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Independents Day

The IRS and 'Congress race to simplify independent contractor classifications.

This story appears in the June 1996 issue of Entrepreneur. Subscribe »

The IRS is trying to stay one step ahead of the sheriff, who in this case is Congress. That explains the IRS' recent string of apparent accommodations on the issue of independent contractors, the number-one concern at the 1995 White House Conference on Small Business.

At press time, there were nearly 218 House co-sponsors-enough to pass a bill-of H.R. 1972 (introduced by Rep. Jon Christensen, R-NE), which would force the IRS to provide an alternative to its much-reviled 20-factor test for determining whether a service provider is an employee or an independent contractor. The political heat rose a few degrees more on March 13 when Sens. Kit Bond (R-MO) and Don Nickles (R-OK) introduced their version of the House bill (S. 1610).

Entrepreneurs have long argued that IRS rules discourage employers from hiring independent contractors; the same rules also often result in small businesses being forced to pay thousands of dollars in back taxes and interest.

"The so-called 20 common law factors that serve as the basis for current classification decisions are nebulous and inconsistently applied," says Marc S. Wagner, a partner in the CPA firm Wagner & Oudenne in Southampton, Pennsylvania, who says some of his small-business clients have had to pay big back tax bills because the IRS ruled they had misclassified employees.

Christensen estimates IRS audits have resulted in the reclassification of some 439,000 independent contractors as employees since the mid-1980s. The federal tax gain from payment of fines and taxes: $678 million.

Meanwhile, IRS commissioner Margaret Milner Richardson recently announced initiatives to help mitigate the problem. "We are trying to accomplish the same thing as Christensen," says Steve Pyrek of the IRS.

One improvement announced by Richardson on March 5 was a pilot classification settlement program that gives IRS auditors the option of reducing back taxes for employers who unwittingly misclassify workers. Currently, an auditor must assess back taxes for all years under audit; the pilot program would allow auditors to reduce that to either one year's worth of back taxes or 25 percent of one year's back taxes.

Of course, neither this nor the other initiatives announced by the IRS changes the 20-factor test. Marshall Washburn, the IRS' national director of specialty taxes, emphasizes that the IRS is increasingly flexible in terms of how agents apply those factors; in March, the agency released a draft of a training manual for IRS examiners that seeks to clarify the rules for classifying employees (see May's "Business Beat," page 15). But that manual didn't change the rules; the 20-factor test is still sacrosanct.

Christensen's bill sets up an alternative to the 20-factor test. It is available, however, only to taxpayers who have filed 1099s for the workers involved. A service provider would be considered an independent contractor if he or she meets one of the following five criteria:

1. He or she has a significant investment in assets and/or training,

2. incurs significant unreimbursed expenses,

3. is liable for potential damages and may be terminated without cause,

4. gets paid on a commission basis, or

5. purchases products for resale.

In addition to meeting at least one of these criteria, a worker must also meet all the following criteria to be considered an independent contractor: He or she must have a principal place of business or demonstrate the intention to offer a service to others, be marketing on a regular basis, and have a written contract from the service receiver saying the provider will not be treated as an employee. There are a few other requirements as well.

The House Ways and Means Committee, which has jurisdiction over the bill, is waiting for an estimate from the Joint Tax Committee on the bill's fiscal effect on the federal treasury before it takes any action on it. However, according to James Morrison, a senior policy advisor for the National Association for the Self-Employed, the Treasury Department has already said it's impossible to determine in advance whether revising the 20-factor test would mean a loss or gain to the treasury. Morrison's point is that according to the U.S. General Accounting Office, whether an employer pays taxes for an employee or an independent contractor pays taxes for himself, the total is about the same.

Morrison is frustrated with Congress' failure to enact the Christensen bill. "Congress can put out more press releases [about independent contractors] than a camel can carry," he complains, but taking action is an entirely different matter.

Sticking with the camel metaphor, it is true you can lead one to water, as small business has learned in the case of the independent contractor issue, but it may be much harder to force Congress to drink.

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