Independent contractors: the consequences of reclassification.

The Internal Revenue Service has identified the employee-independent contractor reclassification issue as a significant compliance challenge. Reclassification can be particularly devastating to small businesses, resulting in tax assessments, penalties and interest charges so large that bankruptcy is the only alternative. Because it is so costly, business owners and their CPAs must be aware of the tax and other consequences before making any decision to change.

In 1988, the IRS began a nationwide employment tax examination program (ETEP) to increase compliance by requiring businesses to treat misclassified independent contractors as employees subject to withholding taxes. Employers classifying workers as employees must withhold federal income and Social Security taxes (including Medicare) from employees' pay and match the Social Security and Medicare taxes. Employers also are subject to federal unemployment tax (FUTA) and various state employment taxes.

Between October 1987 and December 1991, the General Accounting Office reported that 6,900 ETEP audits resulted in $468 million of proposed assessments and reclassification of 338,000 workers as employees.

RELIEF?

In some cases, taxpayers can obtain relief from reclassification by taking advantage of Internal Revenue Code section 530 (see the sidebar on page 48), which absolves employers of prior employment tax liability if they meet certain safe haven requirements. (For more on the use of section 530, see JofA, Dec. 92, page 63.) While companies are not obligated to withhold income taxes or pay employment taxes when they meet section 530's requirements, the IRS frequently uses the section as a bargaining tool, agreeing to its applicability only if a business reclassifies workers prospectively. Faced with costly legal battles most small businesses can't afford, many have accepted the IRS offer.

Reclassification of a worker from independent contractor to employee for federal purposes is likely to cause a similar reclassification for state tax purposes. Since many states do not have retroactive relief provisions like section 530, they might try to assess employment-related taxes. In addition, numerous federal laws (such as the Age Discrimination Employment Act of 1967, the Occupational Safety and Health Act of 1970 (OSHA), the Employee Retirement Income Security Act of 1974 (ERISA), the Emergency Planning and Community Right to Know Act of 1986, the Americans with Disabilities Act of 1990 (ADA) and the Family Medical Leave Act of 1993) impose compliance costs on businesses when the number of employees exceeds certain thresholds. Other consequences of reclassification include nondiscrimination and coverage requirements in pension and profit-sharing plans and workers' compensation rules.

STATE TAX CONSEQUENCES

State laws differ in their definitions of "employee." However, many states refer to the IRC or to federal income tax provisions or indirectly adopt the federal definition by referring to common law rules focusing on an employer's right to control an employee's work. A few states (including Arkansas, Iowa and Mississippi) have their own definitions of employee: typically a person who performs services for another and receives wages.

EMPLOYEE MANDATES AND THRESHOLDS

Some small businesses cannot afford the administrative and compliance costs of programs like OSHA and the ADA. Paperwork and complexity have led them to avoid hiring new employees and to grow by using independent contractors or by requiring current employees to work excessive overtime. Among the most burdensome laws with low thresholds is OSHA, which applies to companies with 11 or more employees or the ADA, which applies to those with 15 or more. Businesses often describe OSHA as a regulatory nightmare. ADA compliance is far more burdensome than compliance with similar state laws. While the ADA's legislative history and purpose suggest "employee" be defined broadly, there remains an incentive for companies to classify workers as independent contractors to avoid falling under its jurisdiction (see "ADA Compliance: Let Uncle Sam Help," JofA, Sept. 94, page 61).

PENSION AND PROFIT-SHARING PLANS

Under IRC section 410(b), a retirement plan will not be considered tax qualified and eligible for favorable tax treatment under IRC section 401 (a) unless it meets minimum funding requirements, which mandate that it cover and provide benefits for the lesser of 50 employees or 40% of employees who satisfy the plan's minimum waiting period and age criteria.

Failure to meet these coverage requirements due to unforeseen circumstances (such as reclassification) does not affect their application. Thus, reclassification may result in a failure to satisfy nondiscrimination tests and cause the loss of favorable tax treatment and of corresponding tax deductions for plan contributions. In addition, workers who have been wrongfully excluded from such plans may bring action against an employer under ERISA.

WORKERS' COMPENSATION

Workers' compensation acts apply to workers whose services are a regular and continuing part of a business. They are not designed to impose a potential liability on businesses for every worker on the premises. Although the acts differ by state, worker status generally is determined by the facts and circumstances surrounding employment, with a heavy emphasis on the employer's right to control. Consequently, legislation has generally adopted the independent contractor distinction as an express or implied limitation of coverage for workers' compensation benefits. At the same time, the law has sought to prevent businesses from using independent contractors to avoid the obligation to carry workers' compensation insurance.

For many small businesses, the annual premium for workers' compensation is the single largest insurance outlay. Reclassification is likely to result in increased premiums. However, premiums should not be the only concern; workers incorrectly classified as independent contractors may sue for damages in that capacity rather than make a claim as employees for more limited compensation under workers' compensation laws.

CURRENT DEVELOPMENTS

The classification of workers as employees received more congressional scrutiny in 1994 in the wake of health care proposals that would have required small employers (those with fewer than 10 to 20 employees) to pay part of their employees' health insurance premiums. As dim as prospects for health care reform appear now, employers still should consider these as potential costs of reclassifying independent contractors.

In June 1995, attendees at the White House Small Business Conference took another look at the issue and singled out worker classification as their top tax concern. In response, both the IRS and Congress are again addressing the problem. The IRS has eased its stance by requiring high-level approval of large-scale reclassification efforts, improving IRS training materials and providing quicker resolution of section 530 audits. IRS commissioner Margaret Milner Richardson has said "it does not matter to the IRS whether a worker is classified as an employee or an independent contractor, so long as the worker...is paying his or her proper amount of taxes."

Richardson feels Congress must provide a simple and uniform definition of independent contractors and employees. Two related bills are currently under consideration. HR 582, the Independent Contractor Tax Fairness Act, was introduced by Congressman Jay Kim (R-Calif.) in January 1995. The bill proposes to overhaul the system in three ways by

1. Establishing a new, objective definition of independent contractor.

2. Codifying and expanding section 530 to include all tax liabilities, including income tax.

3. Shifting the focus of IRS efforts from reclassification of independent contractors to enforcing compliance with existing tax laws.

HR 1972, introduced by Congressman Jon Christensen (R-Nebr.) in June 1995 would similarly simplify the definition of independent contractor.

SHIFT IN FOCUS

Small businesses should still expect the IRS to scrutinize worker classification, but the focus may change to increased compliance efforts. Although Congress and the IRS are taking steps to ease the independent contractor-employee controversy, employers still must be cautious with worker classification and take particular care in planning for and documenting their worker relationships.

Section 530 Safe Harbor Provisions

Congress enacted Internal Revenue Code section 530 as part of the Revenue Act of 1978 (P.L. 95-600) and ma& the section permanent as part of the Tax Equity and Fiscal Responsibility Act of 1982. Section 530 was designed to preclude the Internal Revenue Service from retroactively correcting erroneous classifications of workers if an employer consistently and in good faith classified them as in&pendent contractors.

Section 530 applies if an employer has

* Not treated the worker as an employee in the past.

* Consistently treated the worker as an independent contractor on all returns filed (including form 1099).

* A reasonable basis (reliance on authority, prior IRS audit or a long-standing industry practice) for treating the worker as an independent contractor.

* Not treated anyone else holding a substantially similar position as an employee.

EXECTIVE SUMMARY

* RECLASSIFICATION OF INDEPENDENT contractors as employees can have devastating tax and other consequences for some companies, particularly for small businesses.

* SOME TAXPAYERS MAY BE TEMPTED TO obtain relief from retroactive federal tax assessments resulting from reclassification by taking advantage of Internal Revenue Code section 530. Many states, however, do not have similar retroactive relief provisions and might try to assess their own employment-related taxes.

* AGREEING TO PROSPECTIVE reclassification may subject businesses to federal laws with employment thresholds, such as OSHA and the ADA. This means businesses will have to bear the costs of complying with these laws.

* OTHER POTENTIAL CONSEQUENCES of reclassification include violating nondiscrimination and coverage requirements in retirement plans and the provisions of workers' compensation regulations.

* BOTH THE IRS AND CONGRESS ARE addressing independent contractor-employee concerns. The IRS has eased its stance by requiring high-level approval of large-scale reclassification efforts, improving IRS training materials and providing quicker resolution of section 530 audits. Two bills have been introduced in Congress to define independent contractors.

KATHY KRAWCZYK, CPA, PhD, is assistant professor of accounting, North Carolina State University, Raleigh. She is a member of the American Institute of CPAs. LORRAINE M. WRIGHT, PhD, is assistant professor of accounting, North Carolina State University, Raleigh. ROBY B. SAWYERS, CPA, PhD, is assistant professor of accounting, North Carolina State University, Raleigh. He is a member of the Institute of Management Accountants and the AICPA.