Smoky Mountain's secret to successfully claiming workers to be independent contractors.

EXECUTIVE SUMMARY

This article illustrates that due diligence pays off. It examines Smoky Mountain Secrets, Inc., in which a taxpayer successfully defended against an IRS reclassification of workers as employees. The taxpayer's president sought tax advice on the classification issue when Sec. 3508 was first enacted, and the tax adviser and the client scrutinized Sec. 3508 and Section 530 of the Revenue Act of 1978 in determining that the workers were independent contractors. The Eastern District of Tennessee recently concluded that, given the law as it then existed and the taxpayer's efforts to obtain tax advice, the taxpayer's classification of its telemarketers and delivery people as independent contractors was correct, saving almost $4 million in payroll taxes.

Taxpayers won a major victory recently against the IRS's relentless assault on workers classified as independent contractors. Smoky Mountain Secrets, Inc.(1) a landmark decision, provides much-needed clarification of the independent contractor versus employee question. The case addressed the classification under Sec. 3508(a) and (b) (2) of direct sellers as nonemployees, Revenue Act of 1978 (RA '78) Section 530 and common law.

Background

Smoky Mountain Secrets, Inc. (SMS) is a Tennessee corporation that markets gourmet foods and condiments to consumers in various states. Most sales are solicited through SMS's staff of commission-based telemarketers located in sales offices in 14 different states, although some orders are received via mail, from repeat customers and from on-the-spot sales by delivery people. Orders solicited by the telemarketers are delivered to customers' homes by delivery persons who often need to actually close the sale to collect the amount due. SMS also employs a large staff of workers that it classifies as employees (e.g., home office staff, office managers and warehouse workers).

Prior to starting to work for SMS, telemarketers and delivery persons are required to sign a contract that sets forth that (1) the worker will be paid on a commission-only basis (tied directly to the number of sales delivered and paid for), (2) the worker is an independent contractor, not an employee, and (3) no taxes will be withheld. New contracts are signed every year. SMS issues a Form 1099 to every telemarketer and delivery person who earns over $600 per year.

The IRS assessed SMS for approximately $3.9 million in FICA and FUTA taxes for 1989 and 1990, contending that its telemarketers and delivery personnel were employees. SMS paid part of the tax and sued in district court for a refund. The parties stipulated that SMS actually issued a Form 1099 to every telemarketer and delivery person who earned $600 or more during the years in issue.

RA '78

Interim relief enacted in Section 530 of the RA '78 prevents the IRS from arbitrarily reclassifying workers retroactively. A business is protected from retroactive reclassification of its workers if it treats all similar workers as independent contractors, files all proper Federal tax documents (e.g., Forms 1099). and has a "reasonable basis" for the classification. A reasonable basis is determined by (1) judicial precedent, published rulings, or technical advice or letter rulings to the taxpayer, (2) a past IRS audit of the taxpayer in which no assessment was made on similarly treated individuals, (3) long-standing recognized practice of a significant segment of the industry or (4) some other manner.(2) The legislative history indicates that the "reasonable basis" test is to be construed liberally in favor of the taxpayer.(3)

Sec. 3508

Sec. 3508 was enacted by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Section 269(a), to ensure independent contractor status for direct sellers. A direct seller is classified as a nonemployee for Federal tax purposes (and the recipient of the services is not considered an employer) under Sec. 3508(b) (2) if:

[] The worker engages in the trade or business of selling or soliciting in homes or in other than a permanent retail establishment.

[] The worker is compensated substantially based on sales, not hours worked.

[] The services are performed under a written contract that provides that the worker will not be treated as an employee for Federal tax purposes.

In addition, TEFRA Section 269(c) indefinitely extended RA '78 Section 530.

Taxpayer's Actions

In 1983, the first year of SMS's inception, its president read about Sec. 3508 in a magazine and consulted a tax adviser to determine if it could apply to classify his telemarketers and delivery people as nonemployees. The client and the tax adviser scrutinized Sec. 3508(a) and (b) (2) and discussed each individual element in Sec. 3508(b) (2). The client produced a copy of the contract then being used for its telemarketers and delivery persons. Based on the language of the statute, the contract and the client's description of the relevant facts about his business, the tax adviser tentatively concluded that the taxpayer's telemarketers and delivery personnel were independent contractors.

Following this meeting, the tax adviser reviewed and sent copies of the Senate, House and Conference Committee Reports on Sec. 3508 to the client. These reports addressed the factors considered by Congress in enacting both Sec. 3508 and RA '78 Section 530.

Subsequently, the client sought the advice of another practitioner, a former IRS agent, who concluded that SMS's telemarketers and delivery personnel were independent contractors under common law. After giving this advice, the practitioner attended an IRS professional education course on the 20-factor test of Rev. Rul. 8741.(4) and reconfirmed to SMS's president that. under that test, the workers were properly classified as independent contractors.

Subsequent Pronouncements

In 1989, the IRS Acting Commissioner, in testimony before a House Subcommittee on Employee-Independent Contractor Issues, stated:

Section 530 of [RA '78] established a moratorium on the reclassification of workers as employees for the purpose of the employer's federal employment tax obligations, if the employer has a "reasonable basis" for not treating the workers as employees. It also prohibited the publication of IRS rulings and regulations on the employment status of workers.(5)

The Court's View

The district court concluded that SMS's workers qualified as direct sellers under Sec. 3508; further, even if they did not qualify under that section, SMS was entitled to relief under RA '78 Section 530. In discussing RA '78 Section 530, the court concluded that SMS demonstrated a reasonable basis for classifying the workers as independent contractors by relying on the advice of two tax professionals.

Advising Clients

Despite SMS's success, practitioners must continue to be extremely careful when clients want to hire independent contractors. Both Sec. 3508 and RA '78 Section 530 should be thoroughly reviewed on a regular basis.

To survive an audit involving independent contractors and to correctly advise clients, the following points should be noted:

[] Sec. 3508 provides guidance for qualified real estate agents and direct sellers who are paid based on sales and/or output under the terms of a written contract.

[] RA '78 Section 530 is helpful to taxpayers who survived a prior IRS audit on the same issue, are in an industry in which independent contractor status is a recognized practice or can show facts similar to that in a published case or ruling.

[] Smoky Mountain Secrets, Inc. should not be used indiscriminately as support for classifying workers as independent contractors. Each situation's facts and circumstances must be carefully considered and a determination made as to how close the client's facts are to those in Smoky Mountain Secrets.

[] SMS is currently seeking recovery of its legal fees on the grounds that the IRS assessment was wrongful and substantial fees were required to reverse the assessment. Generally, under Sec. 7430(c) (2), only professional fees incurred after the issuance of the deficiency notice may be recovered.

Conclusion

To prevail in court against the IRS on an independent contractor case, practitioners should consider the following:

[] Despite assertions to the contrary,(6) the IRS has declared war on independent contractors and on taxpayers who use their services.

[] Diligent tax research should be undertaken before rendering advice on worker classification issues.

[] Determine whether the client has sufficient financial, physical and mental stamina to see the case through trial.

[] If litigation is inevitable, hire a tax lawyer experienced in worker classification issues and in litigating with the IRS.

[] Persevere.

RELATED ARTICLE: Abbreviations Commonly Used in The Tax Adviser

TTA             The Tax Adviser
aff'g           affirming
AFTR2d          American Federal Tax Reports, second
                series (Research Institute of America)
Ann.            IRS Announcement
CB              Cumulative Bulletin
Cir.            Court of Appeals
Cl. Ct.         Claims Court
COBRA           Consolidated Omnibus Budget
                Reconciliation Act of 1985
Cong. Rec.      Congressional Record
Ct. Fed. Cls.   Court of Federal Claims
DC              District Court
DRA             Deficit Reduction Act of 1984
ERISA           Employee Retirement Income
                Security Act of 1974
ERTA            Economic Recovery Tax Act of 1981
Fed. Reg.       Federal Register
F2d             Federal Reports, second series
F3d             Federal Reports, third series
F Supp          Federal Supplement
GCM             General Counsel Memorandum
H. Rep.         House Ways and Means Committee
                Report
IR              Internal Revenue New Release
IRB             Internal Revenue Bulletin
LTR             IRS Letter Ruling
PL              Public Law
Regs. Sec.      Treasury Regulation
Rev. Proc.      Revenue Procedure
Rev. Rul.       Revenue Ruling
rev'g           reversing
RRA             Revenue Reconciliation Act of 1993
Sec.            Section (refers to the Internal)
                Revenue Code of 1986 unless
                other wise indicated)
S. Rep.         Senate Finance Committee Report
SSRA            Subchapter S Revision Act of 1982
Sup. Ct.        Supreme Court
TAM             Technical Advice Memorandum
TAMRA           Technical and Miscellaneous
                Revenue Act of 1988
TC              Tax Court (regular decision)
TC Memo         Tax Court (memorandum decision)
TD              Treasury Decision
TEFRA           Tax Equity and Fiscal
                Responsibility Act of 1982
TRA             Tax Reform Act of 1986
USTC            United States Tax Cases
                (Commerce Clearing House)

(1) Smoky Mountain Secrets, Inc., DC Tenn., 1995 (76 AFTR2d 95-6974, 95-2 USTC [Paragraph]50,573). (2) See Rev. Proc. 8518, 1985-1 CB 518. (3) H. Rep. No. 95-1748, 95th Cong., 2d Sess. 5 (1978), 1978-3 (Vol. 1) CB 629, 633. (4) Rev. Rul. 87-41 1987-1 CB 296. (5) Statement of Michael J. Murphy; Acting IRS commissioner, Before the Subcommittee on commerce, consumer, Monetary Affairs, and House Government Operations committee on Employee-Independent Contractor Issues (5/16/89) pp. 4 5.

Editor's note: Mr. Gee was the tax adviser for Smoky Mountain Secrets Inc., and testified at trial. Author's note: The author thanks Douglas P. Stives, CPA, MBA, Curchin & Company, P.A., Red Bank, NJ., as well as the rest of the AICPA Tax Division Small Business Tax Committee, for their many helpful comments and suggestions.