Avoiding IRS reclassification of workers as employees.

Executive Summary

The classification of workers as employees or independent contractors is a controversy significantly affecting many businesses. The primary defensive weapons available against an IRS challenge are the 20 factors provided by Rev. Rul. 87-41, and, in limited situations, Section 530 of the Revenue Act of 1978. However, as this article shows, in recent years, the courts have focused on just five of the ruling's factors and have provided some guidance on how to resolve the issue. As discussed in this article, this in-depth analysis should be helpful in avoiding IRS reclassification. The current legislative posture is also discussed.

The continuing controversy of whether workers should be classified as employees or independent contractors presents a serious dilemma for many businesses. This classification determines the applicability of payroll taxes, workers' compensation insurance, retirement plans and company fringe benefits. Worker status also is relevant for collective bargaining purposes and when assigning responsibility under civil rights acts. The past decade has been characterized by confusion, litigation and calls for simplification. Although legislation is pending, Congress has yet to provide relief

Without a clear standard, the IRS is aggressively pursuing additional taxes and penalties by reclassifying workers as employees; in fact, it has reclassified more than 400,000 independent contractors as employees since 1988 and currently reclassifies nearly 2,000 per week.(1) Further, the IRS has applied its own rules inconsistently, even in identical situations.(2) To quell the uncertainty faced by businesses, many alternative proposals have been presented.(3) Recently, the IRS announced two changes designed to achieve more uniform application of the standards: (1) National Office approval must be obtained for all local office reclassification projects and (2) additional training will be provided to examiners.(4)

An IRS reclassification includes not only assessments for the employer's share of payroll taxes but also interest and penalties, which can be substantial.(5) It also Can include the worker's share of FICA taxes, especially in flagrant situations or when they cannot be collected from the worker. If the hiring company is insolvent, the owners, officers and directors may be held responsible because the underpayment involves withholding taxes.(6) A worst-case scenario could result in the disallowance of the company's qualified pension plan because these "employees" (i.e., the independent contractors) were excluded from coverage.(7)