The tax treatment of independent contractors: where we are, and where we're headed.

• Author: Hollrah, Russell A.

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...