By: A.J. Cook

The Internal Revenue Service continues to intensify its war against businesses and tax-exempt organizations incorrectly classifying employees as independent contractors. It claims because of misclassification it loses more than $38 billion in employment taxes a year.

The IRS says that besides the employment tax loss many of these misclassified workers aren't paying income taxes. The agency's statistics show that when the business files nothing with the IRS, less than 30 percent of worker's report their compensation.

Why do businesses and tax-exempts misclassify? Because there is no clear definition and tests distinguishing the status are complicated and subjective. Besides that, organizations have a strong incentive to opt for independent contractor classification. With this classification they need not keep track of withheld income taxes, which is difficult in high employee turnover industries, nor pay hefty Social Security taxes. Add to this that some workers refuse to allow anyone to report their names and compensation to the government.

Classifying, at first blush, seems simple. The worker is an independent contractor if the business controls only the results of the work. The worker is an employee if the business can also control how the work is done.

The IRS's newly issued training materials give these examples: The company asked trucker John to make a delivery from Houston to Dallas. John agrees to pick up the load the next morning. The company said the delivery must be made within two days. John is an independent because the company told him only what to do. John's friend Bill, however, is an employee. He reports to the company warehouse every morning, and the manager tells him what deliveries to make that day. The manager directs how to load the cargo and what route and in what order to deliver it. The manager not only tells him what to do, but how to do it.

When the distinction is not as clear, other factors are considered:

• Performs without specific instructions.
  
• Is paid by the job, not by the time spent.
  
• Can hire, supervise and pay assistants.
  
• Can make a profit or suffer a loss.
  
  

• Renders services personally.
  
• Must comply with instructions about when, where and how to work.
  
• Relies on equipment and supplies from the company with little or no capital investment.
  
• Has a continuing relationship with the company and doesn't offer services to others.
  

Companies are subject to conflicting interpretations when the relationship with workers has factors on both sides. In one case, where physicians worked for a corporation, some factors supported employee status, others supported independent. The IRS ruled they were employees. In another case dentists also worked for a corporation and possessed factors on both sides. A court ruled the dentists were independents. With mixed factors the answer may depend on who decides -- the IRS or the courts.

The government has admitted that status tests lack precision and predictability and in many cases yields inconsistent answers. So the tug-of-war between the IRS and employers continues.

So much controversy arose over these definitions that Congress passed a "safe haven" law. This prevents the IRS from forcing employee status if the company meets the following three requirements:

• Did not treat workers in a similar position as employees for employment tax purposes.
  
• Has filed Form 1099, when required, with the IRS as if the worker was an independent.
• Has a reasonable basis for treating the worker as an independent.
  

Ah, that word "reasonable" -- the cause of so many tax battles. Examples from Congress and court cases shed some light. The employer has a reasonable basis it:

• Relies on court cases, IRS rulings or the advice of an accountant or attorney familiar with the
  law and facts.
  
• Had an audit previously and the IRS didn't challenge the status.
  
• Was following longstanding industry practice.

Of these, "industry practice" creates the most controversy. The IRS is stubborn about allowing this exception even when the taxpayer has strong evidence supporting its position. One company, whose workers were appraisers, commissioned a survey of the industry which showed that 75 percent of all survey respondents treated their appraisers as independents. The IRS, unconvinced, challenged the status. A court reversed the IRS and agreed with the company.

In another case, a court was satisfied with the company's own survey. The IRS had challenged Paul D. McClellan of Sterling Floors and Kitchens in Detroit over the status of floor installers. Posing as an unemployed installer, he called 41 competitors and found 40 of them classified workers as independents. The IRS still disagreed. The judge said Congress passed the safe haven law to curb overzealous enforcement in just such situations. He added that the IRS obstinance bordered on bureaucratic arrogance. McClellan not only won his case, but the court nailed the IRS for legal fees and court costs.

The Planning tip: Businesses and tax-exempt organizations have three lines of defense. Be prepared to use any one of the following against an IRS challenge:

• Show that you don't have the authority to control how the work is done.
  
• Show that you don't furnish the worker's equipment or supplies, you don't set the worker's hours nor pay by the time spent, the worker stands to make a profit or loss and there is no continuing relationship with the worker.
  
• Show that you have not treated this type of worker as an employee on tax reports, have filed annually the IRS Form 1099, when required, for payments to the worker and have a reasonable basis for considering the worker an independent contractor.
  
  

A.J. Cook is a lawyer and CPA. His tax column appears weekly in numerous newspapers. Why isn't it published in your hometown newspaper? Ask its Business Editor to subscribe.

Copyright © 1987-2001 A.J. Cook All Rights Reserved
This information is not intended for use without professional advise.
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Released 5-6-96 and 5-13-96