Status Quotient How to determine whether to classify workers as employees or independent contractors.

The question of whether to classify workers as independentcontractors or employees continues to haunt most small-businessowners. But entrepreneurs aren't the only ones plagued by thisshady 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 ofthese misclassified workers aren't paying income taxes. Theagency's statistics show that when the business fails to filewith the IRS, less than 30 percent of the workers report theircompensation.

Businesses have good reasons for misclassifying. Because thereis no clear definition between classifications, and testsdistinguishing the status of each are complicated and subjective.Aside from that, organizations have a strong incentive to opt forindependent-contractor classification. With independentcontractors, companies need not keep track of withheld incometaxes, 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 andcompensation to the government.

Classifying may seem simple. The worker is an independentcontractor if the business controls only the results ofthe work. The worker is an employee if the business can alsocontrol how the work is done.

The IRS' newly issued training materials gives theseexamples: A company asked trucker John to make a delivery fromHouston to Dallas. John agrees to pick up the load the nextmorning. The company said the delivery must be made within twodays. In this case, John is an independent contractor because thecompany only told him what to do. John's friend Bill,however, is an employee. He reports to the company warehouse everymorning and the manager tells him what deliveries to make that day.The manager directs how to load the cargo, what route to take, andin what order to make the deliveries. The manager not only tellshim what to do but how to do it.

When the distinction is not as clear, other factors areconsidered:

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 towork.

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

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

Companies are often confused when the relationship with workershas factors on both sides. In one case, where physicians worked fora corporation, some factors supported employee status, while otherssupported that of an independent contractor. The IRS ruled thatthey were employees. In another case, dentists also worked for acorporation and the relationship possessed factors on both sides. Acourt ruled the dentists were independents. With mixed factors, theanswer may depend on who decides the issue--the IRS or thecourts.

The government has admitted that the status tests lack precisionand 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 theemployer, not to mention the cost (and bother) of keeping recordsand reporting taxes withheld. This is an important considerationfor small companies with high employee turnover, and also for thosewith a preference for concentrating on their business rather thanon legal niceties. It is also important to large corporationstrying to "outsource" work previously done by their ownemployees.

Controversy Abounds

As noted above, the worker is considered an independentcontractor if the company controls only the results. The worker isan employee if the company also controls how the work is done. Somuch controversy has arisen over these definitions that Congresspassed a "safe haven" law. This prevents the IRS fromforcing employee status if the company meets the following threerequirements:

The company . . .

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

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

• Has reasonable basis for treating the worker as an independentcontractor.

Ah, that word--"reasonable"-- is the cause of so manytax battles. Examples from Congress and court cases shed some lighton the problem. "Reasonable" basis can be claimed by anemployer who . . .

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

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

• Was following long-standing industry practice.

Of these, "industry practice" creates the mostcontroversy. 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 surveyof the industry which showed that 75 percent of all surveyrespondents 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 independentsurvey, but accepted one performed by the company itself. The IRShad challenged Paul D. McClellan, of Sterling Floors and Kitchensin Detroit, over the status of floor installers. Posing as anunemployed installer, McClellan called 41 competitors and foundthat 40 of them classified workers as independent contractors. TheIRS still disagreed. But when the case went to court, the judgestated that Congress had passed the safe haven law to curboverzealous enforcement in just such situations. He added that theIRS' obstinacy bordered on bureaucratic arrogance. McClellannot only won his case, but the court nailed the IRS for legal feesand court costs.

Planning Tips

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

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

• Show that you don't furnish the worker's equipment orsupplies; that you don't set the worker's hours nor pay bythe 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 anemployee on tax reports; have filed the IRS form 1099 annually,when required, for payments to the worker; and have a reasonablebasis considering the worker as an independent contractor.

Finally, for additional documentation on this issue, contact theIRS at (800) 829-3676 to order Publication 15, Employer'sTax Guide, which includes detailed information on thistopic.

Web Help

Check out the following World Wide Web sites for additional taxinformation:

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

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 noticesand articles.

1040-Online: 101 Common Questions (http://204.42.80.117/ref/101.html)provided by Parsons Technology Inc., presents answers to the 101most 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/) providesmore than 3,900 federal and state tax documents that can beimmediately downloaded, and access to all IRS forms, instructionsand publications.

Worth Reading

For additional documentation on this issue, see IRS Publication15, Employer's Tax Guide. To order, call the IRS at (800)829-3676.

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