Smoky Mountain's secret to successfully claiming workers to be independent contractors.

• Author: Gee, Edgar H., Jr.

EXECUTIVE SUMMARY

This article illustrates that due diligence pays off. It examines Smoky Mountain Secrets, Inc., in which a taxpayer successfully defended against an IRS reclassification of workers as employees. The taxpayer's president sought tax advice on the classification issue when Sec. 3508 was first enacted, and the tax adviser and the client scrutinized Sec. 3508 and Section 530 of the Revenue Act of 1978 in determining that the workers were independent contractors. The Eastern District of Tennessee recently concluded that, given the law as it then existed and the taxpayer's efforts to obtain tax advice, the taxpayer's classification of its telemarketers and delivery people as independent contractors was correct, saving almost $4 million in payroll taxes.

Taxpayers won a major victory recently against the IRS's relentless assault on workers classified as independent contractors. Smoky Mountain Secrets, Inc.(1) a landmark decision, provides much-needed clarification of the independent contractor versus employee question. The case addressed the classification under Sec. 3508(a) and (b) (2) of direct sellers as nonemployees, Revenue Act of 1978 (RA '78) Section 530 and common law.

Background

Smoky Mountain Secrets, Inc. (SMS) is a Tennessee corporation that markets gourmet foods and condiments to consumers in various states. Most sales are solicited through SMS's staff of commission-based telemarketers located in sales offices in 14 different states, although some orders are received via mail, from repeat customers and from on-the-spot sales by delivery people. Orders solicited by the telemarketers are delivered to customers' homes by delivery persons who often need to actually close the sale to collect the amount due. SMS also employs a large staff of workers that it classifies as employees (e.g., home office staff, office managers and warehouse workers).

Prior to starting to work for SMS, telemarketers and delivery persons are required to sign a contract that sets forth that (1) the worker will be paid on a commission-only basis (tied directly to the number of sales delivered and paid for), (2) the worker is an independent contractor, not an employee, and (3) no taxes will be withheld. New contracts are signed every year. SMS issues a Form 1099 to every telemarketer and delivery person who earns over $600 per year.

The IRS assessed SMS for approximately $3.9 million in FICA and FUTA taxes for 1989 and 1990, contending that its...