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The War Of Independents

The IRS takes aim at independent contractors. Are you safe?

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.

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