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
curt@patentax.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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