Monday, July 22, 2013

When Are You An Independent Contractor?

William Delaney
Written by William Delaney, EA, ATA of Westwood, MA

An engineer was retired from the service of his employer, a corporation, on December 31, 1954, and was engaged immediately thereafter by the corporation to render services, beginning in 1955, similar to those performed for it prior to his retirement.  The services are performed in the engineer’s own research laboratory.

Due to the circumstances involved, the engineer renders services solely for the corporation.  Held, under the particular facts in this case, the engineer is not an employee of the corporation for Federal employment tax purposes.

The engineer is engaged in a trade or business, the income from which should be considered in computing net earnings from self-employment for purposes of the Self-Employment Contributions Act of 1954.  (See Rev. Rul. 57-10) Today, we would consider this determination, and the need for it, as rather quaint. Of course this is self-employment income and, of course, it would be subject to FICA tax (Medicare had not been enacted).  However, the Internal Revenue Service felt that this 1957 revenue ruling needed amplification and so, in 1982, it addressed essentially the same fact pattern in Rev. Rul 82-210 and came to grips with this…

ISSUE:  Does an agreement to provide services exclusively for one client preclude liability for the self-employment income tax imposed by section 1401 of the Internal Revenue Code?

Why would there even be a need, in 1982, to address this issue?  Because, as noted in the Law and Analysis section of the Revenue Ruling, the Internal Revenue Service acquiesced (to rest satisfied, or apparently satisfied) in the result of a 1972 Tax Court case, Herbert R. Barrett v. Comm., 58 TC 284, in which “…a consultant who only had one client and who had agreed not to provide services to any of the client’s
competitors was not engaged in a trade or business for purposes of section 1402(c) of the Code,” which was contrary to the Rev. Rul. 57-10 determination.

This (by today’s standards) surprising decision in Barrett was greatly influenced by an earlier United States Supreme Court case, Deputy v. du Pont, 308 U.S. 488, 499 (1940).  In a concurring opinion written by Justice Felix Frankfurter, the Justice opined:

“ ...carrying on any trade or business…involves holding one’s self out to others as engaged in the selling of goods or services.”  The triggering event, in the view of Justice Frankfurter, was providing goods or services to more than one customer or client.  Otherwise, the activity did not rise to the level of a trade or business.

The 1940 opinion did not reach any conclusion as to applicability of a social security tax on self-employment income because that law, enacted in 1935, had not yet been expanded  to include coverage for self-employed persons.

So, in 1982 when the Internal Revenue Service decided to revisit the issue of what constitutes income from self-employment for purposes of the self-employment tax, it  was first necessary to overcome its earlier decision to acquiesce in Barrett.  The Internal Revenue Service had found an opening as a result of a 1981 2nd Circuit Court of Appeals decision, Grosswald v. Schweiker,653 F. 2nd, (2d Cir. 1981) wherein the court decided that a contractor who had entered into an exclusive consulting agreement with one bank (the type of fact pattern which did not rise to the level of a trade or business in the opinion of Justice Frankfurter) was actually engaged in a trade or business within the meaning of Sec. 211(c) of the Social Security Act (a possibility which the Deputy v. du Pont decision had not addressed) and that the term engaged in a trade or business as “…construed under section 162 of the Internal Revenue Code…” had a meaning identical with Sec. 211(c) of the Social Security Act. (see also note #1 – below) Based on this principle, the Internal Revenue Service decided in Rev. Rul. 82-210, HOLDING:  An agreement to provide services exclusively for one client does not preclude liability for self-employment tax imposed by section 1401 of the Code.

Meanwhile, the Comptroller General of the United States issued a report to the Joint Committee on Taxation (Congress of the United States) regarding “Tax Treatment Of Employees  And Self-Employed Persons By The Internal Revenue Service:

Problems  And Solutions (November 21, 1977).  It made reference to the 20 factors or rules promulgated by the Internal Revenue Service (the 20 part test still in use today at the federal level) and commented (pages 6 and 7 of the report)  “If an employer-employee relationship exists under the common law rules, the parties involved cannot by contract or other means define the relationship otherwise for tax purposes.

Thus, it is of no consequence that the employee is designated as a partner, coadventurer, agent, independent contractor, or the like.”  Simple to state, but not so simple when applied to real life situations as the report
noted and as all of us have experienced.

#1 – “While we cannot say that the theory of Barrett is ‘as thin as the homeopathic soup that was made by boiling the shadow of a pigeon that had been starved to death,’…(attributed to Abraham Lincoln), we have to say that we find it unpalatable.”

Until recent years, this is where matters stood.  If in doubt as to whether or not an individual should be classified as an employee or as an independent contractor, one would apply the 20 part test and, hopefully, the result would be clarity. However, as the GAO report observed (digest ii) “…IRS has interpreted the common law definition of an employee in such a way that persons operating separate businesses are often
considered the employees of another business because one can exercise a certain amount of control over the other.”

The handy dandy form which could be completed and filed with the Internal Revenue Service (Form SS-8) allowed the IRS to make the determination for you.  In actual practice, this form is primarily used when the facts emphatically point one way or another, and the ‘employer” has not seen the light. The Congress involved itself to the extent that it enacted three “safe havens” which came to be known as Temporary Section 530 Relief (made permanent by TEFRA [1982]):

(1) Judicial precedent, or published rulings, or technical advice pertaining to the taxpayer, or a letter ruling to the taxpayer.
(2) A past IRS audit.
(3) A long-standing practice of a significant segment of the relevant industry.

In addition, Section 530 Relief includes the ability to demonstrate a “reasonable basis” for independent contractor classification, with reasonable basis to be liberally interpreted.

Although there is some recent federal history of “voluntary” reclassifications to employee status (see worker classification settlement program and voluntary worker classification settlement program), a large segment of the independent contractor population remains unchallenged and outside of the collection of federal employment related taxes.

The action has now shifted to the states, since they realize that independent contractor status has become more common as employers seek ways to cut their costs of doing business and also avoid taxes and mandates which apply to employees but not to off-payroll “independent” workers, such as mandatory health insurance coverage.  One of the best statutory re-writes of a state law which defines an employee is Massachusetts General Law, Chapter 149, Section 148B:

(a) For the purpose of this chapter…, an individual performing any service, except as authorized under this chapter, shall be considered to be an employee…..unless:-
      (1) The individual is free from control and direction in connection with the performance of the service, both under his contract for the performance of service and in fact; and
      (2) The service is performed outside the usual course of the business of the emoployer; and,
      (3) The individual is customarily engaged in n independently established trade, occupation, profession or business of the same nature as that involved in the service performed.
(b) The failure to withhold federal or state income taxes or to pay unemployment compensation contributions or workers compensation premiums with respect to an individual’s wages shall not be considered in making a determination under this section.
(c) An individual’s exercise of the [voluntary] option to secure workers’ compensation insurance with a carrier as a sole proprietor or partnership…shall not be considered in making a determination under this section.
(d) Whoever fails to properly classify an individual as an employee according to this section and in so doing fails to comply, in any respect, with chapter 149, or section 1, 1A, 1B, 2B, 15 or 19 of chapter 151, or chapter 62B, shall be punished and shall be subject to all of the criminal and civil remedies, including debarment, as provided in section 27C of this chapter…..Any entity and the president and treasurer of a corporation and any officer or agent having the management of the corporation or entity shall be liable for violations of this section.
(e) Nothing in this section shall limit the availability of other remedies at law or in equity.

The Massachusetts Attorney General has interpreted the “Three Prong Test” in an Advisory issued by the Fair Labor Division of the Attorney General’s Office in 2008:

Prong One – Freedom from Control.  “…The test is so narrow as to require that the worker be entirely free from direction and control from outside forces”
Prong Two – Services Outside the Usual Course of the Employer’s Business.  “…if the worker is performing services that are part of an independent, separate, and distinct business from that of the employer” [American Zurich. V. Dept. of Industrial Accidents, 2006 WL 220508 (Mass. Super. 2006)], prong two is not implicated.
Prong Three – Independent Trade, Occupation, Profession or Business.   “…we determine whether the worker is wearing the hat of the employee of the employing company, or is wearing the hat of his own independent enterprise.” [Coverall v. Division of Unemployment Assistance, 447 Mass. 852, 857-598 (2006).

One example provided in the Advisory as to how the Massachusetts Attorney General’s Office will apply the prong two test involves accountants:

“An accounting firm hires an individual to move office furniture. Prong two is not applicable (although prongs one and three may be) because the moving of furniture is incidental and not necessary to the accounting firm’s business.”

So, unless both freedom from control (prong one) and an independent trade (prong two) can be established to the satisfaction of the statute, the furniture mover would be classified under the law as an employee.  All three prongs must be satisfied in order to be exempt from classification as an employee.

Another interesting situation arose as the accounting community became aware of this statutory change. It was commonplace for accounting firms (both large and not so large) to engage the services of independent contractors to prepare income tax returns during tax season.  These individuals were off-payroll and did not receive the employment-type benefits available to the full-time accountants who were performing similar tax preparation work side by side with the independent contractors in the accounting firm’s office(s).  When the accounting firms became aware of this new three prong test and applied it, they could not find any way to wiggle off the hook.

The independent contractors looked like, felt like, and smelled like employees of the accounting firm---therefore they were employees under the law, with all that this classification would imply (payroll taxes; fringe benefits; unemployment benefits, etc.). Although it is my understanding that some influential firms protested that this law change was intended to find the guy who runs around in a pick-up truck with a wheel barrel in back, looking for work as a “contractor”, it was quickly determined that no such limitation as to applicability could be found in the unambiguous language of the statute.

Under Oregon Revised Statute (RS) 670.600 a definition of “independent contractor” has been crafted as applicable to the Department of Revenue, Employment Department, Construction Contractors Board and Landscape Contractors Boards.

Under this law, workers may be properly classified as independent contractors provided they,                                                                                        
1. Are free from direction and control, beyond the right of the service recipient to
2. specify the desired result, AND
3. Are licensed under ORS 671 or 701, and
4. Are responsible for other licenses or certificates necessary to provide the service, AND
5. Are customarily engaged in an “independently established business.”

The OR statute provides a five part test for meeting the definition of an independently established business.  Three of the five criteria must be met in order for the five part test to be satisfied.  Additional provisions include:

Establishing a business entity such as a corporation or limited liability company, does not, by itself, establish that the individual providing services will be considered an independent contractor.

Other OR state agencies (Bureau of Labor and Industries – Wage and Hour Division and/or Civil Rights Division; Workers’ Compensation Division, apply differing criteria and factors in arriving at a determination.

New York has enacted the Construction Industry Fair Play Act (2009) which applies to all contractors in the construction industry.  The test which would allow

 “A business entity, including any sole proprietor, partnership, corporation or entity that may be a contractor under this section shall be considered a separate business entity from the contractor where all the following criteria are met.”

The law then provides for a three criteria test, very similar to the Mass. three prong test, and provides both civil and criminal penalties for violation. Unlike the Mass. statute, this law also includes a 12 part test for determining if the business of the independent contractor is considered to be separate from the business to which services are provided.  All 12 parts must be met.  The accounting argument in Mass. that the statute was only intended to catch guys driving around in a pick-up truck would be valid in New York.

RI has adopted a similar but different approach to the classification problem.  The Department of Labor and Training has required (since 2001) that a DWS-11-1C form (Notice of Designation as Independent Contractor) be on file with the agency. On it’s web site the agency defines an independent contractor as,

An independent contractor is someone who maintains an independent business and is available for hire to provide services to the public.  Generally, a person cannot become an independent contractor just because he or she want to be or because an employer prefers them to be.  It is not enough that the employee and the employer agree.  If a person only works for one business and is directed and controlled by that business, the person is probably an employee and not an independent contractor. (answer to question #1)

If an employer misrepresents the employee as an independent contractor, the employer may be subject to criminal prosecution. (answer to question #14)

Minnesota requires some construction contractors to register with the Department of  Labor and Industries (Minn. Stat. chapter 326B)

“Contractors who hire unregistered subcontractors, misclassify workers and fail to register are in violation of the law, which can result in civil penalties. (DLI web site – Do I have to register)

The statute applies to boiler, electrical, elevator, HPP, plumbing or residential building contractors not already registered or licensed.  Absent such contractor registration, MN would consider you to be an employee.

Maryland has in place a Workplace Fraud Act (Title 3, Subtitle 9, Labor and Employment Article, Annotated Code of Maryland) which uses the term “work provider” in place of employer and “worker” in place of employee.  The DLLR’s Division of Labor and Industry web site provides links to the law, frequently asked questions, notices and compliance information.

Since states have begun to tighten the definition of “independent” in the workplace, what happens if a client improperly misclassifies someone under state law?  Often, nothing unless something happens, such as an accident on the job (the independent contractor is now not so independent and beings to think as if he is your employee); the independent contractor’s arrangement is terminated and he/she files for state unemployment benefits; the independent contractor first learns about the full cost of the self-employment tax when he comes to you for tax preparation (do you advise him to seek reimbursement from his non-employer work provider).

A few years ago, an employee of a charitable organization came to me for her usual income tax preparation.  However, along with the usual W-2 from the charity, she also handed me a 1099Misc issued by the charity.  After I questioned this she explained that her boss assigned to her a special project for which he had limited
money in the payroll budget, so he paid her off-payroll (so that you would get “something” extra) while she worked (overtime) on the project several evenings per week.  Then, at the end of the year a 1099Misc was issued.  Needless to say, she did not expect to pay SE tax and, as usual, it’s the tax preparer delivering the bad news long after the fact!

I told her what to do---tell her employer that this separate arrangement, among other things, was a violation of the state wage and hour law, and they should compensate her exclusively on payroll.  Once she did so, the employer referred the matter to legal counsel.  A meeting with my client was held.  They asked her if she would like to have an attorney present.  She declined.  They “settled” with her for $30,000 and an agreement that she would not file a complaint.  The 1099Misc income was less than $2,000!  After the fact, she called and told me what had happened.

It is possible for an employee to also be an independent contractor with the same work provider, if the second (independent) service is significantly different from the first.  This was not the case here, but see subsequently issued Information Letter 2012-0069 wherein the IRS has provided an example of this exception to the federal general rule.

Now for the practical implications of reclassification from independent contractor to employee by a state agency.  This brings the worker into the withholding tax system, the unemployment tax system, the worker’s compensation insurance system and whatever employment related insurance and tax programs as may be
unique to a particular state.  You know the drill---file the returns, pay the taxes, suffer through interest and penalties, and hope for the best.  However, some of my colleagues argue that a state finding does not change the federal status, since the state finding is based on law which may differ significantly from federal law.
If there were clear and consistent federal law to apply, I might agree.  However, the 20 part test is difficult in application and inconsistent in result.  So, what happens when your state quarterly unemployment return contains an amount or amounts not reflected on the annual 940 return, because workers are classified one way (by the work provider) for federal purposes (off-payroll) and another way for state reporting purposes (on-payroll)?

Unemployment insurance coverage is a federal program, administered by each state. Each year, covered earnings information accumulated by the state is reported to the IRS and they match the state totals against the amounts reported on Form 940.  A difference (in this case, an underreporting on the federal return)
will trigger an adjustment and billing for additional federal tax.  If you think that you can argue your way out of this, think again.  Once the federal 940 return is adjusted, will not a notice regarding federal underreporting on form 941 shortly follow?  You betcha! (thanks to Sarah Palin)   And, do wages for federal and for state purposes on the W-2 form differ?  If so, will the IRS pick-up on this once the 941 returns are adjusted?  A probable you betcha!  To this long-time observer it appears that a cavalier approach to classification is no longer either wise or practical given the significant civil and criminal penalties which may be imposed.

I leave you with this last, interesting court decision.  On August 11, 1009, Suffolk Superior Court (MA) Judge Frances A. McIntyre found that a public lounge which featured (among other things) exotic dancers (aka strippers) had misclassified the strippers as independent contractors.  “In this case, (said their attorney) we have an employer who was charging its employees to work (a portion of their tips were confiscated by the lounge).”  “They weren’t making minimum wage. They weren’t making any wage.”

In arguing for independent contractor status, the lounge stated that the strippers could select their own music, costumes, partners and routines. There were no written rules to  follow.  The lounge further stated that selling alcoholic beverages was its primary business and that the strippers provided entertainment similar to televisions and pool tables.    

Judge McIntyre was not impressed.  “A court would need to be blind to human instinct to decide that live nude entertainment was equivalent to the wallpaper of routinely televised matches, games, tournaments, and sports talk in such a place.”  She also observed that the lounge “…apparently hired its dancers based solely on whether they ‘look good’ rather than on individual performance experience or talent.”  (Chaves et al v. King Arthur’s Lounge)

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