A Preventative Approach To using Independent Contractors

What can companies do to help solve a perennial problem?

  • AS INDEPENDENT CONTRACTOR USE grows, it is important for CPAs to help their employers manage contractor relationships properly. Failure to adopt effective preventive practices can lead to liabilities arising from unemployment, workers compensation, employee benefits, overtime and employment discrimination violations as well as unexpected costs.
  • WHILE THE IRS 20-FACTOR TEST AND relief under section 530 of the Revenue Act of 1978 are important factors for companies to consider when reviewing the status of independent contractors, they are not the only ones. Companies that use independent contractors regularly must protect themselves by taking a defensive position.
  • AS A FIRST STEP, COMPANIES SHOULD determine how they use independent contractors currently. Even if a worker agrees to be treated as an independent contractor, the IRS will hold the company responsible for any misclassification.
  • COMPANIES MUST DECIDE IF USING independent contractors is the best way to do business. Many contractors leave a company after being trained for an employment offer that includes benefits. High recruitment and training costs may outweigh any savings from using independent contractors instead of employees.
  • A COMPANYS NEXT STEP IS TO determine whether workers are independent contractors or misclassified employees. Because many federal and state laws are involved, this process must be done on a case-by-case basis using the factual inquiries employed by the courts and government agencies.
  • IF A COMPANY CONCLUDES SOME of its workers are independent contractors, its work has only begun. When possible, the company should make changes in its relationship with the individual to support independent contractor status in an effort to avoid adverse consequences.

    Note: This article should not be construed as legal advice or as pertaining to specific factual situations

Daniel P. O'Meara, JD, is a member of the labor and employment of the law firm of Cozen and O'Connor in Philadelphia.
Jeffrey L. Braff, JD, is also a member of the labor and employment department of Cozen and O'Connor. Both devote much of their practice to preventive counseling and litigation involving independent contractor issues.

As independent contractor use by companies grows, it is increasingly important for CPAs to know how to manage independent contractor relationships in a way that will prevent unwanted problems. CPAs often are looked to by their employers—or by their clients—for guidance on complex independent contractor issues.

Although potential Internal Revenue Service liability is the best known threat to companies using independent contractors on a large scale, it is not the only one. Failure to adopt effective preventive practices such as those outlined below can lead to liabilities arising from unemployment compensation, workers compensation, employee benefits, overtime obligations and employment discrimination violations as well as a range of other unexpected costs. In short, managing independent contractor relationships demands skills from many disciplines, and the liabilities facing an organization misusing independent contractors on a widespread basis can be overwhelming.

An example of independent contractor relationships gone wrong is Microsofts use of certain software testers, production editors, proofreaders and other workers as independent contractors in the 1980s. In 1990, Microsoft had to pay an IRS penalty for misclassification as well as retroactive overtime. A group of workers also filed a class-action lawsuit, alleging they were wrongfully excluded from Microsofts employee benefits plans, including an employee stock purchase plan. In October 1996, the Ninth Circuit Court of Appeals agreed, finding the workers were wrongfully excluded, and sent the case to the trial court for an assessment of damages. Microsoft obtained a rehearing from the Ninth Circuit (see the sidebar), and lost that decision, too. The companys liability from the case, in addition to IRS penalties and overtime already paid, could exceed $20 million.

Much of the discussion of the legal issues surrounding independent contractors focuses on the IRSs well-known 20-factor test (see the sidebar) used to distinguish independent contractors from employees. It also centers on relief under section 530 of the Revenue Act of 1978 (see the sidebar). While both are noteworthy tiles, they hardly constitute the entire mosaic. Indeed, giving them undue attention could cause an organization to neglect some of the more important issues discussed in this article.

If a company is going to use independent contractors on more than a limited or occasional basis, it should do so properly. This requires the company to take a comprehensive approach to ensure it is not misclassifying any of its workers, as outlined below.

Exhibit 1:
Sample Internal Questionnaire
To: All Department Heads
From: ________________, Independent Contractor Specialist
Re: Independent Contractor Practices

As part of my review of our use of independent contractors, please list below the name, approximate level of use and nature of services provided for each independent contractor used by your department. All proprietorships, partnerships and corporations should be listed, except those independent businesses with trade names, five or more employees and multiple customers. If you are unsure about whether a potential individual or organization should be listed, please include them. Only a brief description is necessary; I will follow up for more information.

Name       Level of use       Nature of services provided      

Step 1: Assess what the company is doing now . A company should first ascertain how it currently makes use of independent contractors in its business. In small organizations, this step may not be necessary. In larger organizations, however, many managers retain independent contractors without consulting accounting professionals. Some believe that if a worker agrees to be treated as an independent contractor, there is no legal issue. However, the IRS does not follow a consenting adults approach; even if a contractor insists on such treatment, the IRS will hold the company responsible for any misclassification. In most organizations, a questionnaire similar to the one in exhibit 1, at right, soliciting information on contractor use can be used to gather the necessary information. In some instances, such as where a contractor has five or more employees or many clients, its not worth gathering information because the entity is clearly an independent business.

Step 2: Make a business decision . For all workers a company treats as independent contractors, a decision must be made—ignoring legal considerations—about whether the company wants to use contractors instead of employees. Many decision makers look exclusively at the lower direct cost of independent contractors. However, if a contractor requires extensive training to do his or her job, the lower direct cost may be outweighed by the indirect costs of replacing the worker when he or she leaves for a more stable position. Although many independent contractors enjoy the autonomy of self-employment, some may sacrifice that independence for benefits coverage. The resulting high recruitment and training costs and the lower quality of services provided by successive waves of new contractors may outweigh any savings.

Another purely business factor is workers compensation insurance. Although a company using contractors properly need not pay workers compensation, the company is not protected by the preemption provisions of the workers compensation laws and can be sued in court for blameworthy workplace accidents or illnesses.

Exhibit 2:
Relevant Inquiries

One of the most important steps in reviewing and reshaping a companys independent contractor practices is assessing all aspects of the contractors relationship with the company. Simply using the IRS 20-factor test is unlikely to uncover all relevant concerns. For example, the issue of the use of helpers or assistants—one of the 20 factors—can be broken out into the following discrete inquiries:

  • Does the worker have the right to engage helpers or assistants?
  • Is prior approval of the decision to engage a helper or assistant needed?
  • Is prior approval needed for a specific individual to work as a helper or assistant?
  • Are there any specifications or standards for helpers or assistants?
  • Must the worker notify the company before, during or after the fact that a helper or assistant will be, is being or was used?
  • Is there any limit placed on the use of helpers or assistants?
  • Is there a requirement that the workers services be rendered personally?
  • What special arrangements, if any, are made when the worker is ill or on vacation?
  • Does the worker or do others in his or her classification actually use helpers or assistants? How frequently?

  • Step 3: Assess the status of current independent contractors . A companys next step is to determine whether workers are independent contractors under the law or are in fact misclassified employees. There is nothing routine about this task, however. Several factors complicate it. Various laws use slightly different tests of independent contractor status. In the preventive process, unfortunately, a company wont know which law will be at issue, and therefore which test will be applied. In addition, most of the tests take literally hundreds of facts into account. No one fact is controlling and it is a rare case in which all the facts point in one direction. In short, the assessment of whether a worker is an independent contractor is a fact-intensive inquiry, one resolved by the courts and government agencies on a case-by-case basis. A company rarely can conclude with certainty that a particular worker will be deemed an independent contractor.

    Although assessing workers legal status is tedious, time-consuming and at best leads to tentative conclusions, it must be done and is the most important step in the preventive process. Before finding the facts, a company should obtain from its law firm or an outside human resources consultant a list of the factual inquiries used by the courts and agencies. The company should work through the list in painful detail. The list should be far more extensive than the IRS 20 factors. Exhibit 2, at right, includes some of the relevant inquiries a company should make.

    A company should next search for past court cases concerning workers at other companies similar to the ones it uses. Whether the classification is sales representatives, carpeting installers, truck drivers, taxi drivers or any other, there are many such "clusters" in the case law. Companies without the in-house resources to find cases related to the job classifications they need should consider retaining a law firm or outside consultant to help.

    After evaluating the materials it has collected, the company must decide whether the workers it is considering—with the facts as they exist currently—are really independent contractors. The company should resolve close cases by concluding the workers are employees. Given the possible penalties, this is not an area where a prudent business should engage in brinkmanship.

    Recent Developments

    Two recent events concerning independent contractor use highlight the need for companies to adopt preventive practices.

    In July 1997, the full Ninth Circuit Court of Appeals issued a new decision in the Microsoft case. The workers once again prevailed, although the decision gives Microsofts employee benefit plan administrator the right to determine their eligibility for benefits, subject to an almost certain appeal by any workers denied benefits. An appeal by Microsoft to the U.S. Supreme Court also is possible. Regardless of the final result, given the costs and time consumed by litigation, Microsoft can at best limit its losses.

    Congress gave serious consideration to overhauling the Internal Revenue Service rules governing independent contractor classification with The Home-Based Business Fairness Act. In the end, however, The Taxpayer Relief Act of 1997, signed into law by President Clinton on August 5, did not change the applicable standards. The proposed legislation would have scrapped the 20-factor common law test and replaced it with a much simpler test. The bill also would have prohibited the IRS from assessing retroactive liability on companies for misclassification.

    In addition to opposition by labor unions, womens groups and an association of technology professionals, the Clinton administration expressed concern about the bills potential impact on worker interests. These forces, combined with congressional concerns about a negative impact on the budget deficit and Social Security, led to the legislations defeat. Some Capitol Hill observers have concluded that its failure means enactment of similar legislation in the foreseeable future is unlikely.

    Step 4: Begin to take action . If a company concludes that some of its workers are likely to be deemed independent contractors, its preventive role is not over—indeed, it may have only just begun.

    Because many of the facts considered in the independent contractor determination are superficial, when possible a company should change those facts to support independent contractor status. For instance, if a worker sends invoices to the business (as opposed to the business simply issuing checks to the worker), this helps support independent contractor status. The company still reserves the right to pay only the amount it deems warranted. Likewise, if a company permits a worker to use its name or logo on vehicles or business cards, it should ensure a disclaimer, such as "authorized seller for," appears near the name or logo. Best of all, the company should consider prohibiting entirely the use of its name or logo by independent contractors.

    Next, a company should prepare a written agreement outlining the relationship. The contract should emphasize the facts supporting independent contractor status. Because many government investigations are completed without taking testimony and are based only on review of documents, preparing a good exhibit—signed by both parties—is invaluable. This exhibit is a legally binding agreement that will define the relationship both contractor and principal will live under.

    A company also should develop a document that could be called "Questions and Answers on Being an Independent Contractor With Us," which outlines all the facts in a favorable manner. The document can be given to prospective contractors and to investigators. The company should maintain copies of letterheads, invoices, logos, business cards and advertisements that show contractors to be independent businesses. For contractors who operate through their own corporation, the company should obtain federal employer identification numbers and the equivalent state number. If helpful facts might be difficult to prove at a later time, the company should take steps to gather such proof at an early stage. For example, if a worker receives only a small portion of his or her annual income from the company, the company should develop a questionnaire for contractors proving that point. A company also should consider requiring written proof from contractors that they have obtained or lawfully waived coverage under workers compensation and unemployment compensation laws.

    In dealing with independent contractors, a companys representatives are known as coordinators and liaisons, not supervisors and managers. Companies should train coordinators and liaisons in the proper treatment of independent contractors, emphasizing the contractors right not to be controlled in the manner and method of his or her work. Coordinators and liaisons also should be taught the proper terminology. For example, independent contractors are not "hired" or "fired" or paid "wages" or "salaries." Instead, they are "retained" or "discontinued" and paid "remuneration" or "fees." When referring to the relationship with the contractor, the company is the "principal," not the "employer." A company should choose terminology reflecting the independent contractor as a freestanding business and review it with coordinators and liaisons until it is second nature. The department that deals primarily with contractors should be known not as "human resources" but as "contractor relations."

    IRS 20-Factor Test

    Much attention has been paid to the Internal Revenue Services 20 factors—perhaps too much. The Internal Revenue Code follows the common law test for distinguishing independent contractors from employees. That test, in turn, reflects hundreds of facts found in thousands of reported court cases. Over time, the IRS developed a training tool for its investigators—a list of 20 common law factors. The IRS made the list public; it can be found in revenue ruling 87-41. It is important to remember, however, that the 20 factors do not constitute an exhaustive list of all inquiries under the common law test, nor does the IRS maintain that they do.

    Moreover, liability can arise under laws for which different tests, or different variations of the common law test, apply. The National Labor Relations Act, for example, in the past put a special focus on the extent of the workers financial investment and opportunity for profit or loss. The Fair Labor Standards Act focused on the degree of the workers economic dependence on the business. Many state unemployment compensation laws now use the common law test and other prerequisites. In short, the 20 factors are only a starting point in fact gathering for a company engaged in preventive practices.

    A company should issue a memorandum restricting coordinators and liaisons from directing contractors in any way that threatens their independent status. If the company runs ads for contractors, it should ensure the ads disclose that a worker will be an independent contractor. The ad should run in the business opportunities section of the classified ads, not the employment section. This is another indication of independent contractor status the IRS may look at—since the workers will not be employees, the business opportunities section is the right place to advertise for them. To bolster its case, the company should save copies of the ads.

    A company should train coordinators and liaisons to document relationships appropriately. Misclassified employees can sue based on alleged employment discrimination, and some employment discrimination laws allow even true independent contractors to sue. Coordinators and liaisons should not issue written warnings to contractors—this indicates employee status. They can, however, develop private documentation to refresh their memories in the event of a lawsuit.

    Every unemployment compensation or workers compensation claim and IRS inquiry should be taken seriously from the beginning. Procedures should be established so anyone in the company receiving such paperwork will immediately forward it to a centralized coordinator. The company should consider designating an "independent contractor specialist" to stay current and monitor all legal issues concerning independent contractors.

    Its a good idea for companies to consult with their employee benefits carriers or outside consultants and explore loss-prevention steps in the event some workers are deemed to be misclassified employees. In many cases, if the benefits plan has a provision excluding the contractor classification at issue, the company can prove misclassified employees would not have been covered by the plan in any event. If the benefits plan is set up properly, the administrators decisions will be overturned only if they reflect an abuse of discretion.

    Companies also should review insurance coverage issues. If contractors obtain insurance through the company—either self-paid or company-paid—this fact weighs against independent contractor status. The real hazard, though, is that the insurance carrier may refuse to pay a claim even though premiums were accepted, because the carrier contracted to cover only the companys employees. In such cases, the company may have self-insured without knowing it. Companies should deal candidly with the carrier about this issue before any claim arises.

    Finally, a company should make every effort to maintain good relationships with its independent contractors. Many investigations are sparked by one disgruntled contractor trying to cause trouble.

    If a company ultimately concludes that some of its workers have been misclassified as independent contractors, its task is more difficult. If a company reclassifies workers receiving 1099s so they receive W-2s, IRS computers may flag this relationship and prompt an investigation that otherwise might not have been conducted. The folklore of independent contractor usage is full of anecdotes about well-intentioned companies that inadvertently caused the problems they sought to avoid. If a reclassification from independent contractor to employee is planned, the company might take the opportunity to totally redefine its relationship with the individual involved making enough changes to justify the reclassification to the IRS or any other agency. Doing nothing about a misclassification is rarely a smart move.

    The analysis in this article focuses on whether existing independent contractors are properly classified. Even if workers are independent contractors under the law, the decision to convert employees to independent contractors may cause litigation. A company may be liable for back pay and benefits if it can be shown the conversion was motivated by a desire to interfere with benefit rights protected under the Employee Retirement Income Security Act or to avoid bargaining obligations under the National Labor Relations Act.

    The use of independent contractors, like the use of dynamite, offers many benefits but also poses many dangers. Using either dynamite or independent contractors without full information and a well-thought-out plan of action is likely to lead to disaster. It is incumbent on CPAs to lead the way by developing an effective preventive approach for their companies to follow.

    Section 530 Relief

    Section 530 of the Revenue Act of 1978 is not a part of the Internal Revenue Code but, rather, is an off-code enacted by Congress. Section 530 affords relief from employment tax obligations to companies that have misclassified workers but consistently have filed the required returns (such as appropriate 1099s), have treated all workers in similar positions as independent contractors and have reasonable bases for this treatment.

    Although companies receiving section 530 relief are relieved of retroactive assessment of employment tax liability, they are required to convert the workers to employees. If available, section 530 relief does not apply to claims under employee benefit plans, does not affect employment discrimination suits or wage-hour matters and plays no role in unemployment compensation, workers compensation, state income tax or other state law claims. Section 530 relief never applies to certain technical workers (such as computer programmers) who are working for third parties out of technical service firms. In short, in the rare situation in which section 530 relief is available, it offers companies a pardon, not a safe harbor, and only for one of many possible liabilities.


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