Worker classification training materials.

On May 3, 1996, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the training materials the IRS has developed to aid the classification of workers as independent contractors or employees. The Institute's comments took the form of a letter from TEI President Jack Skinner to Douglas Izard, Dean of the IRS's School of Taxation. They were prepared under the aegis of the Institute's Federal Tax Committee whose chair is David L. Klausman of Westinghouse Electric Corp. Michael J. Nesbitt of Paychex, Inc. was a principal drafter of the comments, and Patrick J. O'Brien of Sears, Roebuck & Co. also contributed to the project.

I am pleased to provide the comments of Tax Executives Institute, Inc. on the Internal Revenue Service's revised training materials for distinguishing between independent contractors and employees ("Worker Classification").

The IRS is to be commended for providing practical guidance on worker classification to revenue agents. The training materials attempt to frame the issues in a real-world context and generally focus on the most relevant and practical factors affecting the business decision about whether to hire employees or independent contractors. As a result, the approach is less cumbersome and more realistic than the application of the 20-factor test. We believe, though, that the materials would be improved by sharpening or softening the focus in certain areas.

Notwithstanding the goal to provide fair guidance, however, we perceive an undertone in the training materials that may well encourage agents to resolve ambiguities in favor of reclassifying independent contractors as employees. We believe that more can and should be done to provide balance to the materials -- to emphasize that using independent contractors is a common, reasonable, and acceptable business practice. Our specific comments highlight areas where we believe that balance is currently lacking.

Background

Tax Executives Institute (TEI) is the principal association of business tax executives in North America. The Institute's approximately 5,000 members represent more than 2,700 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues involved in classifying workers as either employees or independent contractors.

Introduction -- Page 1-1

The mission of the Internal Revenue Service is to collect the proper amount of tax. In the context of the examination of worker classification matters, a revenue agent has a duty to review the information provided by a taxpayer to determine whether, based on all the facts and circumstances, the service recipient's classification of the worker is reasonably justified. As a result, this section must emphasize the agent's responsibility to review worker classification issues in a fair, objective, and impartial manner without a preconceived preference for one classification status over another.

Moreover, the IRS should consider adding a statement in the Introduction confirming that, where the worker's status is unclear and sound arguments may be advanced for either classification, the service recipient's classification of the worker should be left undisturbed. Such a statement would clarify that where the classification is a close issue and could properly be either status, a finding in favor of the taxpayer's classification is a reasonable conclusion and not a concession. It would, hence, reduce needless and protracted disputes with taxpayers since agents would be apprised that it is unnecessary to reclassify workers automatically in any case where a colorable argument might be made for employee status.

Chapter 1

a. Control Standard -- Page 1-3

In many cases, a service recipient will prescribe requirements about how or when work is to be performed. For example, a service recipient may require that work be completed by the end of the day or that a contractor act in a courteous manner when dealing with the recipient's customers and employees. Should the worker not adhere to the prescribed standards or contractual requirements, the service recipient may decide not to offer additional work to a particular worker. These types of minimum standard requirements, we believe, do not rise to the level of "control and direction" envisioned by the control standard. As a result, we recommend that the text of this section be clarified with examples to emphasize that the right to control and direct the means and details of how work is to be performed is not the same as setting performance standards against which successful completion of the work is to be judged.

b. Control Standard -- Page 1-5

(i) Examining the Relationship. The discussion of how the examination of the relationship should be conducted, with the statement that a "no change" result is acceptable, is well done. To reinforce the discussion in this section, we recommend adding a statement to the effect that, where well-supported arguments may be advanced for either classification, the service recipient's classification of the worker should be accepted.

(ii) Developing the facts. The second bullet point of this section states that "even in the clearest case of independent contractor, the worker is constrained in some way." While the statement is correct, it displays a bias against independent contractors and should be revised or, at a minimum, explained. We recommend revising the point to read, as follows:

Control is a matter of degree. Every worker -- employee and independent contractor alike -- is constrained in some fashion. Independent contractors are subject to varying degrees of review of their performance. On the other hand, employees are permitted varying levels of autonomy consistent with the nature of their job duties.

We also recommend including illustrative examples similar to those referenced in our comments concerning page 1-3.

c. Behavioral Control -- Page 1-8

The section labeled "Instructions" states that "if extensive instructions on how work is to be performed are given and enforced, this could be a strong indication that a worker is an employee." TEI submits that the absence of "instructions" from the service recipient is ambiguous and requires further examination of the facts and circumstances. Where few or no instructions are provided by the service recipient, however, agents too frequently assume that the service recipient retains the power to issue instructions and thereby has a "right to control" the worker. The materials should instruct agents that they cannot simply assume that the right to require compliance with instructions exists. The agent must be able to support the assertion of a "right to control." Otherwise, service recipients are compelled to prove a negative, i.e., lack of a right to control. To balance the discussion, we recommend that a statement be added along the lines of the following:

Where instructions are not given, the relationship between the worker and the service recipient must be examined carefully to determine whether the recipient has the right to require the worker to follow detailed instructions. Evidence of the right to control the means by which the work is to be done must be established in order to support that the worker is an employee. The right of control encompasses more than simply setting standards of acceptable performance. If no evidence of a right to control can be established, there is evidence that the worker is an independent contractor.

In addition, agents often misinterpret guidelines or conditions for performance of the work as evidence of a right to control. For example, in order to avoid disruption of business, a service recipient may require that an independent contractor perform work during non-business hours. This type of condition is a reasonable limitation on the manner in which the job is to be performed and is not evidence of the service recipient's right to control how the work is done. Without clear guidance in this area, agents may conclude that this is evidence of a right to require the worker to "follow instruction."

Finally, the last section on this page lists a number of topics that may be addressed by instructions from the service recipient. Standing alone, instructions on any one of these topics should not be construed as conclusive evidence of a worker's classification. For example, a provision about "when (or where) to do the work" is often a contractual term even in the clearest case of an independent contractor. In addition, the scope and meaning of the final topic -- how to receive compensation -- is unclear. Does this involve compensation received by the worker for services rendered (regardless whether the worker is an employee or an independent contractor)? Or does the phrase pertain to the collection of compensation from an employer's customers? We believe this entire section should be revised substantially or illustrated with examples to clarify its meaning.

d. Behavioral Control -- Page 1-9

The section on "Degree of instruction" includes a statement to the effect that "the absence of actual instructions does not mean the business lacks the right to give them." The inclusion of this statement underscores the need to add more tempered statements on the previous page. While it is a truism that the right to give instructions may exist even where that right is not exercised, there must be actual evidence of a right to give instructions before one may properly conclude that the right of control exists. The relationship must be examined carefully to determine whether the right exists. Adding language to the materials explaining the need to gather evidence, coupled with examples of what may or may not constitute relevant evidence, would be helpful in an area where every nuance of a relationship is fraught with ambiguity.

e. Behavioral Control -- Page 1-14

The third full paragraph on page 1-14 states that "if the results [of the evaluation system] are used to counsel the worker or to direct changes in behavior, the evaluation system is typical of those used to direct and control employees." This overbroad paragraph could lead to an unjustified conclusion that employee status is warranted in nearly every case since virtually every worker is subject to some form of performance evaluation.

For example, assume a taxpayer providing business services regularly hires independent contractors to pickup and deliver packages to and from customers. The packages contain important information that enable the taxpayer to provide its service to its customers. Should the taxpayer receive complaints regarding the timeliness or manner of the delivery services rendered by a service provider, the taxpayer will likely inform the provider of the specifics of the complaint and threaten to cease doing business with the provider unless the service is improved. In one sense, the taxpayer has "counseled" the service provider or directed changes in behavior. In another respect, this manner of counseling the service provider is hardly what is intended to be addressed by the discussion of evaluation systems. A service recipient should always be able to provide feedback about whether contractual obligations are being met without jeopardizing the status of independent contractors.

In addition, the Institute is troubled by the inference that a key question to consider in this situation is whether or not compensation is tied to evaluation results. Withholding payment for unsatisfactory work is a common means of exerting leverage over the performance of independent contractors. For example, where a taxpayer engages an independent contractor to paint a building, the taxpayer might withhold payment for unsatisfactory work. Moreover, contractors frequently demand progress payments during the course of work on a long-term project and the service recipient will generally tie payment to attainment of a specific performance objective. In such cases, the taxpayer has clearly tied compensation to performance results, yet the contractor is not thereby converted to employee status.

Nearly every service relationship will entail some form of evaluation of whether the work has been accomplished in an acceptable manner. Hence, the utility of this factor in distinguishing employees from independent contractors is considerably less than the materials imply. As a result, we recommend deleting this section because it will be difficult to provide meaningful, unambiguous guidance about the significance of performance evaluations.

Should this section be retained, it should be refocused on evaluating the means and process through which workers perform their duties when compared against established training goals or promotion standards as being indicative of employee status. This is a much different focus from an evaluation of the end result of the duties performed -- generally the primary standard upon which a business will reward an independent contractor with additional work.

f. Financial Control -- Page 1-18

At the end of the section on "Significant investment not required," TEI recommends adding the following language:

While a significant investment may indicate the worker is an independent contractor, the lack of a significant investment does not necessarily imply that the worker is an employee. The relationship between the worker and the service recipient must be examined to determine whether there is a reliance on the service recipient for the facilities needed to perform the work. A lack of a significant investment in required facilities may indicate dependence upon the service recipient for such facilities, which, in turn, is evidence of employee status. A lack of reliance on the service recipient for such facilities can be evidence that the worker is an independent contractor.

Adding this statement would bring the analysis in line with the principles enumerated in Rev. Rul. 87-41, 1987-1 C.B. 296. Where there is dependence on the service recipient for the facilities required to perform the work, the recipient has greater means to control and direct the work. Hence, the factor would tend to indicate an employment relationship. Obversely, where owing to the nature of the work only minimal investment in facilities is required, a worker should not necessarily be deemed an employee for lack of significant investment. The focus of the factor, we believe, should be on finding dependence on the service recipient to provide the requisite facilities or materials.

g. Financial Control -- Page 1-20

At the end of the section entitled "Not essential," TEI recommends adding the following language:

Some independent contractors may choose not to solicit additional work for reasons of their own (see, e.g., Rev. Rul. 57-10). The examination should focus on whether there is evidence that the contractor is free to make his or her services available to the general public.

In some cases, an independent contractor may decide to offer his or her services exclusively to one service recipient for a temporary, or even an indefinite, period. The service recipient may have little or no control over the worker's decision. While working for more than one firm at a time is helpful in establishing an independent contractor's status, a worker's failure to do so should not be construed as evidence of employee status unless the service recipient has a right to control this decision. We recommend that the materials include such a cautionary statement.

h. Financial Control -- Page 1-21

The last paragraph of the Description of "Commissions" in the chart on page 1-21 states that "a worker paid on a commission basis who incurs few or no expenses in relation to the services performed assumes no risk of incurring a loss and has no ability to realize a profit." Hence, the paragraph concludes, "the worker may well be an employee."

TEI submits that the statement is misleading. Some service businesses are labor intensive and have few or no related expenses. This explanation should be recast along the following lines: "A worker paid on a commission basis who incurs few or none of the expenses required to perform the services assumes no risk of incurring a loss...." Where a worker is paid on a commission basis, the italicized language is critical to the proper application of the financial control test.

i. Financial Control -- Page 1-22

We recommend that the section on "Economic return" be expanded in order to provide better balance. Concededly, one may earn more or less as an employee by working a greater or fewer number of hours. The same statement, however, is equally true in respect of an independent contractor. Indeed, earning more by working more is nothing more than an indication of a variable, rather than a fixed, rate of compensation. Hence, an explanation should be added to this section to clarify that an independent contractor who earns a greater return by contracting to provide additional services is not thereby converted to employee status. Stating that "earning more by working more" is consistent with employee status without providing instruction that an alternative situation can be consistent with independent contractor status is an example of how the materials repeatedly urge the reclassification of contractors as employees.

j. Relationship of the Parties -- Page 1-25

In our view, the significance of the permanency of the relationship as a factor in determining the worker's classification is tenuous. Many businesses have established long-term relationships with independent contractors that are not reduced to written or oral contracts. For example, many businesses use the same accounting or legal firm year after year without a formal retainer agreement. An ongoing relationship can be evidence of either an employee or independent contractor status. In our view, this factor is not significant in evaluating the relationship of the parties and, hence, should be deleted.

At a minimum, the last sentence of this section on page 1-26, which states that "the absence of a permanent relationship is equally consistent with either status," should be revised. If the absence of a permanent relationship is "equally" applicable to either employee or contractor status, how is it that the presence of a permanent relationship is not "equally" applicable to either status? We submit that if the IRS persists in its view that the permanence of a relationship is indicative of employee status, then impermanence (or temporariness) should tend to indicate independent contractor status. Indeed, business taxpayers are more apt to engage independent contractors to perform specific tasks or short-term assignments rather than add employees.

k. Relationship of the Parties -- Page 1-27

This section on "Analysis of discharge/termination" includes the following statement:

As a practical matter, it may be difficult to distinguish between discharging a worker for failure to perform work properly and terminating a contract for failure to produce the contracted product.

TEI recommends adding the following language at the end of the referenced sentence: "...or deciding not to offer additional work to a contractor." In some cases, the tasks performed by the worker are of such short duration that termination of the relationship while the work is being performed is virtually impossible. In such cases, the service recipient's only alternative is to refrain from engaging a worker for future assignments. The recommended language addresses these situations.

l. Relationship of the Parties -- Page 1-28

The importance assigned to the factor of regular business activity, or "integration" of the worker's task in the business activities of the taxpayer (as set forth in Rev. Rul. 87-41), has in many ways been superseded by business trends. Hence, consideration should be given to either deleting this discussion from the training materials or diminishing its importance.

The materials acknowledge that many legitimate uses of independent contractors involve aspects of a business that are an important, even essential, part of the regular business activity of a taxpayer (e.g., delivery, installation, or product maintenance services). Indeed, in focusing on their core competencies, many business firms have re-examined their activities to "re-engineer" and "outsource" processes previously considered essential to the business. The concept of outsourcing crucial, but non-core, business activities was unheard of when the 20-factor test was developed. Yet, as early as United States v. Silk, 331 U.S. 704, 714 (1947), the Supreme Court recognized that few businesses "...are so completely integrated that they can produce the raw material, manufacture and distribute the finished product to the ultimate consumer without assistance from independent contractors."

Since the use of independent contractors in regular business activities is a legitimate business arrangement, focusing heavily on the integration factor during an examination is likely to result in erroneous conclusions in favor of employee status. The importance of this factor should be diminished substantially if not deleted entirely from the text.

Chapter 3

Consistency Test: Substantive Consistency -- Page 3-10

To qualify for relief under section 530 of the Revenue Act of 1978, a taxpayer must file all required returns and treat all workers in substantially similar positions in the same fashion. The training materials refer to these requirements respectively as the "reporting" and "substantive" consistency requirements. The discussion of "Consistency required" on page 3-10 states that "A substantially similar position exists if the job functions, duties, and responsibilities are substantially similar and the control and supervision of those duties and responsibilities is substantially similar." We agree that the manner in which the "control and supervision" of the duties and responsibilities is exercised is a critical factor in distinguishing whether positions are substantially similar. The discussion of this concept, however, should be expanded and examples should be provided about what factors of control and supervision will result in two workers being treated as holding substantially similar positions. We recommend adding this discussion on page 3-12 under the section on "Substantially similar positions."

Case Studies and Exercises

At the close of every chapter of the training materials there are exercises and case studies for the revenue agents to complete. We would appreciate having the opportunity to review the "instructor's edition" of the training materials wherein the conclusions and reasoning employed to reach the conclusions to the exercises and case studies are supplied.

Conclusion

TEI's comments were prepared under the aegis of its Federal Tax Committee, whose chair is David L. Klausman of Westinghouse Electric Corp. If you have any questions concerning these comments, please call either Mr. Klausman at [phone], or Jeffery P. Rasmussen of the Institute's professional tax staff at [phone].