|TINA STEWARD QUINN, CPA, Ph.D, is an assistant
professor of accountancy at Arkansas State University. |
STANLEY G. FENDLEY, JD, is the former Democratic tax counsel to the U.S.Senate Committee on Small Business. He currently serves as tax legislative assistant for Senator Dale Bumpers (D-Ark.)
Legislation introduced in the 105th Congress—as well as a Treasury Department proposal—has brought renewed hope for progress on the perennial problem of worker classification. The legislation, which builds on a recent proposal from the American Institute of CPAs, is sponsored by Senator Christopher S. Bond (R-Mo.) and Congressman James Talent (R-Mo.), the chairmen of the congressional small business committees.
The Bond-Talent bill would establish objective criteria for determining when a worker is not an employee. By contrast, the Treasury proposal would create a second tier of safe-harbor protection under section 530 of the Revenue Act of 1978 to reduce certain retroactive tax liabilities. This article discusses both the Bond-Talent bill and the Treasury proposal and looks at each one's prospect for success in Congress.
Help For The Self-Employed
The Bond-Talent worker classification legislation is part of a larger bill, the Home-Based Business Fairness Act of 1997 (S 460 and HR 1145), designed to benefit the self-employed. In addition to its worker classification provisions, the act would increase the medical insurance deduction for self-employed individuals to 100% of the premiums paid and expand the home office deduction.
Section 4 of the legislation deals with worker classification by establishing criteria that create a "general" safe harbor for worker classification. A worker would be treated as an independent contractor if he or she meets either an economic and workplace independence test or an alternative business structure and fringe benefits test.
Economic and workplace independence test . A worker must meet the following requirements to be treated as an independent contractor:
Each of the following criteria must be met:
- The worker must be able to realize a profit or loss.
- The worker must incur unreimbursed ordinary and necessary business expenses equal to or greater than 2% of his or her adjusted gross income (AGI) attributable to services performed.
- The services must be for a specific time period or project.
- Only one of the following requirements must be met:
- The worker must have a principal place of business (a home office would qualify if used on a regular basis for essential business activities and the worker has no other place to perform these activities).
- The worker does not perform most of his or her services at one recipient's facilities.
- He or she pays market value rent for use of the service recipient's facilities.
- He or she operates primarily with equipment not supplied by the service recipient.
- The worker must have a written contract with the service recipient that says the worker will not be treated as an employee for federal tax purposes.
Business structure and benefits test . Under this alternative, a worker would be considered an independent contractor if
- He or she conducts business as a corporation or limited liability company.
- The service provider receives no fringe benefits from the service recipient.
- The parties have a written contract.
The general safe harbor will not apply if the service recipient fails to meet the applicable reporting requirements through willful neglect. Other provisions of the bill shift the burden of proof to the Internal Revenue Service if the service recipient establishes a prima facie case that it was reasonable to treat the worker as an independent contractor and the service recipient has fully cooperated with the IRS.
The bill also limits retroactive reclassification of workers—the IRS would not access tax liability for misclassifications that occur prior to the audit. However, the employer would be expected to reclassify workers as employees subsequent to the audit, and would be subject to penalties for failure to comply.
The bill also would repeal subsection(d) of section 530 of the Revenue Act of 1978, which precluded certain technical workers from obtaining relief through the section 530 safe harbor. However, the bill would not repeal the well-known 20-factor test. Rather, that test would remain available to those who cannot, or choose not to, apply the legislation's objective criteria.
S mall business organizations have been quick to endorse the Bond-Talent bill, but some on Capitol Hill have voiced concerns that its tests would be too easily satisfied, leading to involuntary reclassification of traditional employees. In particular, staff members of the tax-writing House Ways and Means and Senate Finance committees worry that the alternative business structure and benefits test would not ensure independence between the parties. Forming a corporation, they say, is such a simple task in most states that employees could be coerced into doing so in order to keep their jobs, particularly in fields where one-person corporations are commonplace, such as the building trade or professional service industries. To gain broad bipartisan support for the Bond-Talent bill, the business structure and benefits test may have to be deleted and replaced with additional objective criteria to protect against such coercion.
In addition to these concerns, there is a separate flaw in the economic and workplace independence test. The part of the test requiring a worker to incur unreimbursed expenses equal to or greater than 2% of AGI "attributable to services performed" is impossible to meet. Because form 1040 calculates AGI after profit or loss from a business (schedule C) is added to total income, there is no such thing as AGI "attributable to" a business. To correct this problem, the sponsors should consider making the floor "2% of AGI" without reference to services performed or, alternatively, returning to language originally proposed by the AICPA—requiring workers to incur unreimbursed expenses that are "ordinary and necessary to the service provider's industry."
Treasury Wants To Forgive Past Mistakes
On April 14, the Treasury Department announced a legislative proposal to eliminate past employment tax liability for employers that misclassify workers but fall just short of meeting section 530 requirements (see the sidebar for more information). Under the Treasury's independent contractor rules proposal, employers that satisfy certain conditions would be able to reclassify workers with no employment tax liability for prior years. Basically, those employers would have to meet the section 530 reporting consistency condition and have a reasonable argument that they meet the substantive consistency and reasonable basis requirements.
As part of its proposal, the Treasury recommends Congress amend section 530 to permit the department to issue regulations or rulings to provide guidance on worker classification. Other proposals are to give the worker or service recipient the option of litigating in Tax Court, to increase the penalty for failure to file information returns and to require government agencies to file form 1099s on payments to corporations.
In the late 1970s, Congress recognized the need for a legislative clarification of the employer-employee relationship and asked the General Accounting Office to conduct a study. The GAO recommended amending Internal Revenue Code section 3121 to exclude workers from the common law definition when the workers met certain criteria. The Ways and Means Task Force on Employee/Independent Contractors was established in 1978. Its members agreed that although the 95th Congress did not have enough time to fully resolve the issue, interim relief should be provided. The result was the safe-harbor provision (section 530) of the Revenue Act of 1978.
Section 530 provided guidelines on what constituted a reasonable basis for treating workers as independent contractors. According to subsection (a)(2), reasonable basis existed
Although section 530 was intended to provide only temporary relief, it is still in effect. Section 1122 of the Small Business Job Protection Act of 1996 made the first major amendment to section 530 since 1986—when the safe-harbor provisions were eliminated for certain technical workers. However, section 1122 both expanded and narrowed the scope of section 530. It did not codify section 530 (section 530 is not part of the Internal Revenue Code) or eliminate the common law category of employee; despite the intentions of section 1122, a number of divergent authorities continue to make determining worker classification very difficult for taxpayers.
T he Treasury Department argues that objective criteria for determining worker classification won't work because the common law standard depends on control, which can be determined only by the specific facts and circumstances of each situation. The Treasury uses these arguments:
- The criteria can be too easily satisfied, resulting in a "large scale" shifting of workers from employee to independent contractor status.
- The criteria can be too easily abused. An employer-employee relationship in substance can easily be disguised as a principal-independent contractor relationship.
- The criteria may be as ambiguous as the common law rules. For example, how is the term "significant" determined?
But these arguments may not prove to be persuasive. Objective criteria are not necessarily easily satisfied or abused. Depending on the criteria, they might prove quite stringent and, as to ambiguity, it is difficult to imagine a more ambiguous system than the current 20-factor test. Finally, the argument that some workers may be misclassified due to the criteria will not be the case since the 20-factor test will remain available for both workers and service recipients who cannot, or choose not to, use the objective criteria.
It is unclear at this point how much relief the Treasury plan would provide. In particular, the nebulous requirement that employers have a "reasonable argument" of meeting the section 530 substantive consistency and reasonable basis requirements has not been spelled out, leading to some skepticism on Capitol Hill.
Finding A Workable Solution
The fact that both the Clinton administration and members of Congress continue to work on this important issue may provide some reassurance for both workers and service recipients. But the prevailing approach must be one that makes a serious attempt to reduce the vagueness inherent in the existing law. The present 20-factor test remains an enigma to most small and midsize businesses, which must spend valuable time and resources attempting to ensure compliance with a hopelessly ambiguous law. Therefore, it is important that policy makers dedicate themselves to forging a workable solution that will satisfy all concerned.