The "independent contractor" versus "employee" controversy has a potentially damaging reach of significant proportion, and well beyond just the obvious tax considerations. And from a national policy standpoint, the IRS' focus on this area is extremely unfair. There are states such as Nevada for which a determination that an independent contractor is or should be an employee has minimal impact. For businesses in California, on the other hand, a determination of employee status for a businesses work force can rachet the employer into unwanted inclusion in laws affecting larger employers and create significant liability.
Five randomly chosen California laws triggered by the existence and number of employees include:
1. A requirement for plant closings, layoffs, and relocations of 50 or more employees regardless of percentage of workforce
2. California Fair Employment and Housing Act anti discrimination rules which prohibit sexual harassment kicks in at 25 employees.
3. Pregnancy discrimination laws are triggered by a 5 employee level rather than the federal 15.
4. California's AB 1825 requires any employer with more than 50 employees to provide "supervisors" with a minimum two hours of harassment training.
5. California's Prop 65 requires a "clear and reasonable" warning before knowingly and intentionally exposing an employee to a listed chemical kicks in at 10 employees.
There are many dozens more at the state level and still more at the federal level. Are the goals of these laws societally good? Yes. However, the drafters believed that they knew that these rules were not "good enough" to apply to all employers or else the application threshold would have been wholly absent. The lawmakers realized that it would be unfair to restrict contracts by requiring independent contractors to be subject to these laws at all, and that small employers should not be burdened with such laws.
In their paternalistic estimation, a startup company should take on additional burdens each time a new hire adds to the employee total. Each added employee will be celebrated and business will be stopped for a week while management can learn, digest, and contemplate its new social responsibility by virtue of the new laws applied to it.
With all of the laws and financial constraints which inhibit new business, its no wonder that a below average citizen often considers a completely illegal means of livelihood as their only alternative. Society says that it wants more jobs and employment, but the legislature passes a patchwork of laws and rules that only the largest employer can handle. In the space between zero employees and 100 employees, the typical business needs a sizeable capital infusion to bring it up to speed on all of the laws with which it must comply. This inhibits entry into the market, stifles new business or kills it off and helps eliminate the pursuit of happiness for those who want to be happy in their own business.
Government can deal much more securely with businesses than individuals, yet uses restrictive laws to inhibit the formation and growth of business. Outside the taxing agencies, even more laws generally depend upon a finding of independent contractor v. employee. Independent contractors can compete and owe no duty of loyalty to those they contract with. Employees create liability for their employers for torts, for representations and for their negligence, and much more. So, when one of the most powerful arms of government decides to create a "sea change" in the equilibrium between independent contractor and employee status, it will do more harm than good, especially at a time where business formation and growth is most keenly needed.
Federally, things on the "independent contractor" versus "employee" front had been generally calm for the past two decades or so. The states, such as California, with a high state tax rate have always been aggressive about "herding" anyone they could into employee status. However, states with their individualized fiefdoms and own dangerous peculiarities in trying to thrust the equilibrium of human relationships toward that of "employee" are bad enough but they are at least isolated. However, an IRS shift produces a corresponding amplifying forcing function at the state level.
For years, the IRS used a 20 factor list with no weighting considerations between the factors and left it to the taxpayer to sort out the propriety of the chosen category. Later in time, the IRS focussed on a super-grouping of three main factors, including (1) behavior, (2) financial relationship, & (3) relationship. Control is the watchword for the first two, and the latter opens itself up to a more intensive factual exploration. The grouping into three overall categories of grouping the earlier factors is somewhat an indication of the perceived importance of the first two against the third category which can contain a number of narrower miscellaneous factors.
Another prior "calming" aspect of the "independent contractor" versus "employee" controversy was a safe harbor with an unusual, if not tautological forgiveness factor in that "even if classified wrong, its OK if you did it reasonably and/or consistently." The motive may have been an assumption that consistent, widespread classification would probably occur at ambiguous dividing lines within different types of industries.
The extent to which all of the foregoing calmness has been a reassurance to employers, that calm was upset last fall when the IRS announced "Limited Amnesty Program for Employee Misclassifications" to enable employers who wanted to voluntarily "adopt" their independent contractors as "employees" and pay a fee for the privilege.
But wait. This is an amnesty. An amnesty is usually appropriate when you have done something clearly wrong and where you are given a chance to come in, take some punishment and then "make it right". But historically the dividing line between independent contractor and employee has been fractured, non-linear, and via the so-called "safe harbor" as an implied or implicit general acceptance that an improperly drawn dividing line should simply "stay that way". When did an awkwardly drawn line become a violation for which an "amnesty" is offered? Well, that gives some insight into the ugliness we can expect over the next half-decade at least.
But shouldn't the public, many of whom are employers and independent contractors become outraged and march in the streets in protest of this? They should, but the average citizen seemingly has such a psychological aversion to anything relating to tax that they actively choose to avoid learning of it completely before learning enough to ignore it. (After a year and a half of offering free tax education to the public I should not have been surprised when none of the public attended.) The only way that the public will even consider this issue is when they are dealt with one-by-one in an audit. This Limited Amnesty Program for Employee Misclassifications is not a secret room in Guantanamo, it was announced quite publicly by the IRS in Announcement 2011-64. As with most changes in American life, the citizen comes to a final realization that the law has changed when the district attorney looks him in the eye and talks about a "very favorable plea bargain" (or in the case of tax, perhaps their first visit with an IRS representative).
The second giant realization of the severity of the sea-change is the fact that this amnesty program is NOT an attempt to finely adjust the "independent contractor" versus "employee" dividing lines more precisely, but to SHOVE them in one direction only -- toward the status of employee rather than independent contractor. Employers have not, under Announcement 2011-64, been given an opportunity to "adjust those of its employees to independent contractor status after a reasoned investigation and thoughtful approach. Uncle Sam wants everyone possible to be an employee because that convenient classification reduces the effort necessary to deal with its citizens diverse and presently uncontrolled activities.
The combination of what should be re-termed a Amnesty Program for Reclassification.as Employees, combined with similar state programs, to force employers directly into operation of other statutes, both federal and local much before they are ready. An employer could wake up one morning to learn that instead of twenty or thirty statutes and rules to worry about, the employer has hundreds because his number of "employees" has skyrocketed overnight.
The state rules on requirements to treat individuals and organizations as an employee will be bolstered by the federal shift forcing greater classification of workers as employees. This federal shift will be bolstered by government's own control of its own taxing system. When the IRS considers someone an employee for tax purposes, its a bootstrap argument that cannot be effectively refuted, much like the tax system's deductions are a matter of "legislative grace". Unfortunately, all the non-tax laws concerning who is an employee operate from the W-2. The effect is that if you are an employee for tax purposes, you will generally be considered an employee by everyone for every purpose imaginable.
How can employers who will potentially be found "guilty" in this treasure hunt, and the independent contractors who may be forced to lose their independence, prevail against the tide before them? Every case is different. There are no guarantees anywhere. Further, because some businesses have restrictions that conflict with many of the factors, complete preservation of the independent contractor relationship will never be assured. Some mitigating factors might help hiring entities and independent contractors who wish to increase the probability that they are able to remain independent. Having a contract which embody mitigating factors may also be beneficial.
1. Eliminate whimsical provisions about when, where, and how to work. Some situations naturally dictate restrictions, so why mention them just to sound bossy?
2. Allow the independent contractor the maximum leeway to optimize his own operations.
3. Prefer to select independent contractors who also independently work for others (preferably not your competitors).
4. Define your trade secrets, identify them to your independent contractors and have the independent contractors sign the same arms-length non-disclosure and trade secret agreements that you force other contracting companies to sign.
5. Require independent contractors to be trained for contracted tasks before engagement. If an independent contractor want to progress to a higher paid and more demanding task, require that training be completed at the contractor's expense before engagement for that task.
6. Independent contractor contracts should have randomized non-contracted inter-periods as might be expected to occur between tasks or when other, different contractors were hired within break periods of other contractors.
7. Independent Contractor agreement should emphasize the result using a set of standards and possibly coupled with remuneration based upon achievement of those standards.
8. Hourly contracts are to be avoided. One of the hallmarks of an employee is the exchange of money for time during which they are under the control of their employer. The true value to the entity hiring the independent contractor is the result achieved. It should not matter to the hiring entity whether a result is reached in 50 hours or 100 hours (so long as time is not critical).
9. All other things being equal, the hiring entity should contract with an entity which may have the capability to provide different ones of its employees to do the task. Have the corporation guarantee that it is contracting as an independent contractor and possibly indemnify the hiring entity. It may be that the independent contractor entity can cover many of its guarantees with insurance and performance bonds (and not to mention that this change in the law may result in a greater variety of insurance products to protect against a mis-characterization by the IRS of employee status).
10. Avoid any integration of an independent contractor's human services into decision making levels in the hiring entity's business. Where in independent contractor is hired to make an evaluation, get another independent contractor to help implement the first independent contractor's recommendations.
11. Any control desired by the hiring entity should appear in the contract and should ideally be subject to bonuses and performance payments. Aspects of the independent contractor's results which are important should be identified and valued with an independent contractor's motive to conform to the hiring entity's wishes being an economic one.
12. Never require the independent contractor's services to be rendered personally. The independent contractor's team may have some individuals who can do the job quickly and others that can't. Any desired gradation in result should be handled with some form of bonus or penalty.
13. The hiring entity should never get involved with aspects of the independent contractor's equipment, hiring practices, or operations. Every thing the hiring entity wants as a result should either appear in the base contract or in bonus provisions. If the hiring entity is worried about security he can put cameras on his facility, or require a bond for theft or damage. Anything the hiring entity wants should be important enough to be stated in the contract.
14. The hiring entity should have a non-continuous relationship with the independent contractor. This can be especially advantageous during the economic downturn where an employer may need a result represented by only one quarter of a person-week, instead of whole, full time person weeks, for example. Where possible, the hiring entity should alternate between any number of independent contractors.
15. Require the independent contractor to verify the genuineness of his or her own independent basis by inspection of tax returns and 1099's. Where the hiring entity can clearly see that the independent contractor is multiply engaged with different hiring entities, the chances are much reduced that any of the independent contractor personnel will be wrongfully characterized as an employee.
16. Premises presence should not be required unless absolutely necessary and if it is necessary it may not necessarily need to be stated explicitly. An independent contractor hired to service the hiring entities elevators must necessarily go to the premises. If anything can be done off premises, the independent contractor should do it off premises.
17. Don't pay the independent contractor on a temporal regular schedule, but only by performance milestone. Don't pay any small expenses of the independent contractor because those expenses were known and accounted for in the contract price or conversely are of such unexpected nature and magnitude to require a change-order.
18. The independent contractor should have significant financial and loss risk explicitly built into the contract and which is easily recognizable by all parties and especially any IRS auditor.
19. In summation, every effort should be taken by both the hiring entity and the independent contractor to keep the relationship at arms length. If the hiring entity wants a long term relationship with any individual, it may consider employee leasing as an intermediate temporal step before making a formal hire.
In general, the previous system where the hiring entity designated independent contractor of employee status for the entities or persons hired is ending quickly. It would have been more honest of our government for Congress to have deliberated and legislated rather than to have stealthily launched a so-called "amnesty" program to herd taxpayers into compliance with an unexpected mandate. The severe impact of this equilibrium shift will not be as apparent because of its widespread but highly differentiated effects.
Hiring entities and independent contractors who want to continue their current status should check their circumstances and adopt the most stringent structure to enable them to carry on with their independent status, or simply accept their closely dependent relationship and surrender into employer-employee bliss. For the closely bound, the Limited Amnesty Program for Employee Misclassifications provides a perfect opportunity to re-commemorate their ineluctable tie.
Curtis L. Harrington is a principal in the law firm of Harrington & Harrington, which specializes in taxation and intellectual property. Curt may be reached by phone at (562) 594-9784, by fax at (562) 594-4414, or by e-mail at email@example.com. In his capacity as a Taxation Specialist of the State Bar of California Board of Legal Specialization, he is currently (2011-2014) a regular board member of the Board of Legal Specialization having just completed a five year membership (2006-2011) ending with chairmanship of the Tax Law Advisory Committee of the Board of Legal Specialization. Curt and admitted to practice before the state bars of CA, TX, AZ, and NV; the U.S. District Court; the U.S. Court of Appeals, Fifth and Ninth Circuits; the U.S. Supreme Court; the U.S. Patent and Trademark Office; and the IRS. He holds a B.S. in Chemistry (Auburn Univ., 1974); M.S. in Chemical Engineering (Georgia Tech, 1977); JD (Univ. Houston, 1983); MBA (Univ. Oklahoma, 1985); M.S. in Electrical Engineering (California State Univ. - Long Beach, 1990); and LLM in Taxation (Univ. San Diego Law School, 1997).
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