What Does the Law Require?
There is increasing interest recently in "virtual" practice, other non-traditional forms of practice, and project "team" organization. Not everyone has the same understanding of how a "virtual" practice would be structured or how it would perform services on projects – nor of the inherent legal and professional liability concerns.
A solid understanding of the basics of traditional business structures and project team organizations can be crucial for future success. As in many endeavors, understanding pertinent laws and regulations and some proficiency with the fundamentals of business organization and management structures will help one to achieve their desired ends. This section will provide basic information about business structures and labor law and while by no means exhaustive, it should be useful when starting a ‘virtual practice’.
While this discussion is applicable to general business entities, some things are different when a business is offering professional services – often radically so – and will be addressed later.
There is a growing type of for-profit entity that caters to many start-ups: the benefit corporation. A growing number of architecture firms have become benefit corporations in the past 10 years, the biggest driver of this growth being startups by Millennials who wish to create public benefits. For Luis, she originally registered her firm, ALLL, as an LLC; however, when the Benefit Corporation Act was passed in her state of Illinois in 2013, she re-registered it as a Benefit Corporation. Some of the advantages of registering as a Benefit Corporation include reduced director exposure in some cases and attracting talent and private investment capital when the organization is focused on the benefit mission, rather than shareholder pressures for dividends or growth.
This is a business owned by one person, but with any number of employees. (A sole proprietor may sometimes be a "sole practitioner.") The owner is completely responsible for all decisions, is personally liable for all business debts and is liable for his/her own wrongful acts or omissions. If there are any employees, the owner is liable for their wrongful acts or omissions (if made in the course of their employment). The owner is taxed personally on the net income of the business. And, finally, the business usually dies when the owner dies.
If a sole proprietorship wants to offer architectural services to the public, the sole proprietor must be licensed to practice architecture in the applicable jurisdiction–unless s/he is performing work not requiring licensure. Importantly, the firm would also need a business license.
When two or more people or entities associate to carry on a business for profit as co-owners, that will generally be treated as a partnership. Each partner is responsible for his/her own wrongful acts or omissions, as well as for those of all other partners and employees, if made in the course of their employment. In other words, your partners can put your personal assets at risk and many attorneys advise that two or more owners form a corporation or an LLC instead of a general partnership. That being said, there are firms that practice successfully as partnerships.
A corporation is a legal entity which exists separate from its owners and officers. Once properly established, the corporation is responsible for its debts and obligations. Legally, shareholders (owners) are not personally liable for the corporation's debts. The reality is often different, however. Banks and vendors will often not extend credit to new corporations without a personal guarantee by the owners (shareholders).
If a corporation wants to offer architectural services to the public, the corporation must qualify to do so in the applicable state. Generally speaking, that requires that at least 51% of the ownership interests in the corporation (sometimes more) must be held by registered architects (at least one of whom is authorized to practice architecture in the applicable state). However, this varies by state and the corporation will need to verify its state laws.
Notwithstanding the general rule about liability, licensed professionals are always personally liable for their own negligent acts or omissions. This is true regardless of the legal form of the business entity and there is nowhere to hide in this respect. Remember, licensed professionals are always personally liable for their own negligent acts or omissions.
A corporation may exist in perpetuity. Shareholders may come and go, but the corporation will persist. Owners (shareholders) must approve of all fundamental changes in the corporation. They elect the Board of Directors. The Board of Directors is ultimately responsible for the management of the corporation. They elect the Officers. The Officers conduct the day-to-day affairs of the corporation.
If the corporation earns a net profit, it is taxed on that profit and it generally must pay the remainder out to shareholders proportionally as a taxable dividend on each share. This so-called "double taxation" can be avoided either by paying out all gross profits as bonuses or by being an S Corporation. An S Corp is allowed to pass income directly to shareholders, where it is taxed once and only once, avoiding a second tax at the corporation level.
A Professional Corporation is generally just like a regular business corporation, except that all shareholders must be licensed to practice the profession which the corporation will practice. If this is not required in a particular jurisdiction, it is generally unduly restrictive.
Limited Liability Company or Partnership (LLC or LLP)
This entity is a hybrid between a partnership and a corporation. It is an alternative to "S Corp" status, limiting liability with no double taxation; however, a firm may be an LLC and elect to be taxed as if they were an S Corp. An "S Corp" may have no more than 100 shareholders, so an LLC is attractive to firms which might have chosen "S Corp" status but were too big. LLCs can be organized to be very flexible in terms of structure and operations to suit individual needs or desires.
Generally, the foregoing entities can work with just one owner; however, when there are two or more owners, a sole proprietorship is not possible. Importantly, once you initially establish a business entity, you are not locked into that form forever – changes can be made, but there may be tax consequences.
Labor Law Overview
Traditionally, many architects have hired "consultants" for longer or shorter periods of time for a number of reasons and to avoid putting them on the payroll, paying benefits, and withholding taxes.
Whether your practice is set up in a more ‘traditional’ or a more ‘virtual’ way, key drivers of claims will continue so your firm’s risk management practices should continue as well. There are several key areas that should take on a greater focus in virtual practice, including:
- The use of independent contractors versus employees, and
- The importance of technology in your practice.
The firm’s use and selection of employees versus independent contractors is of primary concern. It is not just a consideration of how you want to operate but how the law will affect your practice.
In creating a virtual practice, many firms will replace staff expertise or pursue new service and practice opportunities with that of independent contractors. Architects should take care to avoid the legal and taxation difficulties generated by the improper use of independent contractors.
So, who is a "consultant"? You should understand the term to mean an independent contractor and NOT an "employee." This determination is not as simple as it sounds and there can be large financial consequences for getting it wrong. Another way to look at it is: who must be classified as an "employee"?
By way of example, the Commonwealth of Massachusetts has a pretty clear law on the topic. Per M.G.L. c. 149, S 148B, to be considered an independent contractor ("consultant" vs. "employee") each of the following factors must be established:
- The worker must be free from the "employer's" control and direction in performing the services.
(This must be true per the contract and in fact.)
- The service provided by the worker must be outside the "employer's" usual course of business.
- The worker must be customarily engaged in an independent trade, occupation, profession or business of the same type.
"Usual course of business test" is the most expansive. Some other state courts have suggested that it does not include services that are i) used occasionally and at irregular intervals and ii) performed outside of the "employer's" place of business.
Again, Massachusetts law is strict on this topic. For example, if you have someone coming to your office to perform services, using your desk and equipment, etc., they are providing drafting and design services and they have no other established place of business with other clients, etc., you should assume they are an employee and treat them as such. This is not to say that a "consultant" cannot be a sole proprietor with many other clients who are billed, etc. However, the lone person between jobs will probably not qualify. If your "consultants" have created an S Corp or LLC for their practices, then there’s no problem. The consequences are that the firm may be liable for back workers' compensation payments, for payment of income tax withholding that was not done, plus interest, plus other potential penalties and interest. When contracting with consultants, also consider seeking advice from your attorney on drafting a clear provision pertaining to the non-employee status of the consultant.
Employee Liability Issues
Cost and Flexibility Benefits
Using independent contractors rather than employees can be an effective asset protection tool. A firm properly using the services of independent contractors may benefit because:
- The firm is not required to pay employment taxes or workers compensation insurance on the wages paid to independent contractors; however, there are some exceptions to the independent contractor rules state-by-state that should be examined.
- Benefit and retirement plans of the firm are not required to be extended to these non-employees.
- Some tort liability for the independent contractor can be avoided, although in most instances, the professional liability exposure cannot be limited.
- Record-keeping is simplified because no withholding from wages or employer tax reports is necessary.
However, strict rules must be followed so that workers are properly classified as independent contractors; purposeful mis-classification is unlawful. While a firm may designate a worker as independent, the ultimate classification is not up to the employer. A written employment agreement labeling the worker as an independent contractor is helpful, but a label does not create reality. The law—both tax and agency law—has developed elaborate rules that determine whether a worker is properly classified. If the worker does not meet these rules, the label means nothing. If the worker is “reclassified” by the courts or the IRS, the employer faces significant costs and risks.
The intent and use of independent contractors in a virtual practice may be more complicated when the individuals are project-to-project hires under your direct supervision and control -- the most important aspect for a virtual firm to consider as it moves forward.
The Issue of Control
Over the years, the courts have developed approximately 20 factors to test whether a worker is properly classified. For the most part, the IRS follows the same guidelines. Many of these factors can be condensed into one factor—control. With many workers providing professional services to a prime design professional, the control issue is unclear. At times, firms attempt to turn current employees into independent contractors to increase flexibility and cost savings while still directing their actions and often preventing them from pursuing opportunities with competitors. If a worker does not have the ability to determine fees, establish working hours, and offer services to others, it is likely that the worker will be deemed an employee. When the independent contractor works for one firm on a more or less permanent basis, the independence is easy to challenge.
Use of Temporary Employees
For tax purposes, firms often look to IRS “safe harbor” provisions that provide guidance on the reasonable basis for classifying a worker as an independent contractor. While the IRS may have the burden of proving an independent contractor is not truly independent, it is likely that as more firms shed permanent workers to reduce costs, more IRS challenges will be forthcoming. Even the use of workers from an established temporary employment agency is no longer a certain protection. According to the courts, for tax purposes, workers may have two employers and be considered employees of both the temp agency and the company to which they are assigned.
Tort Liability for Independent Contractors
Firms are responsible for the actions of employees within the normal scope of their employment activities. A firm is not normally responsible for torts committed by an independent contractor. In professional liability cases, contrary to the general rule, courts will hold an employer liable for the acts of an independent contractor because the employer has a legal duty that may not be delegated to another. Thus, prime design professionals are not only responsible for their employees but also for the exposures of their sub-consultants, including any individuals providing professional services as independent contractors. In addition, a firm may be separately liable for the negligent hiring of an independent contractor not qualified to legally perform the services required or for failure to meet the standard of care for these services.
Hiring independent contractors may be an effective way for a firm to remain financially viable in a bad economy. Their use also can assist a firm in meeting new client needs. Care must be taken, however, to avoid a reclassification for tax or employment benefit purposes and for the tort liability of an independent contractor.
Additionally, professional liability policies are set up to cover the entity and the individual principals, partners, and past and present employees of the firm. Some policies, including the policy provided under the CNA/Schinnerer program, cover leased employees under your direct supervision and control. However, policies today do not include coverage for independent contractors who, may be working in a company that your firm hires, e.g., a consulting engineering firm, or working as an individual for your virtual practice, so they would need to provide their own professional liability coverage. Bringing your carrier and insurance broker into the conversation early in the process is very important to avoid the possibility of coverage gaps or increased risk exposure.
Another angle may be to consider leasing out your employees to other firms during “down time” – but you still must consider the liability that may occur from that practice. When a design firm provides a client with its own professional employees—essentially leasing its employees to the client—and they are employees of the design firm under the direction of the client-all three parties are at great risk. Obviously, the professional employee is responsible for his or her own actions but the design firm, as the employer, has the all-encompassing responsibility for its employees’ actions in their normal course of practice. The design firm’s responsibility could be mitigated by the actions of the client, but this, depends on state statutory and case law.
From a professional liability perspective, a design firm is liable for the negligence of its employees in performing professional services. It can contractually limit its liability to the clients for whom its employees are providing services and be indemnified by clients, meaning secured against legal responsibility for their actions, in situations where a third-party claim can be tied to a supervisory action of a client. A design firm leasing employees may want to check with legal counsel to determine if additional contract language is needed to best address this exposure. The focus of the review is to see if the firm can better confirm who is and should be in control of the employees’ services and providing a waiver of claim to the design firm that does not have control.
Regardless of the firm’s approach, it is very important for professional service firms to have clear policies on the outside professional activities of its employees. The possibility exists that a firm can be held liable for the actions of its employees even though it did not specifically know of or authorize those actions. A firm with no clear policy against moonlighting, and no clear prohibition against using company equipment or premises for outside employment, can find itself with imputed liability and no insurance coverage.
A firm’s exposure to the possibility of loss is decreased if the clients of moonlighting employees—whether the professional services are being provided for a fee or otherwise—acknowledge that the services are being performed solely by the individual, not by the individual’s employer, and that the firm assumes no responsibility for the actions of the individual providing such services.
A firm is also at risk for being held liable for negligence claims arising out of the moonlighting of its employees if it does not clarify rules regarding the use of company equipment or premises for outside employment activities. An absolute prohibition is not unreasonable. A firm could protect itself and assist employees in understanding their responsibilities by having policies that address these situations.
Using Non-Employees Can Create Tax and Liability Issues
Professional service firms are increasingly considering divesting some or all of its employees and may simply lease employees from other firms or staffing businesses. Professional Employer Organizations or PEOs, serve as a co-employer, offering firms the ability to “lease” employees and the PEO generally handles HR-related functions. Firms may lease professional employees to reduce overhead and respond more quickly to variations in work flow without adding administrative complexity. Other firms are turning former employees into independent contractors as a way for firms to cut wages and benefits since many "independent contractors" had no choice but to work for such a reduction in compensation. With the advent of available health insurance coverage for individuals brought about by the Affordable Care Act, many employees are now eager to set themselves up as independent contractors with the goal of eventually working for multiple firms or directly with clients.
In the case of leased employees actually employed by another entity, it is highly likely that the entity will bear most of the legal responsibility for the employees. That does not, however, reduce the professional liability exposure of the firm using and usually controlling the leased employees. If not done correctly, this approach raises the possibility that both entities will be found to be "joint employers" sharing business and taxation as well as professional exposures.
The use of independent contractors—who are not employees and therefore not subject to the array of federal, state, and local employment laws and who are treated very differently than employees for tax, unemployment compensation, workers’ compensation, and other purposes—can result in professional and business risks to the firm. Unlike employees, independent contractors are not subject to laws such as the Family and Medical Leave Act, the Fair Labor Standards Act, and relevant tax, workers’ compensation, and unemployment laws. Federal laws exist to ensure that all workers are properly classified as independent contractors or employees depending on numerous factors that include but not limited to, the following:
- the extent to which the worker’s services are an integral part of the employer’s business;
- the permanency of the worker/employer relationship;
- whether the worker uses his own tools or equipment when performing the job;
- the nature and degree of control by the employer;
- the worker’s opportunity for profit and loss; and
- 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.
Classifying workers as independent contractors has become increasingly common in recent years, to the point where we are now beginning to see the inevitable regulatory push-back. One example in Pennsylvania is the Construction Workplace Misclassification Act, which severely limits the ability to qualify as an independent contractor and enhances penalties for those firms that misclassify, or knowingly contract with those who misclassify, construction employees as independent contractors. Also, the Internal Revenue Service and U.S. Department of Labor announced a coordinated program of education, audit, and enforcement directed at the misclassification of employees as independent contractors under the federal tax and wage and hour laws.
Mandating proper classification of workers benefits the workforce, regardless of whether an employer chooses to misclassify its employees as independent contractors or sets up a leasing arrangement with an outside organization. Forcing firms to acknowledge workers over whom they have control as employees also levels the playing field so that employers who attempt to circumvent regulations do not receive an unfair competitive advantage. Professional service firms must be careful in leasing professional employees and should not rely on formulaic documents and contracts that deem workers independent contractors if those workers do not truly fit that profile. Misclassification could result in civil and criminal penalties.
For a virtual practice to function across state lines, across the country, or even internationally, multiple professional registrations will be required for each jurisdiction in which the architect intends to practice.
As a function of each state’s right to govern the health, safety and welfare of its residents, state law governs the practice of architecture. Licensure laws vary by state, but typically contain provisions that define the practice of architecture, its privileges and limitations, and enumerate the minimum education and training requirements to become a licensed architect in the jurisdiction. Like other professions such as medicine or law, practicing architecture without a license in the place where the would-be architect is performing work is unlawful.
To avoid the unauthorized practice of architecture, an architect must maintain a license in each state in which he or she is performing architectural services. This can become confusing to architects working in a virtual practice where they may live in a distant location, be part of a team that is spread out across a geographic region, or take on only certain aspects of architectural services. Likewise, less experienced architecture graduates not yet licensed or not licensed in the state where a project is located may be more likely to engage in work that starts out merely as drafting, rendering or modeling, and unwittingly end up taking on work that amounts to the practice of architecture, or be credited as an architect – especially when engaging in international work. The bottom line is that it is important for the architect to stay up to speed on licensing requirements for each state in which he or she engages in professional services related to the practice of architecture, and where the activities undertaken fall under the statutory definition, be mindful of the law’s individual requirements.
One can look to the experiences of large firms that already operate in multiple states to understand the very same regulatory requirements that a virtual practice would face, but also some of the conveniences. Starting with each state’s Secretary of State or business licensing body, the architect should investigate the requirements for registering the business, as well as verifying with the state licensing board the individual’s requirements to practice architecture. NCARB provides ample resources for understanding state architect licensing requirements and is an essential first stop.
It is worth noting that while a large firm may have an individual or a team solely dedicated to tracking the business aspects of a multi-state practice, for a small firm or sole practitioner this administrative burden may become heavy, e.g., keeping track of state business and professional registrations, continuing education requirements, and the like. When planning for a virtual practice, this should not be an afterthought, but something carefully worked into the business plan, as it will require additional time and administrative overhead.
In addition, understanding each state’s laws pertaining to signing and sealing drawings is also important. Permitting, construction contract administration, observation, fielding questions by code enforcement officials and managing jurisdictional inspections are factors to consider if the architect is performing design services only. Traditionally, many construction defects happen when communications falter or break down between the design and construction phases of a project. In a virtual practice, the line may be blurred where responsibilities shift or are eliminated. Architects may face client conflicts or complaints if they are in absentia and that may result in complaints to the state licensing board or the AIA National Ethics Council.
In summary, the licensing issues in virtual practice can be observed in firms that already manage multiple offices, virtual platforms, and mobile communication. For the small firm, this may add additional administrative burdens. It is essential to check each state’s legal requirements for both business and professional licenses, and check the requirements for code enforcement in the jurisdictions. Finally, depending on the business model and the work involved, licensure issues may be just one hurdle that is “worth it” to pursue work across geographic boundaries.
Contractual Cascade: Traditional Practice
As seen in the diagram on the next page, the "owner" or "client" is at the top of the cascade. On the left, there is a line (representing a contract) connecting the owner to the design professional (this assumes an architect, but it could be any design discipline) who is at the next level down on the cascade. Further, there are one or more lines (again, contracts) connecting the architect to various consultants at the next level down on the cascade. Those entities are often engineers, but they could be any discipline providing services to the architect to support the architect in performing its contract with the owner.
On the right side, the general contractor is at the top of the cascade and various subcontractors at the lower level of the cascade. Regarding the construction side, the principles are the same as those that are applicable to the design side. (In both cases, additional levels of the cascade could be added and the same principles would apply.)
As a rule of thumb, obligations and commitments flow DOWN the contract lines (from the top level of the cascade down to lower levels) and liabilities flow UP the contract lines (from the lower levels of the cascade to upper levels). For example, the owner would contract with the architect to perform services. Whether the architect is a sole proprietor, corporation or LLC, it must be licensed or authorized to offer architectural services to the public, e.g., the owner. The architect (depending on the make-up of the firm and other circumstances) would contract with one or more engineers, landscape architects, acoustical consultants, etc. to perform some of the services that the architect has contracted to perform for the owner. In most cases, in traditional practice, the architect has employees as do the various consultants. If the consultants are individuals, refer to the earlier notes about when "independent contractors" must be deemed to be "employees."
Basically, money flows down the cascade and liability "flows" up the cascade. The owner pays the architect who, in turn, pays the consultants. If a consultant makes a negligent error or omission, they will be liable to the architect who will, in tum, be liable to the owner.
If the architect is potentially going to be liable to the owner for a negligent error made by a consultant, the architect will want to be able to recover from the consultant for damages and expenses caused by such an error. The best source of funds for such recovery is professional liability insurance, so it behooves the architect to be sure that its consultants are properly insured.
Contractual Cascade: Virtual Practice
"Virtual Practice" means different things to different people. In a virtual practice, the cascade diagrammed earlier would remain "operational," but the entities in each position on the cascade would be somewhat different than in traditional practice.
The owner remains at the apex of the cascade. The architect remains at the next level down. However, in a virtual practice, this entity might be a sole practitioner who has few, if any, employees. Nevertheless, the individual must be licensed to practice architecture if the services being offered to the owner qualify as the "practice of architecture" under state law.
The consultants at the next level down may be the same as they were in the cascade for traditional practice or they may be a series of individuals or small firms located anywhere around the world.
If some of those consultants are individuals who are taking the place of traditional "staff," the architect must be careful to verify that they are truly independent contractors and will not be deemed to be "employees" for whom the architect must withhold monies for FICA, etc. and for whom workers' compensation insurance must be carried.
Further, since the "staff" may be spread far and wide, supervision and quality control can become difficult. If those individuals are preparing construction documents to which the architect will ultimately apply that architect's stamp and seal, the architect must be cognizant of architectural licensing rules which typically require such documents to be prepared "in the architect's office" or "under the architect's responsible supervision." Typically, an architect cannot stamp previously prepared documents provided by an owner or others.
Just as in traditional practice, the architect will be liable to the owner for the negligent acts, errors and omissions of its consultants. If such consultants are individuals or small firms or located in foreign countries, the architect may have a difficult time pursuing remedies against them. They may be what is referred to as "judgment proof."