Independent Contractors: Are They Or Aren't They?

INDEPENDENT CONTRACTORS:

ARE THEY OR AREN'T THEY?

The use of independent contractors can give businesses greater flexibility and lower labor costs, reduce taxes, and sometimes lower insurance premiums. Cost savings from fringe benefits, payroll, administrative expenses, and reporting can be enormous.

Employees cost as much as one-third more than independent contractors- maybe even more when you factor in the costs of office space, break times, and parking.

The IRS and most states are auditing for improper classifications of 'independent contractor.' Unfortunately, a business that finds the money, strength, and time to fight an audit often discovers that IRS and state policies are ambiguous at best and meaningless at worst. The rules are certain to have precedents, interpretations, and differing criteria. Add to this the possibility that the auditor might not read well or suffer from dyspepsia. You are left on uncertain ground. If the IRS decides you are in the wrong, the fines can be overwhelming.

An auditor looks for the amount of control the employer asserts over the contractor and his or her work. The greater the control, the less 'independent' the contractor looks. The IRS is concerned only with the contractor's results, not with the manner in which the tasks are performed.

Not every IRS rule and standard is easily understood or uniformly applied toward a business, although Uncle Sam would prefer that people thought otherwise. The following conditions might lead an employer to think a contractor is independent-but it ain't necessarily so:

• The person is available upon demand, without stated working hours.
• The person has requested 'independent contractor' status.
• A written agreement exists between the business and the person.
• The person works for another or many other companies.
• The employer does not look over the person's shoulder or oversee every bit of the person's work.
• The person works on commission only, for sales or services performed, for a direct monetary value.
• The employee sends the business a bill claiming 'fee for service.'

These criteria are not worthless. Indeed, some of them may help to prove 'independent contractor' status. But don't depend on any one of them to protect you from major expenses in terms of taxes, interest, and penalties if what you claimed to be an independent contractor is classified as an employee by the IRS.

And it's easy to get caught in the confusion. A disgruntled contractor may turns the employer in by lodging a complaint with any of a number of federal and state agencies. Unions, disliking rogue contractors, may solicit the IRS' attention. The denial of unemployment insurance to a terminated contractor may trigger a state audit.

Moreover, employment tax returns are ever more closely examined for scofflaws. Why? State and federal administrations are scrounging for tax revenues, especially since certain sophisticated tax shelters were done away with.

So it makes sense that independent contractors are now prime game for bounty hunters. Businesses with the most to gain from using independents are the most likely targets for auditing. These would include travel agencies; construction companies (which have their own maze of conflicting laws); franchises; auto body and auto-repair shops; hair salons; physician and lawyer firms; businesses that employ janitors, truckers, and consultants; and even some candlestick makers.

The IRS is always about two years behind in audits, and the large state agencies are usually not much quicker. A business could suffer over long-forgotten episodes.

Have your tax advisors, an outside CPA, or the IRS itself examine your relationship to your 'independent contractors.' If the contractor does not pass their scrutiny, don't expect him or her to make it through a formal audit.

The IRS has 20 criteria by which it determines whether the business has enough domination over a 'contractor' to be judged an employer. It operates on the theory that the employing business should judge only the quality of the contractor's work, not the method of operations.

The IRS holds the significance of each criterion to be based on individual standards, not an industry-wide median. If a business can answer 'True' (T) to the first four statements, the contractor is probably independent. If a business answers 'True' to many of the remaining questions, it may mean 'Go Directly To Jail' (although for some types of business, a 'T' answer to certain of the last 16 questions is normal and thus acceptable).

Some businesses can furnish fringe benefits to independent contractors without having to classify them as 'employees.' The 20 questions above must be answered, and if all is well in the IRS' opinion, the employer may create 'statutory employees.' Most of the following is provided for under Revenue Ruling 90-93 and other pertinent parts of the Code.

Four types of employee are more or less automatically accepted as statutory employees by the IRS: traveling or 'city' salespersons; life insurance salespersons; agent or commission drivers; and home workers. Generally, people in these four categories do not have a withholding or federal unemployment tax deducted from their earnings; the employer MUST, however, withhold a portion of their salary for Social Security and Medicare.

Employers may furnish true statutory employees certain fringe benefits, deductible as 'usual and necessary business expenses.' The type of fringe benefit determines whether it is taxable.

The IRS Code establishes specific requirements for statutory employees. In addition to the worker belonging to one of the four groups just designated or passing the '20 Questions' test, an oral or written contract must exist between the parties, establishing the independence of the worker. The worker can hire help if the contract gives the authority to do so. The contract must stipulate that the work be performed by the worker, for the most part. If tools or equipment are required, the worker must have a considerable investment in it. The worker must perform the work for the employer on an ongoing basis.

Even though most individual CPAs are legitimate independent contractors, few of them are able to pass along the information contained here. Even so, the employer's CPA should be consulted for exact instructions on how to issue W-2 or 1099 forms at the end of a calendar year or when the contract is terminated. Proper issuance of W-2s or 1099s is a tax protection for both parties to the contract.