THINK YOU ARE DOING BUSINESS WITH AN INDEPENDENT CONTRACTOR?

Attorney Jennifer M. Krueger
Murphy Desmond, S.C.

Each year, thousands of businesses utilize independent contractors without a clear understanding of whether the worker qualifies as an independent contractor. The current independent contractor rules fall short of providing any real guidance in the determination. Businesses are left to tread water in a sea of confusion. However, Congress may provide the beacon to guide businesses safely to shore.

On May 7, 2001, Senator Christopher Bond (R-MO) introduced the Independent Contractor Determination Act of 2001 (S.837) to the Senate Finance Committee. Representative Donald Manzullo (R-IL) introduced an identical bill, H.R.1783, just two days later. The proposed legislation purports to simplify the independent contractor determination rules, which will provide great relief to businesses utilizing the services of independent contractors. Current laws provide businesses little assurance that their independent contractors meet the requirements.

Currently, the IRS relies on a twenty-factor test in determining whether a worker is an independent contractor. In general, this complex test focuses on whether a service recipient has the right to direct and control workers and the work product. The problem with the twenty-factor test is that it is a complex set of extremely subjective criteria with no clear weight assigned to any of the factors. Businesses spend thousands of dollars on lawyers and accountants in a good faith attempt to satisfy the IRS' procedures. However, those same businesses have little certainty that the IRS will respect the conclusions of their trusted professions.

Misclassification leads to large troubles, especially for small businesses. The IRS' assessment usually occurs years after the parties have formed a working relationship. A misclassification leaves businesses facing years of payroll taxes, interest and penalties. Simply put, most small businesses cannot survive such an event, causing them to shy away from use of independent contractors.

Large businesses are also confused about independent contractor determination. For example, Microsoft faced difficulties with its independent contractors during the 1990s. Microsoft hired what it believed to be independent contractors. The workers signed independent contractor agreements specifically stating in their agreements "to be responsible for all of federal and state taxes, withholding, social security, insurance and other benefits." It was determined that the company integrated the workers into its workforce. Hours, job responsibilities and expectations were similar to that of Microsoft employees. The IRS ruled that the workers were employees, not independent contractors. Microsoft issued W-2 forms and paid back payroll taxes and overtime hours to the misclassified workers. However, this was not the end of Microsoft's misclassification woes. Some of the misclassified workers brought suit against Microsoft for employee benefits during the term of misclassification. The end came in the case of Microsoft v. Vizcaino, 120 F.3d 1006 (1997) where the Ninth Circuit held that the workers' status as common law employees entitled them to employee benefits.

The Independent Contractor Determination Act of 2001 strives to reduce confusion and remove subjectivity from the independent contractor determination. The legislation provides two "safe harbors" called the general test and the incorporation test for determining whether certain individuals are independent contractors. Under the bill's new worker-classification rules, an individual is an independent contractor if he or she meets the requirements of either of the safe harbors.

The General Test.
The independent contractor must satisfy three criteria to meet the requirements of the general test:
1. Economic Independence. Economic independence is accomplished if the independent contractor has the ability to realize a profit or loss. Services must be performed in a particular amount of time or lead to a specific result. The independent contractor must also have a significant investment in the assets of his or her business or incur unreimbursed expenses consistent with industry practice. Such unreimbursed expenses must equal at least 2% of the independent contractor's gross income from the performance of services during the taxable year.
2. Workplace Independence. An independent contractor may meet the workplace independence requirement in a variety of ways. Workplace independence is shown if the independent contractor operates out of his or her own principal place of business. In the event a service recipient prefers the independent contractor provide services on site, workplace independence may be shown if the independent contractor operates at multiple sites of the service recipient or pays a fair market rate of rent for use of space at the service recipient's facilities. Also, the use of the independent contractor's own equipment exhibits workplace independence.
3. Written Contract. The service recipient and independent contractor must have a written contract providing that the independent contractor will not be treated as an employee and is responsible for his or her own taxes and benefits. The service recipient must file a Form 1099 for the independent contractor.
The Incorporation Test.
The incorporation test applies if the worker conducts business as a corporation or limited liability company and has a written contract, where it is stated that the worker is not an employee and will be responsible for his or her own taxes and benefits. The bill limits the number of former employees that a service recipient may engage as an independent contractor under the incorporation option. The limitation equals the greater of 3% of the service recipient's employees in the preceding year or 10 persons.

The IRS will have the burden of proof in showing a worker does not fall into a safe harbor if the worker or service recipient had a reasonable basis for relying on the safe harbors. Moreover, the twenty-factor test is still available if a worker could not meet the legislative safe harbors.

The legislation also includes a provision limiting the IRS' ability to assess businesses for taxes resulting from the misclassification of an independent contractor. The IRS' misclassification assessment applies prospectively provided the independent contractor and service recipient:

Maintained a written contract,
Met applicable reporting requirements; and,
Sustained a reasonable basis to believe the worker was an independent contractor.

There are critics of the legislation who claim the bill allows for greater contracting abuses such as allowing employers to eliminate employee benefits for their workers. However, it is doubtful that a typical employee would qualify as an independent contractor under the legislation. Senator Bond claims that the bill reduces such abuses by aiding enforcement through clear and objective rules.

The legislation provides great benefits to businesses currently struggling to understand the twenty-factor test. Service recipients may exercise some control over the independent contractor without jeopardizing the independent contractor's status. Further, the worker's status is proved though objective documentation, such as a written contract and insurance records. The unyielding discretion associated with twenty-factor test is reduced and small businesses gain confidence in their use of independent contractors.

However, the future of the Independent Contractor Determination Act of 2001 is uncertain. H.R. 1783 has been stalled in the House Committee on Ways and Means and S.837 in the Committee on Finance since early May 2001. Senator Bond has introduced similar legislation over the past couple of years. Therefore, if the legislation is not passed, it is likely that Senator Bond will present similar legislation again in the future.

In the meantime, businesses should consider the guidance of the proposed legislation in their relationships with independent contractors. It identifies the more common elements analyzed in independent contractor determination cases. The best safety ring for businesses at this point is to require the independent contractors to form and work through their own corporation. Business are well advised to monitor the amount of control they have over the independent contractor until someone tosses out a lifeline to tow them safely to shore.