be (but is not required to be) terminated by the original owner of the copyright (i.e., the independent contractor) starting 35 years after the date of the assignment for a period of five years.  A company contracting for copyright works from independent contractors will need to gauge whether a potential 35-year assignment is enough.

As unintuitive (and even silly) as California Labor Code Section 3351.5(c) and California Unemployment Insurance Code Section 686 may seem, they are currently law. Companies should bear in mind their potential effects when contracting for the creation of intellectual property in California.

We are looking into how California courts have enforced California Labor Code Section 3351.5(c) and California Unemployment Insurance Code Section 686, and will publish an in-depth article on this topic in the next few months.