Guest Article

The IRS vs. The Independent Contractor

By Andrew E. Schultz

For this particular HR manager, it's been a difficult morning commute. Her mind has been racing with thoughts of the recent meetings dealing with downsizing...and the rumors that several of her friends are about to be downsized right out of their jobs. As she drives, the same buzzwords keep going through her mind, Rightsizing. Reengineering. Headcount...and how in the world to implement corporate culture and knowledge management initiatives in such an environment.

As she pulls into the parking lot, however, she's a bit surprised by what she sees. Walking into the building, briefcase in hand, is a former colleague who supposedly left the company weeks ago. Standing nearby is a group of recently-downsized friends, conversing animatedly.

Then it occurs to her that there aren't many empty parking spots for a company that has been doing so much downsizing.

After finally finding a spot, she approaches the group, and asks if they're back with the company. The answer, she is told, is both yes and no. Yes, they're working at the company. But, no, they're not working for the company.

Who they are working for, apparently, is themselves.

It's an increasingly familiar scenario in today's business world. Talented professionals leave their firms - voluntarily or not - and, in short order, return to work for those firms as consultants. Often, these people end up at their old desks, doing their old tasks (and, apparently, parking in their old spots). Now, however, their old employer is their new client. And they're getting paid as 1099 independent contractors, instead of as W-2 employees.

Contingent workers such as these - independent contractors, returning retirees, consultants, freelancers, etc. - are becoming an ever-increasing segment of the American workforce:

And the trend isn't anywhere near peaking. The Department of Labor, in fact, states that within five years, the biggest employer in America will be "Self." And some experts say that one out of every three workers in this country may soon be part of the contingent workforce.

The reason is simple. There's ever-increasing pressure on corporate America - especially in public companies - to keep the "head count" down, to limit the number of full-time employees so that the company's balance sheet reflects more positively on Wall Street. And there's increasing pressure on every company, public or not, to be lean and flexible so as to better meet the challenges of the new millennium (while at the same time, lessening the chance of having to implement layoffs should the economy falter).

The work, however, still needs to get done...and that's where contingent workers come in. Companies are realizing that independent contractors, because of their diverse professional experience, often possess a depth of knowledge that can exceed that of their regular employees; and it can be utilized without having to pay employment taxes or provide benefits.

It sounds like a great situation...a win-win situation for both the contractors and the company. But recent events are proving that the reality may not be as great as the theory.

The reality, in fact, is often very painful. If your company has people who are being paid on a 1099 basis, look out! The IRS has its sights set on you...and them.

And the impact could be felt all the way to your benefit plans.

The IRS Perspective

The IRS is not convinced that independent contractors are paying their fair share of taxes. In fact, the General Accounting Office has estimated that unpaid taxes by the self-employed account for a $20 billion annual tax loss to the U.S. Government. Not surprisingly, the IRS - as well as state taxing agencies - have allocated significant resources in an attempt to recover this pot of gold.

Recent studies indicate that close to half of the nine million individuals currently working as independent contractors are misclassified; in the eyes of the law, they're actually "employees."

The criteria used by the IRS and many states has traditionally been a series of common law questions, known in tax circles as "The Famous Twenty Questions." These questions generally point to how much control a company has over a worker's performance. The more control, the more likely your Independent Contractor will be classified as an employee.

If your company is the worker's primary source of income, and/or the worker is a former employee of your firm, it will be extremely difficult to prove that an Independent Contractor relationship truly exists.

And, just for the record, you'd be best off avoiding getting into a legal arena with the IRS. In 90% of the companies it looks at, the agency finds some misclassified contractors. If that happens, your company could be affected for a long time.

This scenario could have a devastating effect, for instance, on qualified benefits or pension plans. If the IRS rules that large numbers of people were actually functioning as employees rather than as independent contractors, these people could suddenly be eligible to participate in the pension plan - sometimes retroactively. This could jeopardize the plan's ability to meet IRS requirements for qualification...and could conceivably result in the loss of tax breaks to both the company and the enrollees.

Recent Rulings Have Raised The Stakes

Fines, penalties, and interest charges from both the IRS and state tax authorities have been staggering, including a number of assessments of more than $10 million from a single firm.

A U.S. Court of Appeals decision involving Microsoft has further raised the stakes on this issue. In a controversial decision, the court ruled that a group of Microsoft Independent Contractors, who were determined by the IRS to actually be employees, were in fact entitled to receive the benefits of Microsoft's stock purchase plan for the period in which they were misclassified.

Recently, an Appeals Court in San Francisco widened the scope, ruling that the company might also be forced to give retroactive benefits to thousands of other temporary employees. As you might imagine, the impact of these decisions on companies that utilize independent contractors is potentially enormous.

In addition, in October of 1998, the Department of Labor weighed in on this issue for the first time, by taking on media giant Time Warner. The Labor Department sued Time Warner for improperly denying benefits to certain workers. The DOL believed that many of these workers had been misclassified as independent contractors.

Contracts/Incorporation Not Always The Answer

Don't make the mistake of thinking that a written contract with your 1099 wage earners will keep you safe. Many companies have gone this route, with contracts claiming the contractor's independence from the company. However, regardless of what's written in the contract, the IRS and state tax authorities will make you prove that your 1099 wage earners are really independent. For your legitimate independent contractors, a written contract is indeed essential. However, if the actual relationship is that of an employer and an employee, your contract is most likely not worth the paper it's written on.

The Problem For HR

The typical HR department may lack concrete experience in these issues, and may not be properly set up to handle them in the most efficient manner. To further complicate matters, keep in mind that the IRS "Twenty Question Test" is a guideline...but only a guideline. We've seen interpretations vary widely, with different agencies often coming up with different opinions as to the importance of each question. In many cases, this has led to the DOL, for example, seeing a certain worker as an independent contractor, while the IRS has found that person to be an employee. A corporate HR department might have extreme difficulty determining what might work for different taxing agencies.

If you decide to work with a consulting firm that is set up to handle these issues, make sure you get one that is experienced at navigating the maze of state and federal regulations. Make sure this firm truly understands just who is and who is not an independent contractor. If you find it necessary to use a third-party payroll, make sure it is set up properly, with contracts that protect intellectual property and with non-disclosure agreements. In addition, make sure the workers are offered significant benefits, and that all co-employment concerns are adequately addressed.

Installing A Compliance System

If your company is currently classifying returning retirees and other professionals as 1099/independent contractors, it's important to come up with a plan...before the IRS does it for you. A good compliance system should include the following:

• A method of analyzing the proper classification of all potential independent contractors.

• A file documentation system for all independent contractors whom you determine to be truly "independent."

• A third-party payroll for those ICs and/or Returning Retirees who probably would not pass the test of the tax authorities.

In our steadily downsizing world, independent contractors are here to stay. It's an axiom of the new economy that when the head count goes down, the contractor-count goes up. Used wisely, they can be an integral part of your company's business plan.

It's a concept that is proving really valuable to those companies who are adequately prepared. But it can prove a nightmare to those who jump into it blindly.

The best way to keep this success formula from turning into a bad dream, however, is very simple: Make sure your company installs a compliance system that really works. And stick with it.

Andrew E. Schultz is president of PrO Unlimited (www.prounlimited.com), a national consulting and outsourcing firm specializing in helping companies address issues related to the use of contingent workers, with a particular focus on the proper utilization of independent contractors. He has spoken at more than 300 seminars and corporate in-house meetings on this issue. PrO Unlimited pioneered the field of contingent-workforce management in the early 90's, and is today recognized as the industry leader in this arena. The company offers clients a variety of services, such as 1099 consulting and audit support and third-party payroll. PrO Unlimited can be reached by calling (toll-free) 1-877-PRO-1099.

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