Independent contractor classification: The debate continues

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Posted by Chris Hediger

October 7, 2011

The Wall Street Journal recently reported on an IRS initiative to crack down on organizations improperly using independent contractors. According to the article, the agency is implementing a program that will allow business owners to reclassify their independent contractors. This way, they can pay a small fee rather than risk a costly audit that could incur a much higher debt in the form of back taxes.

I find the new program frustrating. I have worked with companies that have struggled with the definition of an independent contractor. They live with the fear that one day the IRS's Sword of Damocles will fall on them, despite their efforts to do the right thing.

The intent of an independent contractor distinction is to provide a tax break to businesses that are using non-employee labor in their work. Unfortunately, it seems to have become a means of extracting funds for an emaciated government budget.

I understand the issue. According to the 2010 numbers, an estimated 3.4 million workers were misclassified. In Ohio alone, misclassification cost the state $35 million in unemployment insurance taxes, $103 million in workers' compensation, and $223 million in income tax revenue.

But the issue is not whether the government is owed the money. It's a matter of how clear does it make the distinction for the average business owner?

There is no doubt that there are some business owners who leverage the distinction purely to make themselves more profitable, despite the fact that the employee suffers. However, most who I have come in contact with want to get the classification right. They're just perplexed by the vague distinctions provided by the IRS.

In 1935, new social security taxes made the distinction necessary to determine who owed how much to the program. Since then, the government has struggled to clearly define the distinction.

First it focused on usual common law rules. Then it considered economic reality tests to be the true assessment. And then it reverted back to common law rules.

In 1987, the 20-question test with which most of us are familiar was created as the classification primer. In 1996, those questions were organized into three primary categories: behavioral control, financial control, and relationship of parties (William Hayes Weissman, SECTION 530: ITS HISTORY AND APPLICATION IN LIGHT OF THE FEDERAL DEFINITION OF THE EMPLOYER-EMPLOYEE RELATIONSHIP FOR FEDERAL TAX PURPOSES, IRS, February 28, 2009).

While the 20-question paradigm is helpful, the IRS places greater weight on some factors than others in determining classification. This is not signified in its documentation.

The classification remains vague at best. Perhaps intentionally so.

In the end, I wholeheartedly agree in "giving unto Caesar," as long as I know how to determine what I owe. Classification of workers is essential to ensure companies are getting the work they need done and that workers are protected appropriately.

But instead of coming after businesses based on seemingly arbitrary rules, why not build a clear distinction that the average business owner can easily utilize? One that provides clear distinctions.

Certainly, we can build sophisticated enough software to allow a business owner to answer a handful of questions and be given a clear answer regarding classification. Many companies offer similar products now to help with the decision.

If the government truly wants appropriate classification, make the process easier and the definitions foolproof.


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