By: Nancy E. Joerg, Esq.
Companies and their advisors naturally want to know how to best defend themselves in case the IRS agent decides to attack the independent contractor status of their workers. If independent contractors are reclassified to employee status upon an IRS audit, the taxpayer company under audit will be liable for back employment taxes, possible penalties, etc.
Taxpayer companies faced with an IRS audit should not just argue the merits of independent contractor status. Instead argue BOTH:
1) that the independent contractors are not "common law" employees; and
2) that the taxpayer company has protection under Section 530 of the Internal Revenue Act of 1978 (also called "Safe Haven" or "Safe Harbor").
It is not necessary (or even desirable) to select one or the other of these two legal defenses - either the common law defense or the Safe Haven defense. Aggressively argue both legal defenses when faced with an IRS challenge.
IRS 20 FACTOR TEST
Let us first look at the common law defense strategy. The IRS uses the 20 common law factors to determine whether a worker is an independent contractor or an employee. The 20 factors (with a bit of explanation) are as follows:
- Instructions. A worker who must obey the company's instructions about how the job is to be performed is usually found to be an employee of the company.
- Training. An independent contractor is supposed to come to the company "fully hatched." The company should not have to train the independent contractor.
- Integration. "Integration" refers to how closely related the work of the company is to the work of the worker. The closer the relationship between the work of the company and the work of the worker, the more likely the worker is an employee.
- Services Rendered Personally. If the company demands the worker personally perform the services, then this shows control by the company over the worker which makes it more likely that the worker is an employee.
- Hiring, Supervising and Paying Assistants. When the company hires, supervises and pays the worker's assistants, this shows control by the company over the worker (and makes it more likely the worker is an employee).
- Continuing Relationship. The pressure of a continuing relationship between the worker and the company tends to show an employer-employee relationship.
- Set Hours of Work. A hallmark of independent contractor status is the total freedom to plan one's own workday.
- Full Time Required. As an independent contractor, the worker should be free to accept or reject any job offered by the company.
- Doing Work on Company's Premises. An independent contractor should possess his or her own place of business.
- Order or Sequence Set. As an independent contractor, the worker should set the work schedule.
- Oral or Written Reports. Employees are often required by employers to hand in reports, which are viewed by the IRS as evidence of control.
- Payment by Hour, Week or Month. Payment to independent contractors should be by the job rather than by the hour, day, etc.
- Payment of Business and/or Traveling Expenses. An independent contractor should pay for all of his or her own overhead.
- Furnishing of Tools and Materials. If a company covers the cost of the worker's supplies, tools, and equipment, independent contractor status is weakened.
- Significant Investment. The larger the worker's investment in his or her own business, the more likely it is that the worker is an independent contractor.
- Realization of Profit or Loss. An independent contractor should be capable of either realizing a profit or suffering a loss.
- Working for More than One Company at a Time. While a worker can perform services for several companies and still be classified as an employee for one or all of them, independent contractor status is certainly strengthened if the worker has a diverse and significant client base.
- Making Services Available to the General Public. As an entrepreneur, an independent contractor should hold his or her name out to the general public.
- Right to Discharge. While an employer may discharge an employee, parties to an independent contractor agreement have an obligation to terminate their contract with some type of notice requirements.
- Right to Terminate. When a worker can terminate his or her relationship with the company at any time without incurring liability, it is suggestive of an employee-at-will relationship. An independent contractor cannot simply walk away from his or her contractual relationship to the company. Should an independent contractor wish to terminate an independent contractor agreement, he or she must do so with reasonable notice, in accordance with the terms of the independent contractor agreement.
There is no special number of factors that a taxpayer company must pass in order to prove independent contractor status. Rather, the company must simply "do as well as it can" under the 20 factors (and then hope that the IRS agent is convinced that the workers at issue are independent contractors and not employees). Some factors are more important than others, depending upon the industry and the type of independent contractor at issue.
IRS FORM SS-8: IRS Form SS-8 is the questionnaire that IRS auditors use when they evaluate a company's usage of independent contractors, and decide whether a certain kind of independent contractor is truly an independent contractor, or is really an "employee," under the IRS definition.
IRS Form SS-8 is a wonderful self-audit tool, but the correct answers are not self-evident. The questions are very vague and tricky. There are many hidden issues tucked into this questionnaire. Therefore, it is absolutely essential to review your responses with a professional who has a great depth of experience in evaluating independent contractor status.
We do not advise that you voluntarily send an SS-8 form to the IRS without speaking to a qualified attorney first.
IRS SAFE HAVEN DEFENSE
Even where a company believes it has a very strong common law 20-factor case, the company should still usually present its Section 530 Safe Haven defense to the IRS. (In the legal profession, this is called "arguing in the alternative." It does not normally weaken your 20-factor common law defense to put forth an additional defense under the Safe Haven theory.)
Congress passed Section 530 of the Internal Revenue Act of 1978 in order to give relief to those businesses that, in good faith, used independent contractors (because of a reasonable basis).
Section 530 is liberally construed in favor of the taxpayer, so it pays for a company to be both aggressive and creative under this law.
Section 530 has three requirements. All three must be passed so that the taxpayer company can receive relief under it:
1. The company must consistently use the kind of workers at issue as independent contractors (this means that the company has used the workers as independent contractors, and not as employees, consistently through the years), AND
2. The company has faithfully issued IRS Form 1099s where required, AND
3. The company has a reasonable basis for having classified the workers as independent contractors in the first place. (Note: There are many ways to prove this.)
Conclusion: Defense of independent contractor status is a complex legal issue. This article touches just the highlights of these two powerful defenses of which all companies that use independent contractors should be aware when they are audited by the IRS.
The stakes can be high in these IRS challenges to independent contractor status. Companies are hit sometimes with tax assessments in the hundreds of thousands of dollars (we have seen them in the millions). Adequate preparation and research before a company interfaces with the IRS on the independent contractor issue is crucial.
WARNING: For certain industries, such as real estate, there may be legal exceptions to the normal IRS rules. Therefore, always have a qualified professional do research to see if your type of independent contractors fall under special legal exceptions and rules.
Questions? Call Attorney Nancy E. Joerg of Wessels Sherman's St. Charles, Illinois office: 630-377-1554 or email her at firstname.lastname@example.org. If you would like a free copy of the IRS brochure on Safe Haven, contact Legal Assistant Tammy Nelson at 630-377-1554 or via email at email@example.com.