Avoiding IRS reclassification of workers as employees.

• Author: Burns, Jane O.

Executive Summary

The classification of workers as employees or independent contractors is a controversy significantly affecting many businesses. The primary defensive weapons available against an IRS challenge are the 20 factors provided by Rev. Rul. 87-41, and, in limited situations, Section 530 of the Revenue Act of 1978. However, as this article shows, in recent years, the courts have focused on just five of the ruling's factors and have provided some guidance on how to resolve the issue. As discussed in this article, this in-depth analysis should be helpful in avoiding IRS reclassification. The current legislative posture is also discussed.

The continuing controversy of whether workers should be classified as employees or independent contractors presents a serious dilemma for many businesses. This classification determines the applicability of payroll taxes, workers' compensation insurance, retirement plans and company fringe benefits. Worker status also is relevant for collective bargaining purposes and when assigning responsibility under civil rights acts. The past decade has been characterized by confusion, litigation and calls for simplification. Although legislation is pending, Congress has yet to provide relief

Without a clear standard, the IRS is aggressively pursuing additional taxes and penalties by reclassifying workers as employees; in fact, it has reclassified more than 400,000 independent contractors as employees since 1988 and currently reclassifies nearly 2,000 per week.(1) Further, the IRS has applied its own rules inconsistently, even in identical situations.(2) To quell the uncertainty faced by businesses, many alternative proposals have been presented.(3) Recently, the IRS announced two changes designed to achieve more uniform application of the standards: (1) National Office approval must be obtained for all local office reclassification projects and (2) additional training will be provided to examiners.(4)

An IRS reclassification includes not only assessments for the employer's share of payroll taxes but also interest and penalties, which can be substantial.(5) It also Can include the worker's share of FICA taxes, especially in flagrant situations or when they cannot be collected from the worker. If the hiring company is insolvent, the owners, officers and directors may be held responsible because the underpayment involves withholding taxes.(6) A worst-case scenario could result in the disallowance of the company's qualified pension plan because these "employees" (i.e., the independent contractors) were excluded from coverage.(7)

(1) Bovard, "The IRS vs. the Self-Employed," The Wall Street Journal, p. A14 (4/7/93). To improve its efficiency and consistency, the IRS has developed a computer expert system to determine classification status, SS-8 Determiner available for public use. (2) Approaches for Improving Independent Contractor Compliance (GAO/GGD-92-108, July 1992) (hereinafter, "GAO Study"). The Government Accounting Office (GAO) has frequently recommended that Congress enact clear and specific rules governing worker classification. (3) See Hulen, Kenny, et al., Independent Contractors: Compliance and Classification Issues (American Tax Policy Institute, Aug. 1993). (4) Tax Talk (IRS North Texas District, Fall 1995), p. 5. (5) GAO Study, note 2, estimates that $2.1 billion in payroll-related taxes are lost annually because approximately 3.4 million workers are misclassified as independent contractors. (6) See Roth and Biebl, "How to Avoid Getting Caught in the IRS Crackdown," 171 Journal of Accountancy 34 (May 1991), and Everett, Spindle and Turman, "Employee or Independent Contractor: A Determination with Far-Reaching Consequences," 9 Accounting Horizons 1 (Mar. 1995). (7) Workers reclassified as employees can also be assessed substantial additional taxes, even if they properly reported their incomes on Schedule C and paid self-employment taxes. Many deductions are lost on reclassification (e.g., business-related and travel expenses, home office deductions and contributions to pension and fringe benefit plans). FICA taxes plus income taxes on the lost deductions may exceed the refund due for any self-employment taxes paid.

Who is an Employee?

The controversy persists because there is no clear definition of "employee"; consequently, taxpayers have turned to the courts for help, but no definitive solution has resulted because the courts evaluate each case on its facts. The IRS issued Rev. Rul. 8741(8) to alleviate the conflict, but its 20 factors and the brief and general definitions may be misleading and confusing. The ruling's language is extremely subjective, and it states that the importance of each factor varies by individual, allowing the IRS considerable latitude to assert employee status.

This article provides a guide for classifying workers as either employees or independent contractors. (The discussion excludes domestic workers and workers designated as independent contractors under Sec. 3508 and Regs. Sec. 31.3401 (c)-1 (e). The protection afforded by the Revenue Act of 1978 (RA'78) Section 530 safe harbor is discussed first, followed by an explanation and evaluation of the Rev. Rul. 87-41 factors. Tax planning information is provided that should be helpful in avoiding or withstanding an IRS challenge.

Section 530 Safe Harbor

RA '78 Section 530 was enacted to prevent the IRS from arbitrarily reclassifying workers retroactively.(9) This safe harbor provides relief from payroll taxes if the hiring party consistendy treats workers as independent contractors and has a reasonable basis for doing so. A reasonable basis is determined by (1) judicial precedents, published rulings, or technical advice or letter rulings to the taxpayer; (2) a past IRS audit in which no assessment was made on similarly treated individuals, regardless of whether any IRS challenge was made; (3) long-standing recognized practice of a significant segment of the industry; or (4) some other manner, as discussed in Rev. Proc. 85-18.(10) Congress intended that reasonable basis be construed liberally in favor of the taxpayer. According to REAG, Inc.,(11) to prevail, "a taxpayer need only show a substantial rational basis for its decision to treat workers as independent contractors."

Frequently, Rev. Rul. 8741's 20-factor test is applied when "some other manner" is needed to prove reasonable basis. In such cases, the test is that the taxpayer was acting in good faith and had a reasonable basis for using independent contractor status. Consequently, Section 530 must be the first line of defense against IRS attempts to assess payroll taxes. Even if the IRS insists on use of the 20-factor test, the burden of proof is less onerous with Section 530.(12)

For Section 530 to apply, the hiring party must have treated all similar workers as independent contractors, and proper Federal tax documents (e.g., Forms 1099) must have been filed. If a business meets these conditions plus reasonable basis, it is protected from IRS retroactive reclassification, regardless of how common law defines the worker.(13)

Rev. Rul. 87-41

The courts have differentiated between employees and independent contractors by using common law rules. In Lowen Corp.,(14) the court recognized that neither the statutes establishing employment taxes nor the regulations are helpful in determining worker status. Thus, revenue rulings and case law must be examined.

The common law test generally used in the courts is stated in Regs. Sec. 31.3401 (c)-1 (b) and repeated in Rev. Rid. 8741:

[T]he relationship of employer and employee exists when the person or persons for whom the services are performed have the right to control and direct the individual who pcrforms the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.

The regulation also provides thiat "it is not necessary that the employer actually direct or control the manner in which the services are performed," as long as "the employer has the right to do so." This right overrides all other evidence, including a contractual agreement stating that the worker is an independent contractor.

Most of the cases state that...