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Doggone dangerous!


Many businesses have found the cost-saving benefits of using independent contractors attractive. The advantages are numerous and include not having to withhold income taxes, reduced social security taxes, lower workers' compensation premiums and lower cost for fringe benefits such as pension contributions, vacation pay and insurance. In addition, using independent contractors allows employers to match labor costs with revenues by utilizing workers only when needed. This is particularly useful when business activity is seasonal.

Unfortunately, classifying workers as independent contractors carries considerable risk. The IRS has launched a campaign to identify and reclassify workers who are carried erroneously by employers as independent contractors. It's been said that there are now 750 revenue officers who specifically look for employment misclassifications.(1) Since the beginning of 1991, the IRS has extended regular audits to include a review of year-end 1099 distributions.

The penalties associated with reclassifications can be devastating. In addition to paying their share of FICA taxes, firms that unintentionally misclassify workers are responsible for the payment of back taxes, income tax withholdings of 1.5% of the workers' earnings plus 20% of the FICA taxes normally paid by the worker. The percentages increase to 3% and 40% respectively if the employer fails to file forms 1096 and 1099.

The consequences of intentional misclassifications include payment of all income and FICA taxes in addition to interest and penalties. As an alternative to the rates mentioned above, employers can choose to receive credit against retroactive assessments if it can be shown that the workers in question reported the income subject to the assessment. The responsibility for proving that the income was reported rests with the employer and often may be difficult to obtain.

Despite the reduced rates and credits, the result of reclassifications can be devastating in terms of time and resources expended. One recent 1990 case involved the assessment of over $11 million.(2) Clearly, reclassification assessments can force many businesses (particularly labor intensive firms) into bankruptcy.

Structuring the Relationship

A worker is classified as an employee under common law if he or she is subject to control by the employer. The actual act of controlling need not be present; the employer's right to control is sufficient.

The IRS relies on 20 factors to determine if control (or right of control) is present in the worker/employer relationship.(3) The contract between the worker and service recipient should be structured to incorporate as many of the factors as possible and should focus on the issues of control and intent. Wherever possible, the contract should refer to the worker as an independent contractor and delineate the lack of control.

The employer may also consider requesting a classification ruling by filing Form SS-8. It should be noted, however, that requesting a ruling may attract attention from the IRS, leading to an employment tax review or audit.

The 20 factors, including clarifications, address the following questions:

1. To what degree does the recipient "direct" the worker (independent contractor)? Generally speaking, the more detailed the direction, the more likely the worker is classified as an employee. Control would be limited only to the outcome, not the means.

2. Under what conditions can the worker be fired? An independent contractor should not be dismissed unless the worker fails to meet contractual obligations.

3. Is the worker subject to a "breach of contract" if he or she prematurely terminates the working relationship? An employee has the right to quit a job without undue repercussions, while an independent contractor may incur civil liabilities. The contract should specify the consequences of defaulting or breaching the contract, including premature termination.

4. Are assistants subject to control by the recipient? Assistants should be employees of the independent contractor and, as such, not subject to the recipient's control. The hiring, firing and supervision of assistants should be the responsibility of the worker.

5. Is the worker paid per time intervals? If the worker receives compensation by the hour, day, week, etc., it indicates an employer/employee relationship. Payment should be made on a per-job basis.

6. Does the recipient provide training? One characteristic of an independent contractor is the high degree of skill involved; if additional training is provided, an employee relationship may be indicated.

7. Is the worker distinguished from the recipient's regular employees? The worker should not be performing normal day-to-day operational duties. On-sight references to the worker should emphasize independent contractor status.

8. Is the work performed characterized by personal service? The contractual relationship should not stipulate that the work must be performed personally. If a requirement of the contract is personal performance, the recipient would necessarily be more concerned with the worker than would otherwise be the case in a normal independent contractor/recipient relationship.

9. Does the worker provide continuing services for the recipient? Generally, if the worker provides services on a regular basis for the same recipient, an employee/employer relationship may exist.

10. Are work hours set by the recipient? Scheduling work is a form of control and indicates the existence of an employee relationship.

11. Are tools furnished by the employer? An independent contractor normally possesses the tools necessary to perform contractual services.

12. Is the work performed at the recipient's place of business? While this does not necessarily indicate control, control is more readily exercised when the worker is located in close proximity. Also, a separate place of business is characteristic of an independent contractor.

13. Does the worker devote full time to one recipient? Devoting full time to one recipient prohibits the worker from offering his or her services to multiple clients. This may also create a "dependence" and lead to control by the recipient.

14. Is the worker required to submit regular reports? Regular reporting by the worker is evidence of control. This does not preclude a final report at the conclusion of the job--for example, an audit opinion or a report on internal control.

15. Does the recipient designate, or have the right to designate, the order or sequence of work to be performed? The recipient may specify the output but should not be able to direct how the job is done. Directing the means by which the work is performed indicates control.

16. Does the recipient of the services pay business and traveling expenses? Whenever possible, the cost of foreseen expenses should be negotiated in the contract. The payment of such expenses may be construed as employee expenses.

17. Has the worker made significant investments in his or her business? Generally, a business is characterized by investments in assets. Such investments should include facilities, equipment and supplies.

18. Is the worker exposed to normal profit and loss risks associated with operating a business? If the worker is subject to suffering losses as well as profits on the engagement, evidence is provided that the worker is operating a business and is therefore an independent contractor.

19. Does the worker provide services to the general public? An employer/employee relationship is indicated when the worker performs services exclusively for one recipient. Multiple clients demonstrates the worker is operating an independent trade or business.

20. Does the worker provide services to more than one recipient? The contract between the worker and recipient should not restrict the worker from offering his or her services to other parties.

In addition to the above 20 items, three ancillary factors have been considered by the courts.(4) These factors are considered in conjunction with one or more of the 20 primary items.

1. The level of skill required by the worker: Independent contractors normally possess skills that are unique and greater than the recipient's regular employees. Workers with high levels of skill are more likely to offer their services to the general public.

2. The intent of the parties: All correspondence, particularly the contract, between the parties should reflect the independent contractor/recipient relationship.

3. The prevailing industry practice: How do other firms in the same industry structure similar relationships? This question becomes particularly important when seeking relief under Sec. 530.

IRS classification decisions are made based on a review of all factors; no one factor predominates. The precise weighting, if any, is undeterminable. In addition, the IRS may rely on previous court cases and rulings. To reiterate, the focus is on control. The factors are applied to each review or audit, leading to unique and sometimes inconsistent results. In those instances where decisions regarding control are equivocal (which is usually the case) the revenue agent will invariably make determinations in the government's interest.

Preparing for the Examination

If a classification review or audit is imminent, the employer should analyze each independent contractor relationship. The analysis should be conducted in consultation with legal and accounting professionals and should focus on the question of control, the independent contractor's business status and the nature of the independent contractor's services. Specifically, the analysis should address the following:

* A written agreement between the parties structuring the legal relationship in a manner that emphasizes the independent contractor status. This would include as many of the 20 factors as possible. Does the contract provide for penalties in the event of nonperformance? Consider including in the contract the independent contractor's responsibilities for payroll tax compliance.

* Draft a questionnaire (based on Treasury Form SS-8) for each worker to answer.

* Determine if the worker is receiving any fringe benefits.

* Is the worker using assistants? If so, who is responsible for their payroll and supervision?

* Obtain from the worker examples of business cards and stationary.

* Determine if prior rulings or court cases addressing similar situations are available.

* Survey the work area. The independent worker should not be "merged" with regular employees.

* Determine if regular employees are performing duties similar to those of the independent contractor.

* Verify that expenses incurred by the independent contractor are not reimbursed by the company.

* Determine if the independent contractor has other clients.

* Gather documents verifying that the independent contractor is not paid per hour, etc. The documents should consist of copies of canceled checks and invoices.

Documentation gathered from the analyses should be compiled and included in the contractor's file. A separate analysis should be performed for each contractor. The degree of analysis will vary with the type of examination, with employment tax audits requiring more in-depth analysis and documentation than reviews.

Section 530 Relief

Section 530 of the 1978 Revenue Act was enacted to provide relief from retroactive reclassifications by the IRS. It was intended to be a temporary measure in response to the voluminous litigation arising from the application of the ambiguous common law test. Although not part of the Internal Revenue Code, it continues to be effective. However, it has been targeted for revision or repeal. In particular, the prior audit rule has been characterized as being "flaky," allowing firms to receive undeserved benefits.(5) Therefore, future reliance on Sec. 530 may be tenuous.

Specifically, Sec. 530 provides that for a firm to receive relief, it:

* must not have treated the worker as an employee for any period;

* must have filed all necessary tax forms (including forms 1099 and 1096) consistent with its treatment of the worker; and

* must have a "reasonable basis" for treating the worker as an independent contractor.

Sec. 530 provides that a firm will have a reasonable basis if:

* the firm relied on a judicial precedent, technical advice memorandum, private letter ruling or determination letter;

* the firm was subjected to a prior audit (need not be an employment tax audit) that did not result in the assessment of employment taxes due to the firm's treatment of workers as independent contractors (The IRS appears to be using employment tax reviews in lieu of audits. The status of employment tax reviews relative to Sec. 530 is unclear.); or

* the firm relied on long-standing practices of the industry within which it operates. (While it may not be necessary for all firms in the industry to treat workers the same, the IRS has taken the stand that "nearly all" of the firms must conform to the same practice.) Figure 1 illustrates a flow chart used by the IRS in making Sec. 530 determinations.(6) Once a safe haven is established, the firm is precluded from being assessed back taxes and penalties and is allowed to continue to treat its workers as independent contractors.


Due to the recent aggressive stance taken by the IRS regarding worker classification, many firms may be risking devastating retroactive assessments. While the IRS looks at 20 factors when making classification determinations, the focus is on control. Firms should review their policies regarding the treatment of workers as independent contractors.

A portfolio for each independent contractor should be compiled containing documentation demonstrating a lack of control over the worker and showing the worker is operating a business with services offered to the general public. A firm's best defense may depend on demonstrating that it relied on one of Sec. 530's safe havens.

Businesses that use independent contractors must not be complacent. The recommendations offered in this article should be considered standard operating procedure. Don't wait until you've received an IRS notice.


1 Randall W. Roth & Andrew R. Biebl, "A Taxing Matter: When is a Worker an Independent Contractor?" Journal of Accountancy (May, 1991), p. 35.

2 The Independent Contractor Report (Fidelity Publishing Corp: Irvine, 1991), p. 2.

3 Revenue Ruling 87-41.

4 Daniel L. Morgan & Yale F. Goldberg, Employees and Independent Contractors (Commerce Clearing House: Chicago, 1990), p. 454.

5 Catherine Hubbard, "IRS Working on Revenue Ruling to Minimize Snags Surrounding Employee/Contractor Status," Tax Notes (December 24, 1990), p. 1396.

6 Claude R. Wilson, Jr. & P. LaVern, Revival of the Independent Contractor Issue (AICPA: New York), p. 5.

Walter B. Moore, PhD, CPA, is an assistant professor of accounting at Cleveland State University.

Mark Turk, CPA, is a partner with the firm of Walthall and Drake in Cleveland, Ohio.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Article Details
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Title Annotation:Independent contractor-employee classification issue
Author:Moore, Walter B.; Turk, Mark
Publication:The National Public Accountant
Date:Jul 1, 1993
Previous Article:What about health care?
Next Article:Independent contractor safe harbors: not so safe.

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