IRS attempts to clarify independent contractor status.

Responding to widespread uncertainty among businesses and workers about the definition of an independent contractor, the Internal Revenue Service in March issued a new training manual to help field agents make that determination. The amount of control that a business exercises over a worker is a key factor in making a decision on the worker's classification.

In addition, the IRS established a program to help businesses being examined settle their employee classification issues, the classification settlement program (CSP), and a procedure for early referral to appeals if they don't agree to settle and reclassify the employees in question during their audit.

Worker classification is one of small-business owners' biggest headaches; if the IRS disputes a worker's independent contractor status, the employer may be forced to pay fines and retroactive Social Security and income taxes, as well as provide health insurance and other employee benefits. The consequences of reclassification are "enough to put someone out of business," said Michael J. Knight, principal of Michael J. Knight & Company, Fairfield, Connecticut, and chair of the American Institute of CPAs small business taxation committee.

The right to direct and control

"With the exception of statutory employees, worker classification is based on a common-law standard in determining whether the worker is an independent contractor or employee," according to IRS commissioner Margaret Milner Richardson. "That standard essentially asks whether the business has the right to 'direct and control' the worker." The IRS has adopted the factors courts have been using to determine worker classification in the new training manual. The new training materials do not replace the existing 20-factor test found in revenue ruling 87-41. Rather, they attempt to identify and clarify the factors that should be considered, reinforce the importance of section 530 of the Revenue Act of 1978 and ensure consistency throughout the country in decision making, according to the IRS. (Section 530 provides businesses with relief from federal employment tax obligations when workers are reclassified as employees if certain requirements are met.)

IRS agents are asked to consider the following factors in making right-to-control decisions:

* Behavioral control--whether the employer can dictate how the work is done (such as through instructions and training).

* Financial control--whether the company can direct or control how the business aspects of the worker's activities are conducted (such as whether the worker's expenses for materials or equipment necessary to perform the work are reimbursed; whether the worker has made a significant investment in materials or equipment; the method of payment; whether the worker can gain a profit or sustain a loss; and whether the worker also can make his or her services available to the public).

* The relationship of the parties-- the agents should look at the parties' intent and any written contracts, employee benefits, permanency, discharge and termination arrangements and the employee's integration within the business.

"I think the new guidance will be helpful to the practitioner, but it is not a cure-all," Knight said. "As CPAs, we are looking at the common law for a clear definition we all can follow, but there isn't one, and the factors the IRS considers are subjective. The problem of worker classification is still there, and it should be addressed so that the issue is clear in the minds of business owners, CPAs and workers."

Additionally, in March, the Contractor Tax Simplification Act, which would simplify the 20-factor test, was introduced by Senators Don Nickles (R-Okla.) and Christopher S. Bond (K-Mo.).

Resolving disputes

Both the classification settlement program, which will run for a two-year test period until March 4, 1998, and the early referral procedure, which will be available until March 17, 1997, are voluntary.

* Classification settlement program (CSP). This program sets up procedures by which businesses and tax examiners can resolve issues early in the audit process. If, during an audit, the IRS examiner believes that a business has erroneously classified a worker as an independent contractor, the agent may offer a settlement. Offers will vary, depending on the entity's compliance with section 530. Generally, under a closing agreement, a business that filed form 1099 returns but did not meet all the other section 530 requirements could reclassify the workers and pay only a specified tax assessment up to one year's liability. The CSP is available to businesses that have an open examination or appeals case as of March 5, 1996.

* Early referral procedure. This will enable companies to ask that an audit be referred to the appeals division for an early review. Requests must be made by March 18, 1997.

"It's a good idea to appeal early in the process, but it still represents additional costs to the taxpayer," noted Knight.

To receive a copy of the new training manual at no cost, write to: Douglas Izard, Dean, IRS School of Taxation, M:CD:TX, 2221 South Clark Street, Arlington, Virginia 22202.

For general information about the classification settlement program and the early referral procedure (which was discussed in IRS Bulletin Announcement 96- 13, March 18), call the IRS Office of Specialty Taxes at [phone]. For answers to technical questions about early referrals, call Thomas Louthan at the IRS at: [phone].