The tax treatment of independent contractors: where we are, and where we’re headed
Russell A. Hollrah
A business that uses independent contractors is probably most susceptible to its classification of such workers being challenged by the Internal Revenue Service in the context of either employment taxes or employee benefits. In the employee benefits area, the challenge would likely concern whether such a worker is a “leased employee.” This article sets forth some of the general rules of current law in these two areas. In addition, certain significant developments are examined that businesses might want to monitor or, if circumstances warrant, take an active role in supporting or opposing.
Where We Are With Respect
To Employment Taxes
In today’s world, the types of relationships between businesses and providers of services are myriad. Nevertheless, for purposes of federal taxes, a service provider must generally be categorized as either an employee or an independent contractor. (1) The explosion of novel relationships between businesses and service providers has imposed a strain on the tax law and on such other laws whose application varies, depending on whether the affected worker is an employee or an independent contractor.
While many have commented upon the advantages or disadvantages of being an employee or an independent contractor, the ramifications of being classified as one or the other cannot be compared in any meaningful way unless the underlying differences between the two types of worker are fully explored. For example, an independent contractor can deduct fully the business expenses incurred, whereas an employee can deduct such expenses only as a miscellaneous itemized deduction. An employee’s miscellaneous itemized deductions are not deductible except to the extent they exceed two percent of the taxpayer’s adjusted gross income. To flatly assert, however, that this disparity accords an independent contractor an advantage over the employee is misleading because it manifests ignorance of or an indifference to the underlying disparities between the two types of workers.
An independent contractor is not simply an employee who has in some respects altered his employment relationship in order to fall outside the “employee” characterization. Rather, an independent contractor is a sole proprietor. Such an individual is one who has “gone out on his own” to start a business. The independent contractor has control over what he does, for whom he works, and the manner in which he performs whatever it is that he does for a living. Hence, the “control” test, developed under the common law, provides that an employment relationship exists “when the person for whom the services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which the result is accomplished.” (2)
Notwithstanding the dissimilarities between employees and independent contractors, the Treasury Department in a recent study reported that “Federal and State tax, labor and related laws do not systematically favor classification of an individual as an employee or independent contractor.” (3) The study acknowledges, however, that depending on the specific circumstances, misclassification may provide artificial advantages to the business, to the service provider, or to both. The Treasury Department’s finding that current law does not systematically prefer one status over the other should deflect attention away from such comparisons and on to the more significant issues affecting worker classification, namely:
* how to assist businesses in properly classifying workers who are not clearly independent contractors or employees; and
* how to increase the compliance rates of independent contractors with respect to their federal tax oblivations. (4)
Although both of these issues are important, this article will address only the first, concerning classification. The worker-classification issue was especially contentious years ago, when there existed a lower Social Security tax rate for independent contractors, in the form of the tax imposed by the Self Employment Contributions Act (SECA), than the combined tax rate for employees, in the form of employer and employee FICA taxes. (5) The differences between the SECA tax and the combined FICA taxes have since been largely eliminated. (6)
Beginning in the late 1960s, the IRS sought to ferret out workers who had been misclassified as independent contractors by significantly increasing its audit activities in the worker-classification area. At the time, a worker’s status generally was determined by application of the 20-factor common law text. (7) The IRS’s increased audit activities resulted in many worker reclassifications, with affected businesses’ being assessed large retroactive employment-tax deficiencies (plus interest and penalties). The IRS’s zealotry in this pursuit ultimately became excessive. As a result, Congress enacted section 530 of the Revenue Act of 1978, which prohibits the IRS from challenging a business’s classification of a worker as an independent contractor, provided the business satisfies certain requirements. Section 530, moreover, does not affect a business’s opportunity to defend its classification of a worker under the common law test, in the event it is not eligible for section 530 protection.
Section 530 protection is generally available to a business if the following requirements are met:
* it has a “reasonable basis” for such treatment;
* it consistently treats (and in the past always has treated) such worker, and any other similarly situated workers, as an independent contractor; and
* it complies with all federal tax and information reporting requirements incident to, and in a manner consistent with, its treatment of the worker as an independent contractor.
In order to establish “reasonable basis” under section 530, a business must be able to demonstrate reasonable reliance on any of the following:
* judicial precedent, published rulings, or letter rulings or technical advice issued to or with respect to the taxpayer;
* a past IRS audit in which there was no assessment attributable to the employment tax treatment of the individual or of individuals substantially similar to that of the individual; or
* a long-standing recognized practice of a significant segment of the industry in which the individual was engaged.
If a business cannot satisfy one of the three statutory safe harbors, reasonable basis for purposes of section 530 also can be established “in some other manner.” (8)
Because the protection of section 530 is limited to the business and does not extend to the affected worker, a business may be permitted to treat a worker as an independent contractor while the worker is treated as an employee. In such a case, the worker would be responsible for the employee share of FICA taxes only (and not SECA taxes), but the business would have no FICA liability. Thus, the Social Security trust fund would receive only one-half of the amount that should have been paid.
Section 530 prohibits the IRS from issuing any regulation or revenue ruling that would clarify the status of workers for purposes of the employment taxes. Notwithstanding this prohibition, an IRS official recently announced that the IRS is preparing guidance that will present IRS’s position with respect to section 530. (The IRS official averred that section 530 does not preclude IRS from issuing “its position” with regard to the current state of the law. (9)) If the IRS does issue such guidance, taxpayers should carefully assess its validity.
Section 530 was originally enacted as a temporary provision, pending Congress’s development of a better definition for purposes of worker classification. As part of the Tax Equity and Fiscal Responsibility Act of 1982, Congress made the provision permanent. (10) TEFRA also enacted section 3509 of the Code, which contains a series of generally lesser penalties that apply to businesses that improperly misclassified workers as independent contractors. (11)
In 1986, the universe of workers whose status could be affected by section 530 was reduced. Section 1706 of the Tax Reform Act of 1986 eliminated the availability of section 530 protection of taxpayers that broker the services of technical services workers. Technical services workers include engineers, designers, drafters, computer programmers, and systems analysts. Section 1706 also modified the section 530 prohibition against the IRS issuing guidance on worker-classification matters, to permit the issuance of such guidance insofar as it pertains to the technical services workers whose eligibility for section 530 protection was removed. (12)
Where We Are Headed With Respect
To Employment Taxes
After section 1706 became law, Congress thought it would be wise to assess its effectiveness. Consequently, section 6072 of the Technical and Miscellaneous Revenue Act of 1988 instructed the Treasury Department to prepare a report on the efficacy of section 1706. Such report, which was released on March 15, 1991, concluded that section 1706 improved the administrability of the worker-classification rules and recommended that Congress consider expanding the scope of section 1706 to apply to technical services workers who do not work through brokers.
The Treasury report found that the misclassification of employees as independent contractors results in an artificial increase in tax revenues. The primary reason for this counterintuitive result is the prevalence of generous employee fringe benefits programs, which convert a portion of an employee’s compensation from taxable cash to nontaxable benefits-in-kind. Independent contractors are not eligible to participate in such programs. (13)
Finally, the Treasury report recommended that the section 530 prohibition against the IRS issuing guidance on worker-classification matters be repealed.
In addition to the Treasury report, there have been several other worker-classification developments. For example, on November 9, 1990, the House Government Operations Committee issued a report that examined the current state of the law in the worker classification area and recommended several specific changes, some involving legislative action. (14) On April 23, 1991, the Employment and Housing Subcommittee of the House Ways and Means Committee held a hearing on the treatment of workers in the construction industry. And on July 30, 1991, a hearing was held before the Exports, Tax Policy and Special Problems Subcommittee of the House Small Business Committee, which focused on problems generated by IRS’s renewed vigor in aggressively pursuing small businesses that are suspected of misclassifying workers as independent contractors.
Several other miscellaneous developments arguably presage action in this area. The IRS has publicly acknowledged stepped-up auditing activities on the worker-classification issue. (15) (This is the same type of IRS activities, of course, that spurred the enactment of section 530 in the first place.) In addition, the Treasury Department has been reported to be in the process of preparing a legislative proposal that “would limit the rules under [section 530] and allow the IRS greater leeway in reclassifying independent contractors as employees.” (16) IRS officials have also informally expressed an interest in requiring that all payments made by businesses to independent contractors be subject to withholding, similar to the withholding that is imposed on wage payments made to employees. Finally, there appears to be some disunity among the private-sector groups on what, if anything, should be done either to clarify the 20 common law factors, (17) or to modify or repeal section 530. (18)
The November 1990 report of the Government Operations Committee concluded that the prior-audit safe harbor of section 530 creates competitive disadvantages and provides protection against IRS reclassification to businesses that “blatantly” misclassify their workers. In addition, the report found that the 20-factor common law test is too subjective, which has resulted in the IRS applying the test inconsistently. Finally, the report said businesses that are determined to have misclassified workers as independent contractors would “voluntarily” reclassify such workers as employees, if they could avoid the associated back taxes and penalties. Each of these findings has been disputed by various private sector groups.
The competitive disadvantage argument arises where there are two similarly situated businesses, but only one of them is eligible for section 530 protection based on the prior-audit safe harbor. Assuming that neither business could satisfy the common law test for treating its workers as independent contractors, the business with section 530 protection arguably enjoys a competitive advantage over the other business. What especially rankles the ineligible business under these circumstances is that its competitor’s section 530 protection is fortuitous, inasmuch as it is available only because an IRS agent failed to properly evaluate such business’s classification of workers during an audit. Since a taxpayer’s reliance on the prior-audit safe harbor must be reasonable, however, the strength of the “competitive disadvantage” argument is open for doubt.
Based on its findings, the Government Operations Committee report recommended, among other things:
* that the tax-writing committees consider eliminating the prior-audit safe harbor of section 530;
* that IRS and private sector representatives discuss revising the common law factors to craft a clearer and more objective test for distinguishing between employees and independent contractors; and
* that some type of amnesty growth be administered by the IRS that would permit businesses that in good faith mistakenly classified workers as independent contractors, and had complied with the tax and information reporting obligations associated with such classification, to reclassify such workers as employees and avoid back taxes and penalties.
The Employment and Housing Subcommittee of the House Government Operations Committee followed up on the November 1990 report by holding an April 23, 1991, hearing on how workers can be oppressed by businesses, particularly within the construction industry, by being treated as independent contractors. The hearing concentrated on instances where businesses engaged in egregious behavior with respect to their workers, solely to reduce labor costs. For example, testimony was heard concerning a business with a union workforce that treated its workers as employees for the minimum number of hours each month that would qualify the workers for union benefits; to the extent an individual worked more than the minimum number of hours, the business recharacterized the worker as an independent contractor. Thus, at the end of the year, the workers received both a Form W-2 and a Form 1099 from the same business.
Although suggestions were made concerning how section 530 could be modified to address clearly fraudulent behavior, even the IRS representative acknowledged that section 530 does not sanction such activities. In other words, the hearing focused on fraudulent business practices that would be unaffected by changes in the law. Nevertheless, the IRS utilized the hearing as another opportunity to criticize section 530. (19) The subcommittee staff was reported to be preparing legislation to modify section 530, but no such legislation has yet been introduced.
The Exports, Tax Policy, and Special Problems Subcommittee of the House Small Business Committee got into the act during the summer. At a July 30 subcommittee hearing, the Treasury Department recommended that section 530 be modified to permit IRS to issue guidance with respect to worker classification matters. (20) Subcommittee members expressed concern with authorizin the IRS to issue guidance unless private sector representatives were expressly brought into the guidance process. A representative of the Small Business Administration testified that the SBA flatly opposed the suggested modification to section 530.
Witnesses also argued that the IRS’s enforcement strategy be changed. For example, under current law, the Code penalizes failures to file Forms 1099 less severely than misclassifications, even though failures to file such forms account for more tax revenue loss than does the misclassification of workers as independent contractors. It was recommended that the penalty regime be amended to reflect this phenomenon, perhaps by increasing the penalties for failures to file Forms 1099 and reducing the penalties associated with worker misclassification. This recommendation received strong backing from members of the subcommittee.
The hearing also revealed a continued desire for a new worker-classification standard. (21) Moreover, there was general support for an amnesty provision, along the lines suggested by the full Government Operations Committee in its November 1990 report. In his regard, Representative Doug Barnard of Georgia announced that Representative Ed Jenkins of Georgia would soon introduce legislation providing amnesty to any business that converted workers currently treated as independent contractors to employee status.
H.R. 3109 was introduced by Congressman Jenkins in August 1991. This bill would provide a form of amnesty to businesses that reclassify their independent contractors to employee status during any period ending before December 31, 1993. The amnesty would be conditioned on the business’s having had a “reasonable basis” for treating the worker as an independent contractor. The reasonable-basis test in H.R. 3109 is patterned after, but is narrower than, the safe harbors of section 530. Unlike section 530, H.R. 3109 does not include the prior-audit safe harbor. Moreover, the bill’s other tests, while borrowed from section 530, are conjunctive rather than disjunctive. Thus, whereas a business may qualify for section 530 relief by demonstrating reasonable reliance on either (i) judicial precedent, published rulings, etc., or (ii) a long-standing industry practice safe harbor, reliance on both must apparently be shown to satisfy H.R. 3109.
Because H.R. 3109 would effectively provide amnesty protection only to a business that currently satisfies section 530 (subject to certain exceptions), (22) it follows that only the exceptional business that qualified for the relief offered by H.R. 3109 would find such relief attractive. The apparent limited applicability of this amnesty protection raises a question whether the bill presages legislation to narrow the scope of section 530.
* * *
The foregoing developments, taken together, suggest that legislative change in this area is a possibility. Moreover, the congressional hearings revealed that the private sector lacks unity on the issue. Although private sector groups may differ in their views, one characteristics they share is that they generally do not have much control over what, if anything, will ultimately be enacted. One “wildcard” that should not be ignored is the IRS’s desire that payments made by businesses to independent contractors be subject to withholding. If a withholding requirement were imposed, all businesses that use independent contractors, and intend to continue doing so, would surely suffer.
Where We Are With Respect
To Leased Employees
The leased-employees rules provide that a worker who is not an employee under the common law rules will nevertheless be treated as an employee for purposes of certain employee benefits rules, if the worker satisfies a three-part test. (23) In general, a worker will be deemed a leased employee if:
* the services are provided pursuant to an agreement between the recipient and any other person;
* the individual performs services for the recipient on a substantially full-time basis for a period of at least one year; and
* the services are of a type historically performed in the business field of the recipient by employees.
Under Prog. Reg. $S 1.414(n)-1(b)(12), the “historically performed” test will be satisfied if:
* it was not unusual for services of the type being performed by the worker to have been performed by employees of persons within the business field of the service recipient in the United States, on September 3, 1982; (24) or
* with respect to one specific business, the services being performed for such business by the worker has evern been performed for that business by an employee of such business.
A consequence of this interpretation of the “historically performed” test is that only the exceptional independent contractor could escape the test. Thus, the proposed regulations have been criticized for being so broad that the employees and partners of a law or accounting firm could be deemed leased employees of a client of the firm, if such individuals were to work a sufficient number of hours for the client and it was not unusual for employers in the client’s business field to have in-house counsel and accountants. (25)
Where We Are Headed With Respect
To Leased Employees
The “historically performed” test is likely to be replaced with some variant of a “control” test. A control test substitute proposal was contained in three of the pension simplification bills introduced recently.
For example, H.R. 2730, the Pension Access and Simplification Act of 1991, introduced by House Ways and Means Committe Chairman Dan Rostenkowski, would replace the “historically performed” test with a test requiring that “such services are performed under any significant direction or control by the recipient.” According to a technical explanation of the bill, a determination whether a business exercises “significant direction or control over a worker” would be based on the following factors:
* whether the individual is required to comply with instructions of the service recipient about when, where, and how the work is to be done;
* whether the services must be performed by a particular person;
* whether the individual is subject to the supervision of the service recipient; and
* whether the individual must perform services in the order or sequence set by the service recipient.
Conversely, factors that would be irrelevant in making such a determination include:
* whether the service recipient has the right to hire or fire the individual;
* whether the individual works for others; and
* whether the individual has a significant investment in facilities or equipment used by the individual in performing the services. (26)
The Rostenkowski proposal expressly repudiates the egregious example, noted above, in which the current proposed Treasury regulations would treat as a leased employee an employee of a firm who performs substantially full-time services for a client of such firm.
Another leased-employee bill was introduced on June 13 by Representative Rod Chandler of Washington. Under H.R. 2641 (the Employee Benefits Simplification Act of 1991), the test would be whether “the recipient exercises primary control over the manner in which such services are performed.”
H.R. 2742, the Employee Benefits Simplification Act, introduced by Representative Ben Cardin of Maryland, would supplant the “historically performed” test with a test requiring that “such services are performed by such person under the control of the recipient.” H.R. 2742 is identical to S. 1394, which was introduced into the Senate by Senators Lloyd Bentsen and David Pryor. (27)
In June testimony before the Select Revenue Measures Subcommittee of the House Committee on Ways and Means, the Treasury Department expressed a preference for the leased-employee language contained in the Rostenkowski bill. The Department voiced opposition to the Cardin and Chandler bills on the grounds that they would lose significant revenue and make substantive changes. The revenue loss associated with those bills, however, is likely not attributable to their leased-employees provisions.
While Congress is considering legislative change to the leased-employee rules, the IRS has stated that it is reviewing the scope and effect of the proposed regulations. The IRS has been reported to “feel” that the proposed regulations under section 414(n) are “too broad in their reach and that substantial adjustment is required.” Consequently, the proposed regulations may be formally withdrawn and a new set of narrower proposed regulations promulgated for public review and comment. (28) Any change in this area — whether legislative or administrative — will likely benefit businesses that seek to avoid their independent contractors being treated as leased employees.
The changes that have been proposed to modify the “historically performed” test of the leased-employee rules pose relatively little downside risk to businesses that use independent contractors and seek to avoid such workers being deemed leased employees. Each proposal would narrow the scope of such provision. In contrast, the possible changes that would affect a worker’s classification for employment tax purposes are wide open. This issue is especially unpredictable as a result of the variety of views that have been expressed on the issue. Although both issues are important, the employment tax issue would seem to be the one that businesses should more assiduously follow, and perhaps seek to influence.
– Notes –
(1) A third type of worker, a hybrid of employee and independent contractor status, is a “statutory employee.” A statutory employee is treated as an employee for employment tax purposes, but can deduct business expenses fully, as an independent contractor. The term “statutory employee” is defined in section 3121(d)(3) of the Internal Revenue Code.
(2) Treas. Reg. $S 31.3401(c)-1(b).
(3) U.S. Department of the Treasury, Taxation of Technical Services Personnel: Section 1706 Of the Tax Reform Act of 1986, at 15 (March 15, 1991) (“Treasury Section 1706 Report”).
(4) The U.S. General Accounting Office has issued several reports concerning the compliance issue. See, e.g., IRS Could Reduce the Number of Unproductive Business Nonfiler Investigations (GAO/GGD-88-77); State and Local Compliance With IRS’ Information Reporting Requirements (GAO/GGD-89-63); Missing Independent Contractors’ Information Returns Not Always Detected (GAO/GGD-89-110); and Profiles of Major Components of the Tax Gap (GAO/GGD 90-53BR).
(5) In addition, A business is fully responsible for federal unemployment (FUTA) taxes with respect to employees, but no FUTA tax is owed with respect to independent contractors; independent contractors are generally are not entitled to unemployment benefits.
(6) Under current law, the SECA tax rate and the combined FICA tax rate are the same. In addition, the same portion of each is deductible. The independent contractor is entitled to deduct one-half of the SECA tax imposed, and the business is entitled to deduct the employer share of the FICA taxes. The FICA and SECA wage bases, however, may differ.
(7) See Rev. Rul. 87-41, 1987-1 C.B. 296 (detailed explanation of the 20 factors of the common-law test).
(8) See Rev. Proc. 85-18, 1985-1 C.B. 518.
(9) BNA Daily Report for Executives No. 157, at G-1 (August 14, 1991).
(10) Section 269(a) of TEFRA also provided that certain real estate agents and direct sellers are deemed to be independent contractors withour regard to either section 530 or the common law test.
(11) Section 3509 of the Code limits a business’s liability for failure to withhold income or FICA taxes with respect to a worker who had been mistakenly treated as an independent contractor to 1.5 percent of the wages paid to the worker plus 20 percent of the employee-portion of the FICA taxes on the affected wages. If the business had not complied with the information-reporting requirements incident to its treatment of the worker as an independent contractor, the percentages double. Furthermore, if the worker is treated as an employee for income tax purposes but not for FICA tax purposes — or if the worker is treated as an independent contractor with intentional disregard of the law — the reduced penalty regime does not apply. Section 3509 also does not apply to the business’s liability for the employer share of FICA taxes or for FUTA taxes. To the extent applicable, section 3509 is a mandatory provision.
(12) Rev. Rul. 87-41, 1987-1 C.B. 296 (guidance relating to technical services workers.)
(13) Some tax-favored benefits are also available to independent contractors, such as the partial deduction for accident and health insurance.
(14) House Committee on Government Operations, Tax Administration Problems Involving Independent Contractors, H.R. Rep. No. 101-979. 101st Cong., 2d Sess. (1990).
(15) BNA Daily Report for Executives No. 160, at G-2 (August 20, 1991).
(16) Tax Management Compensation Planning Journal 77 (February 1991).
(17) Some groups advocate legislation that would provide a more objective test for distinguishing between independent contractors and employees. Others, while not opposing such a legislative change, strongly oppose any legislative tinkering for fear that once the “door is open” on this issue, the downside possibilities–such as the IRS’s withholding concept — will render the legislative approach entirely too risky to pursue.
(18) Private sector groups urging modification to section 530 (or its repeal) generally encompass taxpayers that do not qualify for section 530 protection and cannot satisfy the common law test, but who believe that their competitors who qualify for section 530 protection also could not satisfy the common-law test. The most common theory for how such competitors are eligible for section 530 protection is that they were audited by the IRS on some narrow issue unrelated to worker classification, thereby becoming eligible for section 530’s prior-audit safe harbor.
(19) BNA Daily Report for Executives No. 79, at G-2 (April 24, 1991).
(20) Another aspect of section 530 that was discussed at the hearing concerned the open-ended nature of its protection. Thus, whereas the propriety of section 530’s protection against retroactive reclassification and the attendant penalties and interest was not challenged, some witnesses questioned the prohibition against the IRS prospectively reclassifying a worker.
(21) At the April 23 hearing, the Treasury Department testified that although the common law test does not lack precision and predictability, no clearly bitter definition has ever emerged, notwithstanding years of effort by talented individuals. Thus, Treasury would prefer to permit IRS to issue guidance clarifying current law, rather than seeking to develop a new and improved version of the 20-factor common law test.
(22) H.R. 3109 does not appear to contain a “consistency requirement” as does section 530.
(23) I.R.C. $S 414(n).
(24) If a particular business field did not exist on such date, the test would be applied by analogy to similar business fields that did exist on the prescribed date.
(25) Staff of the Joint Committee on Taxation, Staff Description of H.R. 2730 at 17 IJCS-12-91) (August 5, 1991) (“Joint Committee Description”).
(26) The relevant and irrelevant factors are also set fort in the Joint Committee Description, supra note 25.
(27) Two other pension simplification proposals — H.R. 2390, the Pension Coverage and Portability Improvement Act of 1991 (introduced by Representative Sam Gibbons of Florida); and the Administration’s POWER proposal — do not address the leased employee issue.
(28) Tax Management Compensation Planning Journal 101 (March 1991).
Russell A. Hollrah is an associated in the Washington, D.C., law firm of Edward N. Delaney & Associates, Chartered. Mr. Hollrah received his LL.M. degree from Georgetown University and practices primarily in the area of corporate tax (federal and state) and employee benefits.
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