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When the IRS comes calling.

Employing independent contractors can get you into tax trouble. Some tips for staying out.

Using independent contractors to supplement nursing home staffing is commonplace. Shortages of registered nurses, physical therapists, occupational therapists, speech therapists and similar professionals are common. Also, because of the economy and tightened government purse strings, you may have had to cut back on employees and contract with self-employed workers to fill-in, as needed. If you work through an employment agency or some other organization that treats the workers as its employees, there is no need to be concerned, because taxes are being withheld from workers' compensation. On the other hand, if you contract directly with independent contractors or through a number of different agencies or registries, you may indeed have a problem -- with the Internal Revenue Service.

Unfortunately, the IRS does not seem to care whether the workers holding themselves out as independent contractors have, in fact, filed their tax returns and paid their taxes. In dozens of cases where we have represented businesses or agencies that contract with independent contractors, we have been able to determine that these workers all filed their tax returns and paid their taxes. As illogical as it may sound, the IRS disregards this when it conducts an audit of a business utilizing independent contractors.

How It Begins

It can begin harmlessly enough, because the notice from the Internal Revenue Service is innocuous and may not even say that you are being "audited". In fact, the notice may tell you that you're going to experience a "compliance check". A compliance check looks, acts, and feels like an audit, except that once the IRS has completed reviewing all your employment tax returns and conducting an in-depth interview with the business owner and accountant (if you allow it), you may never be formally advised of the IRS's decision. Based on my experience with the IRS, you just never hear from them again.

Why? Because according to the IRS, a compliance check is not an audit and, as will be explained in more detail in this article, if you haven't had an "audit", then your business cannot rely on the Section 530 safe haven provisions in the event of a subsequent IRS audit.

The IRS can also conduct an audit of your business for corporate tax purposes and, as part of that audit, question the status of all independent contractors with whom you do business. This is an "audit", and a favorable resolution will entitle you to Section 530 safe haven relief.

Why Me?

How does the IRS choose which companies to audit? Your business can be selected for an employment tax audit or compliance check in several ways:

1. Luck of the draw: 1-2% of all businesses get audited;

2. Your business has a high number of Form 1099's and very few employees on payroll who receive a Form W-2. This signals to the IRS that your business relies substantially on independent contractors.

3. A worker or disgruntled former worker submits a Form SS-8 to the IRS requesting clarification of their status as an independent contractor.

4. A disgruntled former contractor files a claim for unemployment benefits and the State taxing authority cooperates and advises the IRS that you're classifying workers as independent contractors.

5. A competitor snitches on you to the IRS. This competitor may be using staff employees and feels that you are getting an unfair advantage.

6. The IRS, in conducting an audit or compliance check of a competitor in your industry, asks the competition to provide names of other, similar businesses utilizing independent contractors, in order to verify that the use of independent contractors is an industry practice and -- lo and behold -- you too are audited.

After You Open the Envelope

The information requested by the IRS in both compliance checks and the employment tax audits is virtually the same, and the letter sets forth the date the agent expects to arrive in your office or place of business to start working. The questions that first come to your mind are: "Do I have to meet with the IRS? Do I have to let them interview me? Do I have to let them come into my office? Should I try to get by without help?

The answer to each is NO!! You do not have to be interviewed by the IRS, you do not have to let them in your office, and absolutely, you should get advice and assistance. Most businesses, when advised of an IRS audit, call their accountants -- but does your accountant know what to do? Although he or she may be very qualified to prepare financial statements and tax returns, and to represent you with regard to most IRS audits, you both need to determine whether to bring in outside help.

Here is an example of why outside help may be indicated: The IRS's classification of workers as independent contractors is generally determined based on 20 factors, generally known as common law factors. These factors are as set forth in the sidebar, p. 24. The problem is that they are intended to cover every worker's situation in every industry; as a result, they are very difficult to apply. There are no specific rules or guidelines on this, and the weight to be applied to the different factors varies industry-by-industry (and, personally, by different IRS agents and appeals officers). In evaluating each of the factors and weighing how they may apply to your business, it is possible that only two or three will, in fact, be found to predominate in determining an independent contractor relationship.

Practical Guidelines

Based on the author's experience accumulated through representing and advising more than 75 companies in a broad range of industries throughout the United States, here are some practical guidelines to follow in the event an IRS agent shows up at your door or you get a notice about an audit or an IRS compliance check:

Rule Number 1: Do not allow yourself to be interviewed by the IRS without consulting with a CPA or an attorney experienced with the independent contractor issue.

REASON: The Internal Revenue tends to bully and intimidate business owners. You have a right to be represented by a CPA or attorney. It does not indicate that you are guilty.

Rule Number 2: Do not give oral responses to the IRS's requests for information (IDRs), but require that all such requests be submitted in writing. Take the time necessary to complete your responses in private, after consultation with your professional advisors, and submit written responses.

REASON: This way you can be sure to accurately and properly respond to each inquiry and avoid any misinterpretation or misunderstanding by the IRS.

Rule Number 3: Develop your case in detail based on the 20 common law factors and all others factors relevant to your business that may be beneficial to your case.

REASON: The determination of a worker's status under the 20 common law factors can go against you if the IRS can establish that the business owner had the right to control the worker and that the worker was integrated into the business. This reclassification can occur even though only two or three of the factors are in the IRS's favor.

Rule Number 4: Determine whether your are entitled to Section 530 Relief. This requires that (1) you did not treat any similar worker as an employee for any period and (2) all federal tax returns (including information returns) required to be filed by you are filed on a basis consistent with your treatment of the workers as independent contractors.

REASON: If your are entitled to Section 530 Relief, there is a lesser burden of proof in meeting the 20 common law factors than is ordinarily necessary. Under the safe-haven rules, and as established by the Judge in Critical Care Registered Nursing, Inc., a business owner must only demonstrate that he had a reasonable basis for not treating workers as employees.

Rule Number 5: Don't be afraid to go over the agent's head if he is acting unreasonably or being inflexible.

REASON: Some agents have the attitude that there is no such thing as an independent contractor. My experience is that a conference with the agent and his supervisor can be beneficial and can avoid the cost, expense and emotional drain that can occur if your case goes to the next IRS level.

Rule Number 6: Don't give in to the IRS too easily.

REASON: The IRS will concede at the appeals level if your position is well prepared and defended.

Rule Number 7: Don't get in over your head.

REASON: Although many accountants and other tax specialists have a broad range of skills, not all have the requisite experience to adequately and properly represent and defend their client on the independent contractor issue. The determination of a worker relationship with your business is governed by a multitude of facts. There is no simple method to determine the weight to be given to each factor.


You must carefully review your method of operation before discussing or providing any facts or information to the IRS. Again, avoid inaccurancies by requesting that all IRS requests for information be in writing and making sure that all your responses are in writing. Once an agent's report has been written with incorrect facts, the burden is on the taxpayer and you to overcome the misinformation.

A word to the wise is sufficient: It's a burden you don't need.

Section 530 Safe Haven

In 1978, Congress provided relief to companies that utilize independent contractors, but are under attack by the IRS, by adopting Section 530 of 1978 Tax Act. Section 530, as amended, has never been incorporated in the Internal Revenue Code. Therefore, in order to even find this section, it is necessary for your accountant to go to the 1978 Tax Act or the IRS cumulative bulletin for 1978.

Section 530 offers four safe havens that grant relief to taxpayers utilizing independent contractors. The business must first meet two threshold tests, however. First, it is necessary that a business has always issued a Form 1099 to all workers treated as independent contractors. Second, the business must have always treated similar workers as independent contractors.

If both tests are met, then any of these "Safe Havens" will prevent reclassification of the workers:

1. A federal court decision, published rulings or a letter ruling to the taxpayer, whether or not relating to the particular industry or business in which the taxpayer is engaged;

2. A past IRS audit (not necessarily for employment tax purposes) of the taxpayer if the audit entailed no assessment attributable to the employment tax treatment of workers holding substantially similar positions;

3. A long-standing recognized practice of a significant segment of the industry in which the individual was engaged (the practice need not be uniform throughout an entire industry); and

4. In the event a taxpayer is unable to meet any of the three specific "Safe Havens," the business may nevertheless be entitled to relief if the taxpayer can demonstrate, in some other manner, a reasonable basis for not treating the individual as an employee.

The determination of the "reasonable basis" standard is to be construed liberally in favor of the taxpayer. In fact, this directive and a directive to liberally construe the safe haven provisions both derive directly from the Congressional Report for Section 530.

Twenty Common Law Factors

The classification of any worker as an employee or independent contractor is generally determined by the IRS under 20 factors (known as the common law factors). The weight to be given the factors varies depending upon the facts and circumstances surrounding the work relationship, and may differ from assignment to assignment.

1. Instructions. A worker who must adhere to specific instruction from another employee is generally considered an employee.

2. Training. If a company makes an effort to train a worker to perform services in a specific manner, the worker may be considered an employee.

3. Integration. If a worker' s services are integrated into the business, he or she is most likely subject to the company's control and would therefore qualify as an employee.

4. Services rendered personally. Results that must be presented in person indicate that the employer is interested in the methods as well as the results, and suggest an employer-employee relationship.

5. Hiring, supervising, and paying assistants. Independent contractors are usually responsible for hiring and supervising assistants who may be needed to complete a job.

6. Continuing relationships. An ongoing relationship between a worker and the employer is indicative of an employer-employee relationship.

7. Set hours of work. If a worker must adhere to set hours, he or she is subject to the company's control and would most likely qualify as an employee.

8. Full time required. If a worker is required to work full time, he or she may be considered an employee because such a requirement would hamper his or her ability to serve other businesses.

9. Working on the employer's premises. Work that is performed on the employer's premises is more likely to be controlled by the employer, and such control suggests an employer-employee relationship.

10. Set order or sequence. An employer who sets a specific order in which services are to be completed maintains a level of control over the worker, suggesting an employer-employee relationship.

11. Oral or written reports. Control that suggests an employer-employee relationship is exhibited when a worker must submit regular written or oral reports to the employer.

12. Payment by hour, week, or month. Payment in hourly, weekly, or monthly increments usually indicates an employer-employee relationship, while commission or payment made per job suggests the worker is an independent contractor.

13. Payment of business and traveling expenses. If the employer pays business and traveling expenses for a worker, that worker is considered an employee.

14. Provision of tools and materials. Independent contractors usually furnish their own tools and materials; if a worker is an employee, the employer usually provides such materials.

15. Significant investment. A worker's investment in facilities he or she uses to perform service indicates an independent contractor role, particularly when the employer maintains no control over the facilities.

16. Realization of profit and loss. A worker who is affected by profits and losses that result from his or her services is typically considered an independent contractor.

17. Working for more than one firm at a time. A worker who performs significant services for a number of firms concurrently is generally viewed as an independent contractor.

18. Making services available to the general public. An independent contractor regularly offers his or her service to the general public.

19. Right to discharge. If an employer maintains the right to discharge a worker, the worker is probably considered an employee; independent contractors cannot be fired if they meet the contractual requirements.

20. Right to terminate. If a worker maintains the right to terminate his or her services at any time without possible liability, that worker is probably an employee; independent contractors are legally bound by the contracts they accept.

Barry H. Frank is a senior tax partner in the Philadelphia-based law firm of Mesirov Gelman Jaffe Cramer & Jamieson. He is a nationally recognized expert on the independent contractor issue, and has testified before Congress on the topic. Mr. Frank, along with his partner, Jeffery Cooper, successfully represented Critical Care Registered Nursing, Inc. in its victory over the IRS in U.S. District Court.
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Title Annotation:includes related articles; nursing homes
Author:Frank, Barry H.
Publication:Nursing Homes
Date:Oct 1, 1994
Previous Article:Partnering with hospitals for subacute care.
Next Article:Going electronic for reimbursement.

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