The tax executive's guide to contemporary work relationships.

America's workplace is experiencing dramatic evolution. Traditional permanent, full-time employees are gradually being supplanted by outside firms and by individuals who work part-time, temporary or as independent contractors. Such nontraditional arrangements are most often, though not always, entered into by companies to contractout functions that are not integral to their core business.

I. The Emergence of Alternative Staffing Arrangements

The workplace evolution has given rise to new industries that specialize in taking over the staffing and operation of non-core departments of other companies. For example, AT&T Corporation may contract to take over the communications operations of another business; Xerox Corporation may take over another company's mail room and print shop; and Electronic Data Systems may assume control of another company's telecommunications operations. Companies such as these offer their clients the opportunity to completely "outsource" entire departments.

Although a department might be outsourced to a business that possesses special expertise in performing the type of function being contracted out, another alternative is to outsource the function to a business that offers no special expertise for performing any specific function, but instead merely substitutes itself as the "employer" of individuals performing the work. Such organizations, known as "leased employers," essentially assume the administrative burden associated with being the "employer" of the affected workers. In many leasing arrangements, employees of a company become employees of a leasing firm, but perform the same work for the company.

An alternative to outsourcing a department to another existing company is to outsource the function to the individual or individuals who do the work currently as employees. A New Orleans natural resource company reportedly outsourced its communications department to a new business that was created by former employees who had been operating the department.

Another variant on this theme is to outsource a function currently performed by employees to those same individuals, or other individuals, who work as independent contractors. Outsourcing to independent contractors can sometimes occur as a consequence of a downsizing or a retirement that creates an unanticipated void in the ranks, creating a need for the retired individual to be coaxed back to work.

II. Why Is This Happening?

Outsourcing occurs for a number of reasons. Many businesses are seeking to reduce their full-time payroll because of a perception that the cost--and anticipated future cost--of maintaining full-time permanent employees has exploded.

One of the most compelling issues driving the outsourcing trend is the specter of health care reform. The prototype offered by the Clinton Administration during the 103d Congress, marked by employer mandates, prompted many businesses to take action to minimize their exposure by reducing their ranks of full-time employees.

Employment law developments also contributed to this trend. Illustrative areas of concern include the evolving state of "wrongful termination" law, and the difficulty of complying with, and litigation arising out of, the Americans with Disabilities Act. These developments have increased the already substantial burden that is imposed on employers with respect to their full-time employees.

The "burden" issue is unquestionably a major cause of the outsourcing trend, but another major cause involves businesses striving to adapt to the new--incredibly competitive --global economy. Some companies have responded to the demands of global competition by paring down their permanent workforce and outsourcing work that is seasonal or ad hoc in nature.

III. The Outsourcing Transaction

This article examines the structuring of two of the most common types of outsourcing transactions--(1) a former employee who is retained as an independent contractor, and (2) an employee leasing firm that is engaged to become the "employer" of a group of individuals who will staff a non-core department of a business.

As with most transactions, there is, from a tax stand-point, right and wrong ways to structure an outsourcing transaction. If structured incorrectly, the business contracting-out the work can be exposed to prodigious federal employment tax liabilities, consisting of the employer's share of Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes that should have been paid, federal income taxes and the employee's share of FICA taxes that should have been withheld, interest, and applicable penalties. Moreover, a flawed outsourcing arrangement could have a significant income tax effect--disqualification of qualified retirement plans maintained by the company, if what were thought to be independent contractors are recharacterized as employees, and coverage or discrimination requirements that the Internal Revenue Code imposes on retirement plans are thereby violated.

IV. The Independent Contractor

When engaging a former employee as an independent contractor, the company should be aware that the "safe harbor" protections of section 530 of the Revenue Act of 1978 will seldom be available to the company.(1) This is because the "consistency requirement" of section 530(a)(3) demands that the business has treated all individuals holding a position substantially similar to that of the former employee as independent contractors. Because an individual retained by a former employer will ordinarily be retained to perform services substantially similar to the services performed while an employee, this requirement will seldom be met. Section 530 might be applicable in rare cases, but businesses should not count on it.

In addition, the company should understand that the Internal Revenue Service will be more apt to scrutinize the independent contractor characterization of a former employee than an unrelated individual being retained under similar circumstances. Since section 530 will seldom be available, the business will in most cases need to rely on the common law test.(2) In light of the fact-intensive focus of the common law test, it is important that consulting arrangements with former employees are structured carefully.

A. How Not to Structure an Independent Contractor Arrangement

An example of how not to structure an independent contractor arrangement with a former employee is provided by Rev. Rul. 55-695, 1955-2 C.B. 410. The ruling involves an individual who, upon retirement, was retained by her former employer as a consultant to train her successor. Under the consulting contract, the individual was required to devote all her working time to the former employer.

The individual's compensation consisted of a monthly retainer fee, which would be reduced whenever the consultant was absent from work, for any reason. In addition, the individual was reimbursed for all out-of-pocket expenses. All work was performed on the former employer's premises, and all required equipment and materials were provided by the former employer. Under these facts, the IRS ruled that the consultant was an employee of the former employer.

Although properly structuring an independent contractor arrangement with a former employee is unquestionably difficult, it is doable. Ordinarily, a former employee who the company seeks to retain as an independent contractor falls into one of two category: (i) the individual is a retired senior executive whom the company wants to keep available for limited advice and counsel on an irregular basis, or (ii) the individual is a retired or terminated former employee whose expertise is needed for a specific project.

B. Properly Structured Independent Contractor Arrangements

A retired senior executive whom the company wishes only to keep available for informal counsel and advice presents an easier arrangement to structure. In these cases, there is no need to require the individual to perform services on the company's premises or to work any specified minimum number of hours or any specific time, nor need the company otherwise exercise any control over the performance of the services. Such arrangements can with little difficulty be designed to satisfy each one of the common law indicia of independent contractor status.

If circumstances permit, the contract between the company and the retired senior executive should provide that the retiree will be available to the company a specified number of hours of consulting services per month or per year, and the contract should specify that the services will be performed at such times and places as are reasonably convenient to the retiree. The annual compensation payable to the retiree should not be contingent upon his or her working any specified number of hours.

There generally is no harm in permitting the individual to use office space and facilities provided by the company, so long as the company does not require such use and does not impose any other indicia of control. There also is no harm in prohibiting the individual from competing with the business during the contract term and for a reasonable specified time subsequent to the contract termination. If a non-compete provision is included, the contract should expressly authorize the individual to otherwise perform services for others and to offer her services to the general public, subject to the limitations imposed by the non-compete clause.

C. Ten-Step Guide for Structuring Independent Contractor Arrangements

A more challenging task is the structuring of an arrangement with a former employee to perform specified services. Although such arrangements can be accomplished, they require care and attention. The following guidelines should assist companies in focusing on key issues.

1. The contract between the parties should be in writing.

2. The description of services to be performed is critical. The services should be described in terms of specific objectives. For example, if a computer programmer is to be retained to develop software to accomplish a specific objective, the contract should define explicitly that objective, rather than referring generically to the performance of "computer software development services." Similarly, if a marketing professional is to be retained to develop a marketing program to introduce a specific product to market, the agreement should define that objective explicitly, rather than referring generically to the performance of "marketing services, as directed." Furthermore, if an individual is to be engaged to work on two or more separate projects, a separate contract should be entered into for each project.

3. The individual should not be required to provide the company with progress reports, oral or written. If monitoring progress is important, the company should, to the extent feasible, undertake the necessary monitoring without the contractor's direct involvement. Alternately, the project could be segmented into smaller, discrete projects, so that each anticipated progress point constitutes a specified objective. For example, if an individual is to be retained to develop a marketing program to introduce a new product to the market, instead of requiring progress reports, the program could be subdivided, with each part having a separate objective. The first objective could be to undertake the necessary market research and present a report on the findings by a specified date. The second objective could be to submit a description of the marketing plan to be followed. The final objective could focus on the implementation of the plan, together with a wrap-up report on the results.

4. The individual should not be required to work any minimum number of hours, nor at any specified times or locations. Unless security concerns would be violated, the individual should be permitted to perform work at home or at a separate office the individual maintains. This freedom generally would involve the individual's using his own equipment, e.g., computer, facsimile machine, and printer--all of which would strengthen the individual's independent contractor status.

5. Although a non-compete provision might be appropriate and necessary, the contract should expressly provide that other than the carefully circumscribed nature of the non-compete provision, the individual is free to perform services for others and to offer his services to the general public.

6. It is not necessarily fatal for an individual to be compensated on an hourly basis, but the individual always should be required to submit invoices to obtain payment of fees. A preferred payment arrangement would be by project or by objective, irrespective of the number of hours worked.

7. The individual should be encouraged, though not necessarily required, to establish a separate office away from the company--even if only for adminstrative work, such as preparing bills or paying expenses related to the individual's business--and to operate under a business name as opposed to under his own name.

8. If feasible, the individual should be permitted to hire helpers to assist in the project. There seldom exists a justification for denying a contractor the right to use helpers for administrative assistance. Some circumstances could tolerate the use of helpers on substantive work.

9. The individual should not be subject to termination under the contract, other than for failure to satisfy enumerated objectives in a timely manner.

10. Since the individual's special expertise is the reason for engaging the individual, the contract should not provide, or permit the company to provide, any instructions with respect to how the specified objective is to be accomplished.

This last point bears repeating: the individual should be accorded substantial freedom and latitude to unilaterally determine how to accomplish the objective for which the individual was retained. Company managers must resist the temptation to treat contractors as company employees. In Letter Ruling No. 9345002 (July 13, 1993), the IRS analyzed three arrangements in which a former employee was engaged as an independent contractor. The IRS concluded that only one of the three was sustainable as an independent contractor arrangement. Concededly, technical advice memoranda are not precedential, but they do provide guidance on how the IRS may analyze a particular scenario.

As businesses contract out increasingly more services, the importance that the outsourcing arrangements are structured correctly grows, as does the potential federal employment tax liability for structuring them incorrectly. The more services that are outsourced, the higher the potential liability for mistakes.

V. The Leased Employee

In cases where a function currently performed by employees is contracted out to another business (outside firm), which may or may not hire the former employees who had performed such services, the contracting-out business (the company) should not have any contingent liability for federal employment taxes with respect to the individuals employed by the outside firm. If the transaction is not properly structured, however, the company can remain potentially liable for such taxes.

The outside firm's employees will, in most cases, be performing services for the company. Such individuals, therefore, could be classified as employees of the company under the common law definition of the term employee.(3) To avoid the federal employment tax liability that could result from classification,, the company needs to ensure that its relationships with the individuals and with the outside firm qualify for the "control of payment" exception under section 3401(d)(1) of the Code. That provision states that if the person for whom an individual performs service does not have control of the payment of wages for such services, the term "employer" will be deemed to be the person having control of the payment of such wages.(4) In these circumstances, therefore, it is absolutely critical that the outside firm have control of the payment of wages to the individuals actually performing the work. Qualifying for this exception, however, requires more than literal compliance.

A. How Not to Structure a Leasing Arrangement

A recent example of a leasing arrangement that did not qualify for the section 3401(d)(1) control-of-payment exception is provided in In Re Professional Services Security, Inc., 94-1 U.S.T.C. [paragraph] 50,148 (Bankr. M.D. Fla. 1993). Professional Securities Services involved a business (Professional Services Security, or PSS) that entered into a leasing arrangement, under which the leasing firm would become the employer of security guards who were formally employed by the PSS. Under the agreement, the leasing firm was responsible for preparing and filing all applicable employment tax returns, and for paying the correlative taxes.

The guards were required to maintain logs of what happened during their shifts, which were to be turned in to the PSS for review. Each week, PSS provided the leasing firm with a schedule of the number of hours worked by each guard and, based on that information, the leasing firm would prepare the payroll checks. PSS paid the leasing firm each week an amount sufficient to cover the guards' salaries, employment taxes, and workers compensation coverage, plus a fee equal to four percent of that aggregate amount. The leasing firm would not issue payroll checks until it received payment from PSS.

A bankruptcy court was called upon to scrutinize the arrangement after the IRS sought to recover unpaid federal employment taxes from PSS, and PSS sought to defend against the IRS assessment based on the section 3401(d)(1) control-of-payment exception. PSS's asserted section 3401(d)(1) defense failed.

The bankruptcy court determined that PSS, rather than the leasing firm, had actual control over the payment of wages to the guards. The court's decision was based principally on PSS's remaining very much involved in the process by which the guards were paid their wages. Examples include findings that (1) the guards turned their activity logs in to PSS, (2) PSS accumulated the number of hours worked during any given week by each guard, (3) PSS paid the leasing firm an amount sufficient to make the payroll after the amount to be paid each guard had been determined, and (4) the leasing firm would not issue payroll checks until it received payment from PSS. Based on the foregoing, the court characterized the leasing firm's involvement in the arrangement as merely ministerial.

The reason PSS's arrangement with the leasing firm did not qualify for section 3401(d)(1) protection is that PSS did not divorce itself from the calculation and payment of wages to the guards--as it should have.

B. The Properly Structured Leasing Arrangement

In contrast to the arrangement analyzed in Professional Securities Services, guidance for structuring such arrangements correctly can be found in General Motors Corp. v. United States, 91-1 U.S.T.C. [paragraph] 50,032 (E.D. Mich. 1990). This decision involved a contract entered into between GM and an overseas company, under which the overseas company provided engineers to perform services for GM. The court held that, under section 3401(d)(1), GM was not the employer with respect to the engineers. The court's rationale is illuminating:

Only [the overseas company] knew how much each

[engineer] was being paid. Only [the overseas com-

pany] supplied fringe benefits. Only [the overseas

company! kept financial records on each particu-

lar [engineer]. Accordingly, this court finds that

[the overseas company] performed functions which

were all-encompassing with respect to its own [en-

gineers and! did much more with respect to each

employee than simply perform the ministerial duty

of passing out paychecks. Therefore, this court

concludes that [the overseas company] had control

over the payment of [wages to the overseas compa-

ny! design engineers. Based on these same facts

and circumstances, GM did not have control over

the payment of wages to [the overseas company's]

design engineers.(5)

General Motors demonstrates that PSS's fate was avoidable. The decisions jointly illustrate how leasing arrangements can be near panaceas if structured properly, and potential financial disasters if structured improperly.

C. Ten-Step Guide for Structuring Leasing Arrangements

When advising a business on structuring a leasing arrangement, one should consider the following 10-point guide for circumscribing federal employment tax liability. For purposes of this guide, the business for which the services are performed is referred to as the Company, the business that provides the individuals to perform services for the Company is referred to as the Contracting Firm, and the employees of the Contracting Firm performing services for the Company are referred to as individuals.

1. Individuals should report hours worked to the Contracting Firm, not to the Company.

2. The Contracting Firm should perform the calculations necessary to ascertain the amount of gross wages to be paid, the amount of federal employment taxes to be withheld, the amount of federal employment taxes to be paid, and any other wage related obligations.

3. The Contracting Firm's obligations to the individuals should be completely independent of, and not contingent upon, the Company making any payments to the Contracting Firm.

4. All decisions with respect to wages and benefits that will be provided the individuals should solely be the Contracting Firm's.

5. All employment and financial records relating to the individuals should be maintained by the Contracting Firm, and the Company should not maintain any such records.

6. The Contracting Firm should invoice the Company for fees for services rendered, and such invoices should not disclose the allocation of such fees to their component parts, such as gross wages, employment taxes, and benefits. Similarly, the contract between the Company and the Contracting Firm should not disclose the allocation of the fees being charged by the Contracting Company among such components.

7. The Company should direct any fee questions or concerns that relate to the number of hours worked by individuals to the Contracting Firm and not to the individuals.

8. The Company should never discuss compensation or benefits issues with the individuals. All such inquiries, including those relating to bonuses, should be referred to the Contracting Firm. Nor should a Company inquire about the compensation or benefits package respecting any individual. The Company should affirmatively endeavor not to know about such matters.

9. The Company's contract with the Contracting Firm should be in writing, and the Company should have no direct contract with the individuals.

10. The Contracting Firm should have the responsibility for all obligations, financial or otherwise, relating to the individuals who perform services for the Company, and the Company should not bear any such responsibility.

The section 3401(d)(1) exception overrides the common law relationship between a business and a worker. For example, although an individual might be an employee of a business under the common law test, the contracting firm will be regarded as the employer for federal employment tax purposes as long as the section 3401(d)(1) requirements are satisfied. The common law employer would have no liability for such amounts--if the arrangement is structured properly. It is significant to recognize, however, that the section 3401(d)(1) exception does not apply in other contexts, such as employment and labor law.(6)

VI. Conclusion

As companies explore the opportunities offered by alternative staffing arrangements, care needs to be taken to ensure that the hoped-for objectives are achieved. One of the worst possible scenarios would be for a company to incur the expense and to expend the effort to implement an alternative staffing arrangement, only to discover that nothing substantively has changed. The foregoing guides are offered to help companies avoid that experience.

(1)Section 530 of the Revenue Act of 1978 provides a business that meets its criteria immunity against the Internal Revenue Service's challenging its classification of workers as independent contractors for federal employment tax purposes.

(2)While other statutory safe harbor provisions might be available, such as are contained in section 3508 (which provides statutory independent contractor status for certain real estate agents and direct sellers), these provisions typically will not apply to arrangements with former employees. If the provisions did apply, the individual probably would not be a former employee.

(3)I.R.C. [sections][sections] 3121(d), 3306(i), and 3401(c).

(4)While section 3401(d), by its terms, could be construed as limited to federal income tax withholding, it has been held to apply also to FICA and FUTA taxes. Otte v. United States, 419 U.S. 43, 74-2 U.S.T.C. [paragraph] 9822 (1974); In re Armadillo Corp., 410 F. Supp. 407, 76-2 U.S.T.C. [paragraph] 9546 (D. Colo. 1976) aff'd, 561 F.2d 1382, 77-1 U.S.T.C. [paragraph] 9659 (10th Cir. 1977).

(5)91-1 U.S.T.C. at 87,146.

(6)E.g., the Fair Labor Standards Act, the Employee Retirement Income Security Act of 1974, the Family Medical Leave Act, and Title VII.