How to protect clients against IRS attack on independent contractors.

A business that claims a worker as an independent contractor rather than an employee is nearly always asking for trouble with the Internal Revenue Service. Making such a claim automatically raises a red flag because the IRS considers many of them misclassifications--often perpetrated as a tax dodge. So, since 1988, the IRS has been conducting a high-priority audit campaign to ferret out offenders. Unfortunately, thousands of innocent businesses get caught in the audit net, forcing them to spend much time defending their legitimate independent-contractor claims.

Complicating the issue is the fact that the IRS guidelines on what constitutes an independent contractor are somewhat vague. This article discusses how accountants can best advise clients on ways to protect against an audit and, if one is launched, how to mount a defense. (For more on this issue, see "A Taxing Matter: When Is a Worker an Independent Contractor?" by Randall W. Roth and Andrew R. Biebl, JofA, May 91, page 34.)

GET THE FACTS

To avoid an audit in the first place, CPAs are advised to gather detailed facts about a client's business and industry, including how and when the business uses independent contractors and how competitors deal with the issue. This step is necessary because many CPAs, although knowledgeable about a company's finances, often are not familiar with a client's nonfinancial operations. That's unfortunate; if they had that information, not only would they be able to serve the client better but also they would expand the range of professional services they offer.

Also, the accountant should find out if there is a trade group that can provide information about how the client's industry handles this issue. Some trade associations offer such support for their members.

The next step is to fill out IRS form SS-8--the form the IRS uses to determine independent contractor-employee status-- with the client, obtaining as much background information as possible to ensure each question is answered properly. Do not accept simple "yes" or "no" answers from the client; instead, dig for all relevant facts, exceptions and special situations.

The best way to respond to each question is to answer "no," if at all possible ("no" answers support the independent contractor classification), and then provide a detailed explanation. The exception, of course, is when an unequivocal "yes" is the only answer. Even then, a qualification should be attached if there are any extenuating circumstances.

Since SS-8 questions are general, not all apply to the client's business. In that case, it's best to answer "no" or "not applicable," with a detailed explanation when there is doubt. For example, question lib asks, "Can the worker terminate the services at any time without incurring a liability?" CPAs should assume that no notice is required, either under the terms of a written agreement or according to an oral understanding between the company and the worker. However, would the "ethics" of the worker's business or profession dictate some notice, even if only a few hours or a day? Would the worker's "professionalism" require that he or she not terminate an assignment or shift before it is completed? The question includes the phrase, "at any time," so the answer may be "no." If the worker stops work after two hours of a four-hour work assignment, so a replacement worker is needed, would the worker be required to repay the compensation received for the two hours? If so, the answer to this question could be "no."

MOUNTING AN APPEAL

In general, when appealing most IRS decisions, it is not always the best strategy to present a full appeal at the agent level; it's often wiser to hold back until reaching the IRS appeals office. However, dealing with the independent contractor issue is another story. In our experience, particularly if the client has a good, factual case, it's better to present all the facts and circumstances in the defense at the agent level, including a detailed analysis of the law and how it should be applied to the specific case.

Researching the applicable law and applying it to the specific facts can be difficult, depending on the industry. There are relatively few court decisions and published revenue rulings directly dealing with this issue. While there may be more than 1,000 private letter rulings dealing with the issue, most hold the worker is an employee.

There were two principal reasons for this:

* Many SS-8 applications are filled out and filed with the IRS by disgruntled employees and former employees.

* In many cases the worker may have submitted the SS-8 and the employer, although given the opportunity to respond, failed to do so. Thus, the IRS based its conclusion on only the narrow, biased facts of the worker.

SAFE-HAVEN RELIEF

The first line of defense after the IRS rules against a client should be to develop section 530 safe-haven relief under the Revenue Act of 1978. Under that section, an employer must show a "reasonable basis" for the classification based on published rulings, a past audit or a long-standing, recognized practice of a significant segment of that industry. While tax practitioners most frequently develop their defense based on the 20 common law factors listed in the section, they raise the safe-haven defense only if the IRS determines that those factors indicate an employer-employee relationship.

This is not a good strategy. It would be better to reverse the process: If a section 530 defense can be developed first, the 20 common law factors are easier to prove.

We used just such a strategy in Critical Care Registered Nursing, Inc. v. United States, 68 AFTR 2d 91-5716--a case that was recently decided in the taxpayer's favor. When we prepared the case for trial, we focused our attention on the 20 common law factors and the safe-haven relief provisions. The judge ruled that safe-haven relief should be considered first. It was his interpretation that if the taxpayers were entitled to relief under section 530, they would have a lesser burden of proof in meeting the 20 common law factors under the section's "reasonable basis" provision.

The case was, in fact, decided under section 530, based on the jury's determination that the company had a reasonable basis for treating the registered nurses as independent contractors. This was affirmed by the judge when he denied the IRS request for a new trial.

When section 530 was enacted in 1978, it barred the IRS from issuing further revenue rulings on the issue. However, when the section was amended by the 1986 Tax Reform Act, adding section 530(d), the IRS responded by issuing revenue ruling 87-41, which said the 530 section would not apply to engineers, consultants, computer programmers and analysts.

Revenue ruling 87-41 presents three factual situations and analyzes what constitutes the employer-employee classification and an independent contractor classification. It also provides an updated description of the 20 common law factors. If unable to find any cases, rulings or private letter rulings that deal with a client's industry or business, a CPA should try to align the client's facts so they are similar to the provisions stated in revenue ruling 87-41. If that's not possible, the CPA should develop the facts under the 20 common law factors.

There are about a dozen court decisions addressing the right to section 530 relief and how the rules are to be applied and construed. An analysis of the defense can be found in "Jury Hands Small Business a Victory over IRS: Temporary Nurses Are Independent Contractors," by Barry H. Frank, The Practical Accountant, December 1991, pages 36-39.

HOW TO HANDLE THE CASE

CPAs should counsel clients on this issue before the IRS enters the picture. The CPA should propose a preventive audit of the client's worker practices and procedures, which means reviewing contracts and suggesting changes in anything in the contract that might indicate an employer-employee relationship.

The IRS is eager to get businesses to convert independent contractors to employees as a way of boosting income tax revenue. We urge CPAs not to give in to IRS pressure if the client has a good case. The service will offer tax amnesty for prior liability if a business converts its workers to employee status prospectively. This amounts to a form of "blackmail," which in many instances has worked. Small businesses find it hard to fight the government, particularly if the case cannot be settled at the IRS appeals level and the IRS must be fought in a federal district court. However, our experience has been that these cases can be won at the agent and at the appeals levels.

BARRY H. FRANK, CPA, JD, is a senior tax partner of Mesirov Gelman Jaffe Cramer & Jamieson, a Philadelphia law firm, and is on the faculty of the Temple University Accounting and Tax Institute. JEFFREY COOPER, JD, is a litigation partner of Mesirov Gelman Jaffe Cramer & Jamieson. Both authors are members of the American, Pennsylvania and Philadelphia bar associations.

EXECUTIVE SUMMARY

* CLASSIFYING a worker as an independent contractor raises a red flag to the IRS because the service considers many such classifications as evidence of possible tax dodging.

* THE FIRST step in developing a defense against an IRS audit is for the CPA to gather detailed facts about a client's business and industry, including how and when the business uses independents and how competitors deal with the issue.

* THE CPA ALSO should find out if there is a trade group that can provide information about how the client's industry handles this issue and whether it can help in the event of an IRS audit.

* WHEN FILLING out IRS Form SS-8--the form used by the IRS to determine the status of independent contractors-employees-the CPA should try to answer all questions with a "no" and provide all relevant facts and any exceptions or special situations.

* IN MOUNTING AN appeal on this issue, it's best to present a full appeal at the agent level. This should include a detailed analysis of the law and how it should be applied to the specific case.

* IF THE IRS rules against the client, use the section 530 safe-haven relief line of defense.

* CPAs SHOULD counsel clients on this issue before the IRS enters the picture. They should do a preventive audit of the client's worker practices and procedures, which means reviewing con' tracts and suggesting changes in anything in the contract that might indicate an employer-employee relationship.