From the May 1997 issue of Startups

The question of whether to classify workers as independent contractors or employees continues to haunt most small-business owners. But entrepreneurs aren't the only ones plagued by this shady issue; because of misclassifications, the IRS loses more than $38 billion in employment taxes each year.

The IRS also says that, besides the employment tax loss, many of these misclassified workers aren't paying income taxes. The agency's statistics show that when the business fails to file with the IRS, less than 30 percent of the workers report their compensation.

Businesses have good reasons for misclassifying. Because there is no clear definition between classifications, and tests distinguishing the status of each are complicated and subjective. Aside from that, organizations have a strong incentive to opt for independent-contractor classification. With independent contractors, companies need not keep track of withheld income taxes, which can be difficult in high employee-turnover industries, nor do they have to pay hefty Social Security taxes. Additionally, some workers refuse to allow anyone to report their names and compensation to the government.

Classifying may seem simple. The worker is an independent contractor if the business controls only the results of the work. The worker is an employee if the business can also control how the work is done.

The IRS' newly issued training materials gives these examples: A company asked trucker John to make a delivery from Houston to Dallas. John agrees to pick up the load the next morning. The company said the delivery must be made within two days. In this case, John is an independent contractor because the company only told him what to do. John's friend Bill, however, is an employee. He reports to the company warehouse every morning and the manager tells him what deliveries to make that day. The manager directs how to load the cargo, what route to take, and in what order to make the deliveries. The manager not only tells him what to do but how to do it.

When the distinction is not as clear, other factors are considered:

An Independent Contractor. . .


  • Performs without specific instructions.


  • Is paid by the job, not by the time spent doing the job.


  • Can hire, supervise and pay assistants.


  • Can make a profit or suffer a loss.


  • Can accept jobs with other companies.

An Employee . . .


  • Renders services personally.


  • Must comply with instructions about when, where and how to work.


  • Relies on equipment and supplies from the company, with little or no capital investment.


  • Has a continuing relationship with the company and generally doesn't offer services to others.

Companies are often confused when the relationship with workers has factors on both sides. In one case, where physicians worked for a corporation, some factors supported employee status, while others supported that of an independent contractor. The IRS ruled that they were employees. In another case, dentists also worked for a corporation and the relationship possessed factors on both sides. A court ruled the dentists were independents. With mixed factors, the answer may depend on who decides the issue--the IRS or the courts.

The government has admitted that the status tests lack precision and predictability and, in many cases, yield inconsistent answers. So the tug of war between the IRS and employers continues.

Employee status triggers high Social Security taxes for the employer, not to mention the cost (and bother) of keeping records and reporting taxes withheld. This is an important consideration for small companies with high employee turnover, and also for those with a preference for concentrating on their business rather than on legal niceties. It is also important to large corporations trying to "outsource" work previously done by their own employees.

Controversy Abounds

As noted above, the worker is considered an independent contractor if the company controls only the results. The worker is an employee if the company also controls how the work is done. So much controversy has arisen over these definitions that Congress passed a "safe haven" law. This prevents the IRS from forcing employee status if the company meets the following three requirements:

The company . . .


*Did not treat workers in a similar position as employees for employment tax purposes


  • Has filed Form 1099, when required, with the IRS as if the worker was an independent contractor, and


  • Has reasonable basis for treating the worker as an independent contractor.

Ah, that word--"reasonable"-- is the cause of so many tax battles. Examples from Congress and court cases shed some light on the problem. "Reasonable" basis can be claimed by an employer who . . .


  • Relies on court cases, IRS rulings, or the advice of an accountant or attorney familiar with the law and the facts,


  • Had a previous audit and the IRS didn't challenge the status, or


  • Was following long-standing industry practice.

Of these, "industry practice" creates the most controversy. The IRS is stubborn about allowing this exception, even when the taxpayer has strong evidence supporting its position. One company, whose workers were appraisers, commissioned a survey of the industry which showed that 75 percent of all survey respondents treated their appraisers as independents. The IRS, unconvinced, challenged the status. A court reversed the IRS' decision and agreed with the company.

In another case, a court didn't require an independent survey, but accepted one performed by the company itself. The IRS had challenged Paul D. McClellan, of Sterling Floors and Kitchens in Detroit, over the status of floor installers. Posing as an unemployed installer, McClellan called 41 competitors and found that 40 of them classified workers as independent contractors. The IRS still disagreed. But when the case went to court, the judge stated that Congress had passed the safe haven law to curb overzealous enforcement in just such situations. He added that the IRS' obstinacy bordered on bureaucratic arrogance. McClellan not only won his case, but the court nailed the IRS for legal fees and court costs.

Planning Tips

Businesses and tax-exempt organizations have three lines of defense. Be prepared to use any one of the following against the IRS challenge if you hire an independent contractor:


  • Show that you don't have the authority to control how the work is done;


  • Show that you don't furnish the worker's equipment or supplies; that you don't set the worker's hours nor pay by the time spent; that the worker stands to make a profit or loss; and that there is no continuing relationship with the worker;


  • Show that you have not treated this type of worker as an employee on tax reports; have filed the IRS form 1099 annually, when required, for payments to the worker; and have a reasonable basis considering the worker as an independent contractor.

Finally, for additional documentation on this issue, contact the IRS at (800) 829-3676 to order Publication 15, Employer's Tax Guide, which includes detailed information on this topic.

Web Help

Check out the following World Wide Web sites for additional tax information:

Westside Online Bulletin (http://www.primenet.com/~laig/proserve/bulletin/bu0001.htm) provides 20 IRS classification factors in "An Analysis of IRS Guidelines for Independent Contractor and Employee Status."

Tax Center (http://nestegg.iddis.com/nestegg/articles/taxctr.html) is devoted to articles specifically about taxes.

The Business Hotline Online (http://www2.bizhotline.com/bizhotline/article/artpg11.htm) provides a variety of business information, including IRS notices and articles.

1040-Online: 101 Common Questions (http://204.42.80.117/ref/101.html) provided by Parsons Technology Inc., presents answers to the 101 most commonly asked by taxpayers.

FedLaw-Tax (http://www.legal.gsa.gov:80/legal27.htm) provides links to other sites rich with tax information.

Tax-Forms Online (http://www.tax-forms.com/) provides more than 3,900 federal and state tax documents that can be immediately downloaded, and access to all IRS forms, instructions and publications.

Worth Reading

For additional documentation on this issue, see IRS Publication 15, Employer's Tax Guide. To order, call the IRS at (800) 829-3676.

A.J. Cook, lawyer and accountant, is counsel with the Memphis, Tennessee law firm of Harris, Shelton, Dunlap and Cobb, L.L.P.C.