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Employee or Contractor?
"The Definition Is Changing-- Again!"

© by Greta P. Hicks, CPA

"For nearly 20 years, the IRS has been prohibited by law from issuing any guidance regarding employment tax status," Commissioner Richards said. In 1986 and in 1995, when this author attended the White House Conference on Small Business, the employee versus contractor issue was discussed at length by irate businesses owners. It appears that the IRS has at last heard our complaint. In a March 18 announcement, IRS Commissioner Richardson stated, "People have complained about the uncertainty that results from worker classification under the (20) common law standard(s), yet we (the IRS) are prohibited from issuing guidance that is more up to date. I believe that these initiatives we are announcing today will help ease some pressures that both the business community and the IRS face."

The IRS announced on March 18, 1996 that they are suspending employee-independent contractors audits for the next few months and they have developed new audit training manuals and employment tax audit guidelines. Also included in this announcement is a "let’s make a deal" settlement offer.

Whether a worker is defined as an employee or independent contractor is a matter of a complex set of 20 common law factors plus interpretations by numerous court cases. Back in the late 70’s the courts and IRS audit teams were overwhelmed with mountains of audits related to the definition of an employee. A cry went from businesses to Capital Hill and Congress passed Section 530 of the Revenue Act of 1978. Companies received a brief reprieve from employment tax audits until the late 80’s and early 90’s when the IRS began re-attacking the employee versus contractor issue. Now, with the IRS audit teams again being in a quagmire over the issue, the IRS has taken the initiative to more clearly define employee and to offer those businesses already under audit an alternative to bankruptcy.

The most recent suspension of employee versus contractor audits is to given the IRS time to train auditors in field on the new manual procedure related to worker reclassification. The training materials will focus on defining an employee by determining the control the company has over the workers. The materials discuss the control factors under the 20 common law standards and guides auditors in determining which of those 20 factors are relevant. The IRS defines control as:

Anyone who performs services is an employee if you, as an employer, can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the legal right to control the method and result of the services.

A draft copy of the new manual on worker reclassification can be obtained..free. Write Dean, IRS School of Taxation, CD:TX, 2221 S. Clark St., Arlington, VA 22202.


Safe-Harbor Rules

Section 530 of the Revenue Act of 1978, prohibited the IRS by law from issuing any guidance regarding employment tax status and proposed several "safe-harbor rules" for companies who were under employment tax audits. Roughly, Section 530 passed by Congress in 1978 said, "IRS lay off until we (Congress) defines an employee." Here 18 years later, Congress has not define employee and has prohibited the IRS from issuing any regulations on the subject.

Over the years, the IRS interpretation of the "safe-harbor rules" has gone from liberal to conservative. In 1979 and 1980 on most employment tax audits, the IRS allowed company’s to fall under the safe-harbor rules. But during the era of the "no new taxes," the IRS began a ultra conservative interpretation of Section 530 and it was near impossible for any company under IRS employment tax audit to claim the safety of Section 530.

On March 18 the IRS announced that they are establishing new procedures that will ensure that auditors properly apply the taxpayer relief provisions under Section 530 of the Revenue Act of 1978. The new policy on application of the safe-harbor rules will be more liberal and allow more companies to rely upon Section 530 safe havens.


Let’s Make A Deal

The most significant aspects of the March 18 announcement details the two new expedited procedures for companies whose existing worker classifications are being questioned by the IRS.

First, the IRS is establishing new procedures under an optional classification settlement program that will allow companies and auditors to resolve contractor versus employee issues earlier in the audit process.

For example, companies that filed Form 1099, Information Returns, but failed to meet the other two requirements under Section 530 safe-harbor rules, could reclassify their workers to employees prospectively and pay only a specified tax assessment not exceeding one year’s liability. The amount of the assessment would depend on the extent to which the company has satisfied the safe-harbor requirements under Section 530.

Secondly, the IRS has expanded procedures developed last year to allow companies to, at their option, to appeal employee versus contractor issues to the IRS Appeals function even while an audit is in progress. This procedure, which is a part of the taxpayer rights initiatives the IRS announced earlier this year, is designed to resolve employee versus contractor issues earlier in the audit process.


Time Line

On March 5, 1996, the IRS began a two year test period of the classification settlement program. A one years test of the early referral to Appeals procedures begins on March 18, 1996.

During the suspension of the employee versus independent contractors audits, the IRS will be training field office personnel on the new expedited procedures for companies currently under audit. This author believes that the because the training has not been budgeted for during the current fiscal year, the training will not take place until after October 1, 1996, the beginning of the next fiscal year’s budget. The effect of budget constraints will be to put on hold any existing audits or appeals until after the training of field personnel. The date of the training will vary across the county depending upon other budgetary demands of local offices.


Bottom Line

Under this new policy, the IRS will waive much of the back taxes it asserts that companies owe. For many companies that have been consistent in how they classify their workers, the IRS will let them to shift to employee status without penalties for prior years. This policy is consistent with other recent policy changes which focus on future compliance of companies rather than concentrating heavily of punishment for past non-compliance with the laws. Although not a solution for every company, it is a beginning step to settlement.


For More Information

Call the IRS at 1-800-TAX-FORM and ask for Publication 937, Business Reporting, and for Form SS-8, Information for Use in Determining Whether a Worker is an Employee for Federal Employment Taxes and Income Tax Withholding. The purpose of the SS-8 is for workers and companies to answer the questions, mail the SS-8 to their Service Center, and receive back a Private Letter Ruling from the IRS on the status of the company’s worker(s).. Do not take these questions lightly. Secure a copy of the SS-8 for yourself. The questions are worded in such a way that most all workers are employees. Occasionally, the IRS Revenue Officers requests that companies complete SS-8. Professional tax advise should be sought before submitting this or other forms to the IRS.



Who Is An Employee?


The IRS Definition

The Internal Revenue Service uses these criteria to determine whether an individual is an employee or an independent contractor. The worker is an employee if...

  • You or your representative tells the worker where, when, and how to work.
  • You train the worker.
  • The business performance depends on the worker.
  • The worker has a continuing relationship with the company.
  • The worker’s services must be personally rendered by the him/her.
  • You set the worker’s work hours.
  • The worker works on the employer’s premises.
  • You are paid by the hour, weeks, or month.
  • You furnish tools and materials.
  • You can fire the worker without violating a contract.
  • The worker has a right to quit without incurring a liability.
  • The worker does not offer the worker’s services to the public at large.
  • The worker has no opportunity for profit or loss as a result of the worker’s service.
  • The worker has no significant investment in the business.
  • You require the worker to submit oral or written reports.
  • The worker is a corporate officer.


Section 530 Safe Harbor Rules

Section 530 provides certain safe-harbor rules. If you could fall under these safe-harbor rules, the IRS could not re-define the worker as a employee. In general if, the

  • company treated in individuals consistently as a contractor, and the
  • company was in full compliance by filing all required forms such as Form 1099, and if, the
  • company could rely on one of three basis for their practice of carrying the worker as a contractor
    • Judicial precedent (A court case in the company’s favor)
    • Past IRS Audit (A past IRS audit determine the worker to be a contractor)
    • Industry Practice (There is a long-standing recognized practice of treating such workers as contract)
  • then, the IRS could not change the status of the worker to employee.


20 Common Law Factors

  1. Instructions
  2. Training
  3. Integration
  4. Service rendered personally
  5. Hiring, supervising, and paying assistants
  6. Continuing relationship
  7. Set hours of work
  8. Full-time work required
  9. Doing work on business owner’s premises
  10. Accomplishing work in certain order or sequence
  11. Submission of oral or written reports
  12. Method of payment
  13. Payment of business or traveling expenses
  14. Furnishing tools and equipment
  15. Significant investment
  16. Realization of profit or loss
  17. Work for one entity at a time
  18. Offer their services to the general public
  19. Right to discharge
  20. Right to terminate

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List of Articles by Greta P. Hicks, CPA

GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing educational materials and programs on solutions to IRS problems and is a nationally known speaker and writer on solutions to IRS problems. To arrange for consultation contact: Greta's web site: http://www.gretahicks.com

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