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03.10

By Vin O'Neill

Organizations representing self-employed independent contractors are gearing up for another battle in a long and contentious war in Congress over the “common law test” that the Internal Revenue Service uses to decide whether workers should be classified  as employees or as independent contractors for Federal tax purposes. This year’s fight takes place in the midst of growing Federal and state budget deficits and widespread allegations that many businesses treat certain workers as independent contractors instead of as employees in order to avoid paying Medicare and unemployment insurance taxes and providing other benefits for these workers.  To address these concerns, Congress and the Obama Administration are proposing  new legislation and regulations intended to rewrite applicable tax code provisions and crack down on the misclassification of workers.

Here’s some background on these initiatives and underlying worker classification issues.

Common Law Test - Under current law, the determination of whether a worker is an employee or an independent contractor is generally made using an extremely subjective common law test. This test includes 20 questions, the answers to which help to establish whether or not a worker is subject to the control of an employer or service recipient, not only with respect to the nature of the work performed, but also the terms and conditions under which the work is performed and related services are provided. (1)

Significant consequences — for individual and corporate taxpayers — can result from the classification of a worker as an employee or independent contractor. These consequences relate to withholding and employment tax requirements as well as a taxpayer’s ability to exclude certain kinds of compensation from income or take tax deductions as ordinary business expenses. Some consequences favor employee status, while others favor independent contractor status. Employees, for example, are allowed to exclude the cost of employer-provided pension, health and life insurance benefits from gross income for Federal income tax purposes. Independent contractors, on the other hand, can establish their own pension plans and make tax-deductible contributions to those plans.

Significant tax consequences can also result if a worker is misclassified and subsequently reclassified as a result of an IRS audit. For employers and service recipients, such consequences may include penalties for failure to withhold taxes as well as disqualification of employee benefit plans. For workers, the consequences commonly include liability for self-employment taxes and denial of eligibility to deduct certain business-related expenses.

After years of contentious and often unresolved disputes between taxpayers and the Internal Revenue Service over employment tax classification decisions, Congress enacted a statutory alternative to the common law test in 1978.

Section 530 of the Revenue Act of 1978 — Section 530 allows taxpayers to treat workers as independent contractors, regardless of their employment tax status under the Common Law Test, if they have a reasonable basis for doing so. A reasonable basis includes a judicial precedent, a prior IRS audit or longstanding industry practice. If a taxpayer meets one or another of these criteria, the IRS is prohibited from reclassifying its workers as employees, even prospectively. Section 530 also prohibits the IRS from issuing regulatory guidance about the appropriate classification of such workers. (2)

Obama Budget Proposal — The Obama Administration’s FY 2011 Budget proposal includes provisions that would allow the IRS to issue regulatory guidance on employment tax classification matters and to reclassify workers found to have been misclassified, even if such a reclassification would otherwise be prohibited under Section 530. (3)

To enforce this proposal, the President’s budget earmarks $25 million for 100 additional tax compliance officers. The IRS has already announced plans to audit 6,000 companies for compliance with current law.

The budget document anticipates that the resulting crackdown will generate at least $7.3 billion in employment tax revenue over the next 10 years. A number of states, including California, Illinois, Massachusetts, Montana, New Jersey and New York, are also stepping up their enforcement of employment tax laws, often by enacting stricter penalties for taxpayers that misclassify workers. (4)

Current Congressional Initiatives — In addition to the President’s regulatory reform proposal, key members of House and Senate tax-writing committees have introduced bills to modify existing statutes governing employment tax classification practices.  Last year, Representative Jim McDermott (D-WA-07) and Senator John Kerry (D-MA) introduced the Taxpayer Responsibility, Accountability and Consistency Act of 2009. This legislation (S 2882/HR 3408) would amend relevant sections of the Internal Revenue Code and the Revenue Act of 1978 by expanding taxpayer reporting requirements, changing the Section 530 safe harbor rules and increasing civil penalties for noncompliance.

Similar legislation has been introduced in Congress in the past, only to die a slow death in the face of continuing disagreements about the best way to reform the always-contentious employment tax classification process. Proponents of employment tax classification reforms, including many AFL-CIO affiliated labor unions, have long argued that businesses deliberately misclassify employees as independent contractors in order to reduce their Federal and state tax obligations and avoid having to pay for overtime and other employee benefits.

Small businesses and self-employed workers in the construction, direct sales, transportation and computer consulting industries - where the use of independent contractors is pervasive — are usually among the loudest critics of the proposed reforms.  Although everyone agrees that the employment tax classification statutes could use greater clarity, there always has been and continues to be vehement disagreement on how best to codify and implement appropriate changes.    

Section 1706 of the 1986 Tax Reform Act — Disputes about the proper classification of technical services workers, including engineers and computer specialists, that began in the early 1980s culminated in the enactment by Congress of Section 1706 of the 1986 Tax Reform Act.

 Section 1706 effectively revoked the Section 530 Safe Harbor protections, but only for “engineers, designers, drafters, computer programmers, systems analysts and other similarly skilled workers” in brokered (three party) relationships involving individual workers, technical services providers (staffing firms) and client companies.  As a result, workers who provided technical consulting services to clients through a staffing firm were once again obliged to comply with the 20-factor Common Law Test for employment tax classification purposes. (5)

Sustained efforts in the late 1980s and early 1990s by organizations representing independent contractors and self-employed consultants — including IEEE-USA and the National Association of Computer Consultant Businesses — to persuade Congress to repeal Section 1706 were unsuccessful.

Legislative Outlook — The 111^th Congress and the Obama Administration seem determined to re-engineer current laws and regulations governing the classification of workers as employees or as independent contractors for Federal employment tax purposes. In view of the very real likelihood of Congressional action in the coming months, IEEE-USA will re-examine the need for an updated position on this controversial issue.  Suggestions from readers on what position, if any, IEEE-USA should take will be very much appreciated.

Sources

1. Congressional Joint Committee on Taxation, Present Law and Background Relating to Worker Classification for Federal Tax Purposes (JCX-26-07), 7 May 7 2007.
   http://www.irs.gov/pub/irs-utl/x-26-07.pdf

2. Section 530 of the Revenue Act of 1978
   http://www.workerstatus.com/530text.html

3. Department of the Treasury, General Explanations of the Administration’s FY 2011 Revenue Proposals (February 2010).
   http://www.treas.gov/offices/tax-olicy/library/greenbk10.pdf

4.  Steven Greenhouse, Federal and State Officials Crack Down on “Contractors” as a Tax Dodge, New York Times (Feb 18, 2010)
   http://www.nytimes.com/2010/02/18/business/18workers.html

5. Department of the Treasury, Taxation of Technical Services Personnel: Section 1706 of the Tax Reform Act of 1986 (March 1991)
   http://ia310833.us.archive.org/2/items/taxationoftechni01unit/
   taxationoftechni01unit.pdf

Vin O’Neill, as a Senior Legislative Representative, lobbies Congress and Federal regulatory agencies on professional careers issues, including education, employment, health care, immigration reform, offshore outsourcing, retirement security and tax issues of special concern to IEEE’s US members.

Comments may be submitted to todaysengineer@ieee.org.