A taxing matter: when is a worker an independent contractor?

As many businesses have already discovered, one of the Internal Revenue Service's hottest issues is the reclassification of a worker's status from independent contractor to employee.

This is not merely a semantic issue to the IRS, the employer or the worker. The IRS claims it's shortchanged $10 billion a year because workers are incorrectly classified as independents. The Service says one in seven employers misclassify a total of 3.4 million workers.

Clearly, it's to an employer's advantage to label a worker an independent contractor rather than an employee. However, from a legal point of view, the differences between the two classifications are often not clear. Although there are abundant guidelines"-regulations, IRS advisories and court cases-many of them are contradictory or vague. Further, these guidelines tend to hinge on unique circumstances in relationships between the company and the worker, making extrapolation or comparisons from one set of circumstances to another difficult.

In 1988 the IRS mounted a high priority campaign to address this issue. That campaign continues and the IRS says it now has 750 revenue officers running special audits to uncover what it considers "misclassifications," with the effort concentrated on businesses with assets of less than $3 million.

Additionally, it has developed special training programs and audit techniques for revenue agents and has instructed them to look for misclassification during the course of regular audits.

Of the companies called in for a worker classification review during one recent period, the Service claims 92% were assessed a higher tax, with an average assessment of $67,000. However, the IRS hasn't disclosed how many of those assessments were challenged and how much was actually collected.

When penalties are levied by the IRS, they can total twice the tax that would have been due had the worker been classified an employee right from the start. On top of that, employers then may be required to extend regular employee benefits to the reclassified workers. That can amount to between 30% and 40% of the basic pay.

The issue takes on greater interest today because of the emphasis on business downsizing. Using independent contractors, rather than employees, is a favorite strategy for those businesses seeking to be mean and lean."

Why businesses would rather classify a worker as an independent contractor than an employee:

* It's often easier to cancel or not renew a contract than to fire an employee especially since independents are not protected by any of the antidiscrimination laws.

* When an independent contractor is fired, " the business isn't subject to higher state unemployment insurance premiums.

* Independent workers don't fall under the protection of the federal wage and hour laws (covering overtime and minimum wages) or certain provisions of the Occupational Safety and Health Act.

* If they are injured on the job, they aren't protected by workers' compensation insurance and, of course, they aren't included in a company's pension plan or its Social Security contributions.

THE IRS'S 20 QUESTIONS

In general, what constitutes an independent contractor? The IRS uses a 1987 guide (Revenue Ruling 87-41) in which 20 questions are asked, with a "yes" answer indicating a factor in favor of assessing the worker as an employee.

1. Is the worker required to comply with instructions about when, where and how the work is to be done?

2. Is the worker provided training that would enable him or her to perform a job in a particular method or manner?

3. Are the services provided by the worker an integral part of the business's operations?

4. Must the services be rendered personally?

5. Does the business hire, supervise or pay assistants to help the worker on the job?

6. Is there a continuing relationship between the worker and the person for whom services are performed?

7. Does the recipient of the services set the work schedules?

8. Is the worker required to devote his full time to the person he performns services for?

9. Is the work performed at the place of business of the company, or at specific places designated by the company?

10. Does the recipient of the services direct the sequence in which the work must be done?

11. Are regular oral or written reports required to be submitted by the worker?

12. Is the method of payment hourly, weekly or monthly (as opposed to commission or by the j ob)?

13. Are business and/or traveling expenses reimbursed?

14. Does the company furnish tools and materials used by the worker?

15. Has the worker failed to invest in equipment or facilities used to provide the services?

16. Does the arrangement put the person in the position of realizing either a loss or a profit on the work?

17. Does the worker perform services exclusively for the company rather than working for a number of companies at the same time?

18. Does the worker in fact not make his services regularly available to the general public?

19. Is the worker subject to dismissal for reasons other than nonperformance of contract specifications?

20. Can the worker terminate his relationship without incurring a liability for failure to complete a job?

The IRS notes that employee status exists when the person for whom the services are performed has the right to control and direct the worker, not only on the result of the work, but also on the details and means for rendering the services. The 20 factors are intended as indicators of whether sufficient control is present to establish an employee relationship.

The IRS fine-tunes that guideline by adding that it's "not necessary that the employer actually direct or control" the work, only that the employer has the "right to do so." However, in reality, it is difficult to prove that a worker is not subject to another person's "right" to control when there is no written agreement which states that specifically.

While the IRS promotes the 20question list as a guide, it concedes that it's not the last word. There are scores of rulings and court cases that add exceptions and ambiguity to the question.

Complicating the issue further is Section 530 of the 1978 Revenue Act, which potentially provides protection for employers with classes of workers consistently treated as independent contractors since 1978.

To qualify for this safe harbor, a company must meet three criteria:

(1) The worker must have been consistently issued a Form 1099 as an independent contractor.

(2) No workers in substantially similar positions have been treated as employees after 1977 by the company.

(3) The employer has a reasonable basis for treating the class of workers as independent contractors. The "reasonable basis" test can be met by relying on published rulings or cases, by a prior IRS audit that did not adjust a company's practice or by a long-standing recognized practice that exists in the particular industry.

But the safety zone of the 1978 Act (Sec. 530) may be somewhat illusory. Missing a 1099 obligation may prove fatal (Revenue Rule 81224), and the IRS asserts that protection is afforded to employers only for employment taxes; the worker may still be treated as an employee for other purposes, resulting perhaps in such things as disqualification of the company's retirement plan and the subjection of the worker to the 2% floor rule for deduction of unreimbursed business expenses (Revenue Procedure 85-18).

Further, the IRS takes the position that arguing for safe harbor relief from payroll taxes is an admission by an employer that a worker is an employee under the common law tests.

COSTLY CONSEQUENCES

If a company is found to have violated the law, payment of back taxes, interest and penalties add up quickly. And since some of these payments are designated as withholding taxes, the IRS can make personal claims against the responsible parties. In some cases, the assessments have been so large that the businesses declared bankruptcy, but not before the owners or officers of the company lost their homes and possessions.

If an employer disputes the withholding amount, contending that the worker, as an independent contractor, already paid the required income tax (as well as self-employment taxes), the IRS demands the company prove it by providing signed certificates from each contractor. That can be a problem, especially if a large number of workers are involved and the case extends to pay periods several years earlier.

If the employer is unable to furnish proof, the IRS generally will not provide information from its own records unless the employer files suit and demands it in a discovery proceeding.

In some cases, there is a possibility the IRS will collect far more than is due, simply because proof of payment is unavailable. WHAT TO DO How should accountants deal with the independent contractor-employee issue?

If an accountant has a client who clearly is misclassifying one or more workers, and thus is liable for penalties and possibly even prosecution, the CPA should draft a letter to the client explaining the exposure and liability in detail. That should be done because it's the professional thing to do and because failure to take the step may expose the CPA to a suit by the client.

If an accountant is employed by an organization that is misclassifying workers, it would be prudent and professional for the accountant to compose such a letter to his boss, warning of the danger.

But what:if the circumstances are not clear-cut-that is, an independent observer could argue the classification issue either way? In such a case, the CPA could take the following steps:

Assemble all the facts and compare them with the 20-question IRS revenue ruling. If, in consultation with the client or the CPA's boss, it's determined the situation is indeed not clear-cut, the company might consider, for safety's sake, to reclassify the questionable workers. Employers should be aware this step could be dangerous: The act of reclassification could be interpreted by the IRS as an admission of mischaracterization for prior years.

Another possibility is for the company to do nothing, working on the premise the workers are indeed independent contractors.

In that case, the employer would be wise to strengthen his case by tightening up the relationship to make it even clearer, from a legal point of view, that the worker is an independent contractor. Here are some steps the employer might consider taking:

1. Draft a written agreement that spells out the relationship and have both parties sign it. The agreement should make it clear the company doesn't have the right to control the procedures for accomplishing the contracted services.

2. Consider reciting the worker's obligation to pay income and self-employment taxes.

3. Avoid setting working hours or number of hours per day or days per week. It's okay, however, to give starting and completion dates.

4. If the contractor needs added help, make it clear that he, not the company, would be hiring and paying for it.

S. If the worker needs tools for the job, he should provide them and select their type. To accomplish this, the company might consider assistance in financing the purchase by guaranteeing a note or even lending the money.

6. Avoid exclusive service arrangements. The worker should be able to take on other assignments.

7. Arrange compensation for each job performed rather than time spent on the job.

8. Advise the workers to arrange for their own liability, disability and health insurance coverage.

9. Overhead costs (meals, clothing, transportation) should be part of the contract price, and those charges should not be billed directly to the company's account.

10. Office space should not be provided to the worker on a regular basis.

11. Workers should be responsible for their own training.

12. During downtime," they shouldn't be given other work.

13. Make it clear the contractor can't be fired"; nor can he quit." His responsibility is to fulfill a contract, and that should be part of the agreement.

14. Bonuses should be avoided.

While following these advisories will not guarantee a company will be protected in an IRS audit, it definitely strengthens its position. 2