From the January 1998 issue of Startups

Think you're an independent contractor because you're homebased? Think again. Telling an independent contractor from an employee is about as easy as keeping identical twins straight. And if you're wrong, you may have broken dozens of laws and be forced to pay large fines.

Many companies love independent contractors. By hiring freelancers, businesses avoid salaries, benefits, labor laws, workers' compensation premiums, payroll and unemployment taxes, having to supply office space and equipment, and responsibility for most worker negligence. On the flip side, the independent contractor is typically glad to trade job security for the freedom of being his or her own boss. Generally, independent contractors make 20 percent to 40 percent more than they would as employees. And because they're not subject to withholding, they keep more of their money longer. At tax time, they get to take business-related deductions.

The IRS, claiming it's losing billions of dollars each year due to employers who misclassify their employees as independents, is cracking down. The problem is, the definition of independent contractor under current law is complex. Businesspeople aren't sure what they can and cannot do, and the IRS has aggressively exploited the gray areas to its advantage.

Under basic legal principles, the hiring company's degree of control is what distinguishes the freelancer from the "wage slave." An employer can tell an employee not only what it wants done but also how to do it. With an independent contractor, however, the employer specifies only the ends, not the means. As you might suspect, these tests are too general to be useful. More than 50 years ago, even the U.S. Supreme Court admitted it had trouble applying them. As you'll see, little has changed.

First, Congress tried to help. In 1978, it enacted safe harbor laws (Section 530) to protect employers who had reason to classify their workers as independent contractors, had filed their returns and were consistent in how they differentiated their workers. Although these laws are helpful and have been clarified by amendments several times, most recently by the Small Business Job Protection Act of 1996, they have not eliminated the problem.

Then, in 1987, the IRS tried to help. Poring over court cases and tax rulings, it cooked up a test to clarify employer-employee relationships . . . a test with 20 ambiguous considerations.

Thus, when the IRS audits a business owner on this issue, nine times out of 10, the businessperson loses. That can mean disastrous retroactive payments of Social Security, Medicare, unemployment and income taxes--plus interest and penalties. In fact, it's been estimated that since the mid-1980s, the IRS has reclassified 439,000 workers, pocketing more than $678 million as of mid-1996.

And what if you are the independent contractor who is reclassified as an employee? You'll suffer too, potentially losing your home office, pension plan and other business deductions, not to mention income should the "employer" find you too expensive to keep as a freelancer.


Marc Diener is an attorney in Los Angeles. This article contains general information only. If you are concerned about how these issues might affect you, seek independent counsel.

And That's Not All

When freelancers at Microsoft were reclassified as employees, they sued for retroactive retirement benefits. The reclassification of an injured worker may trigger substantial fines under workers' compensation laws and liability for medical bills and lost wages. Misclassification can even mean criminal penalties under the Fair Labor Standards Act. And if this isn't complicated enough, various agencies and states use different tests to sort their workers. Thus, a worker may be an independent contractor under one law and an employee under another.

Protect Yourself

Despite specific IRS programs to achieve greater consistency and efficiency and congressional attempts to replace the 20-part test, worker classification issues will continue to plague business owners for a while. As we've seen, simply christening a worker an independent contractor won't protect an employer. And for those who consider themselves independent contractors, a home office by itself means little, especially in our age of easy travel and telecommuting, and particularly in the new training manuals developed for IRS agents policing this area. Still, no matter which side of this equation you're on, you can reduce the risk of reclassification. Here are five strategies that may help you survive an IRS challenge:

1. Plan to use the safe harbor. According to attorney Stephen Fishman, author of Wage Slave No More: The Independxent Contractor's Legal Guide (Nolo Press), it's now easier for businesses to take advantage of Section 530, especially if they plan ahead. For example, a company may establish its "reasonable basis" for treating workers as independents by taking a survey to determine, and then conform to, widespread and long-standing practice in its particular industry. It could also obtain, and rely on, the formal opinion of a lawyer or accountant knowledgeable in this area.

2. Let the independent stay in control. A hiring business shouldn't try to tell an independent how to get the job done. Freelancers should not receive training, have set hours or procedures, or have reporting requirements. Independents should be able to delegate duties freely and hire their own assistants.

3. Structure compensation correctly. An independent should bear the risk of profit or loss. Accordingly, they're best off invoicing their employers per job rather than per hour, per day or per week. Freelancers should receive no benefits or expense reimbursements. Employers should report payments to independent contractors on IRS Form 1099. It also helps to have checks made payable to a company or a dba, or to have the independent contractor incorporate.

4. Hire (or be) a self-reliant contractor. Freelancers should have their own offices, supply their own equipment, pay their own taxes, have their own insurance, work for more than one client, do their own marketing and advertising, and not be integrated into the general business operations of their clients.

5. Have a written contract. Although structuring these relationships correctly is crucial, documenting them also helps. Restate the above elements in your formal agreements. Specify that neither party has the right to terminate the deal unless the other fails to live up to its obligations. Add a statement that one party intends the other to be an independent contractor and not an employee. Don't forget to add a provision regarding the ownership of any copyrights or other intellectual property (patents, trademarks or trade secrets) created during the engagement. "In a close case, a written agreement may tip the balance," says Fishman.

Generally, determining independent contractor status is the employer's headache. In addition to the above, employers should keep accurate records to justify their classifications and establish consistent policies. On the other hand, if you're freelancing, use these guidelines to make your prospective client feel as comfortable as possible about hiring you as an independent contractor. This war of independents is far from over.