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

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

At press time, there were nearly 218 House co-sponsors-enough topass a bill-of H.R. 1972 (introduced by Rep. Jon Christensen,R-NE), which would force the IRS to provide an alternative to itsmuch-reviled 20-factor test for determining whether a serviceprovider is an employee or an independent contractor. The politicalheat 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 employersfrom hiring independent contractors; the same rules also oftenresult in small businesses being forced to pay thousands of dollarsin back taxes and interest.

"The so-called 20 common law factors that serve as the basisfor current classification decisions are nebulous andinconsistently applied," says Marc S. Wagner, a partner in theCPA firm Wagner & Oudenne in Southampton, Pennsylvania, whosays some of his small-business clients have had to pay big backtax bills because the IRS ruled they had misclassifiedemployees.

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

Meanwhile, IRS commissioner Margaret Milner Richardson recentlyannounced initiatives to help mitigate the problem. "We aretrying to accomplish the same thing as Christensen," saysSteve Pyrek of the IRS.

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

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

Christensen's bill sets up an alternative to the 20-factortest. It is available, however, only to taxpayers who have filed1099s for the workers involved. A service provider would beconsidered an independent contractor if he or she meets one of thefollowing five criteria:

1. He or she has a significant investment in assets and/ortraining,
2. incurs significant unreimbursed expenses,
3. is liable for potential damages and may be terminatedwithout 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 workermust also meet all the following criteria to be considered anindependent contractor: He or she must have a principal place ofbusiness or demonstrate the intention to offer a service to others,be marketing on a regular basis, and have a written contract fromthe service receiver saying the provider will not be treated as anemployee. There are a few other requirements as well.

The House Ways and Means Committee, which has jurisdiction over thebill, is waiting for an estimate from the Joint Tax Committee onthe bill's fiscal effect on the federal treasury before ittakes any action on it. However, according to James Morrison, asenior policy advisor for the National Association for theSelf-Employed, the Treasury Department has already said it'simpossible to determine in advance whether revising the 20-factortest would mean a loss or gain to the treasury. Morrison'spoint is that according to the U.S. General Accounting Office,whether an employer pays taxes for an employee or an independentcontractor pays taxes for himself, the total is about thesame.

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

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