The tax executive's guide to contemporary work relationships.

• Author: Hollrah, Russell A.

America's workplace is experiencing dramatic evolution. Traditional permanent, full-time employees are gradually being supplanted by outside firms and by individuals who work part-time, temporary or as independent contractors. Such nontraditional arrangements are most often, though not always, entered into by companies to contractout functions that are not integral to their core business.

1. The Emergence of Alternative Staffing Arrangements

   The workplace evolution has given rise to new industries that specialize in taking over the staffing and operation of non-core departments of other companies. For example, AT&T Corporation may contract to take over the communications operations of another business; Xerox Corporation may take over another company's mail room and print shop; and Electronic Data Systems may assume control of another company's telecommunications operations. Companies such as these offer their clients the opportunity to completely "outsource" entire departments.

   Although a department might be outsourced to a business that possesses special expertise in performing the type of function being contracted out, another alternative is to outsource the function to a business that offers no special expertise for performing any specific function, but instead merely substitutes itself as the "employer" of individuals performing the work. Such organizations, known as "leased employers," essentially assume the administrative burden associated with being the "employer" of the affected workers. In many leasing arrangements, employees of a company become employees of a leasing firm, but perform the same work for the company.

   An alternative to outsourcing a department to another existing company is to outsource the function to the individual or individuals who do the work currently as employees. A New Orleans natural resource company reportedly outsourced its communications department to a new business that was created by former employees who had been operating the department.

   Another variant on this theme is to outsource a function currently performed by employees to those same individuals, or other individuals, who work as independent contractors. Outsourcing to independent contractors can sometimes occur as a consequence of a downsizing or a retirement that creates an unanticipated void in the ranks, creating a need for the retired individual to be coaxed back to work.

2. Why Is This Happening?

   Outsourcing occurs for a number of reasons. Many businesses are seeking to reduce their full-time payroll because of a perception that the cost--and anticipated future cost--of maintaining full-time permanent employees has exploded.

   One of the most compelling issues driving the outsourcing trend is the specter of health care reform. The prototype offered by the Clinton Administration during the 103d Congress, marked by employer mandates, prompted many businesses to take action to minimize their exposure by reducing their ranks of full-time employees.

   Employment law developments also contributed to this trend. Illustrative areas of concern include the evolving state of "wrongful termination" law, and the difficulty of complying with, and litigation arising out of, the Americans with Disabilities Act. These developments have increased the already substantial burden that is imposed on employers with respect to their full-time employees.

   The "burden" issue is unquestionably a major cause of the outsourcing trend, but another major cause involves businesses striving to adapt to the new--incredibly competitive --global economy. Some companies have responded to the demands of global competition by paring down their permanent workforce and outsourcing work that is seasonal or ad hoc in nature.

3. The Outsourcing Transaction

   This article examines the structuring of two of the most common types of outsourcing transactions--(1) a former employee who is retained as an independent contractor, and (2) an employee leasing firm that is engaged to become the "employer" of a group of individuals who will staff a non-core department of a business.

   As with most transactions, there is, from a tax stand-point, right and wrong ways to structure an outsourcing transaction. If structured incorrectly, the business contracting-out the work can be exposed to prodigious federal employment tax liabilities, consisting of the employer's share of Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes that should have been paid, federal income taxes and the employee's share of FICA taxes that should have been withheld, interest, and applicable penalties. Moreover, a flawed outsourcing arrangement could have a significant income tax effect--disqualification of qualified retirement plans maintained by the company, if what were thought to be independent contractors are recharacterized as employees, and coverage or discrimination requirements that the Internal Revenue Code imposes on retirement plans are thereby violated.

4. The Independent Contractor

   When engaging a former employee as an independent contractor, the company should be aware that the "safe harbor" protections of section 530 of the Revenue Act of 1978 will seldom be available to the company.(1) This is because the "consistency requirement" of section 530(a)(3) demands that the business has treated all individuals holding a position substantially similar to that of the former employee as independent contractors. Because an individual retained by a former employer will ordinarily be retained to perform services substantially similar to the services performed while an employee...