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States, feds crack down on firms using 'contract workers'

By Paul Davidson, USA TODAY

Editor's note: A previous version of this story overstated the amount of back wages the Department of Labor forced employers to pay to workers.

State and federal authorities, as well as workers themselves, sharply increased crackdowns this year on companies that misclassify employees as independent contractors.

The efforts threaten to curb the big growth of contractors and freelancers in the workforce.

"We're going to have ongoing battles," says Barry Asin, president of Staffing Industry Analysts (SIA), a research group.

The number of worker class-action lawsuits claiming that employers misclassified them as independent contractors rose 50% this year to a record 300 or so, says Garry Mathiason, vice chairman of labor law firm Littler Mendelson.

Meanwhile, the Department of Labor says it forced employers to pay $6.5 million in back wages to 5,261 employees in fiscal 2010, up sharply from $2.6 million owed to 2,190 employees a year earlier. States are also increasing enforcement, with about 20 passing laws the past two years that make it easier to force employers to reclassify contractors as employees and seek unpaid taxes, says Jack Finn, head of the Interstate Labor Standards Association.

Companies are increasingly using contractors to meet peaks in demand and complete short-term projects. The trend intensified in the recession as firms cut staff. The portion of contingent workers in the labor force is up to about 10% from 8% five years ago, Asin says.

Using these contingent workers cuts labor costs about 30%, Labor says, as employers avoid paying unemployment taxes, workers' compensation, health care and other benefits.

About 62% of employers said at least some of their workers are misclassified, according to a September survey by SIA. Labor estimates misclassification cut federal revenue by $3.4 billion in 2010. The practice is common in construction, trucking and home health care.

The question of whether workers should be labeled employees or contractors largely hinges on whether employers control their activities. A report last week by the National Employment Law Project concluded port trucking firms misclassify most of their workers.

Will Cantrell, 38, a truck driver at the Port of Oakland in California, says he's bound by contract to work exclusively for one company but gets no health and other benefits, and he must lease his own truck and pay fuel and other expenses. "I come in when they say, I do loads when they make the schedule," he says.

But Curtis Whalen, an executive for the American Trucking Associations, says many contractors earn upward of $50,000 a year and choose when they work and for whom they work. Firms, he says, must hire contractors because traffic slows from January to July.

More on 1706

A Special Report for WDP from the Law Offices of SAUL, EWING, REMICK & SAUL LLP

Re: Section 530 of the Revenue Act of 1978

Our File No. 07539.52618

At your request, this letter will provide background information on some of the tax issues regarding independent contractors in the computer consulting industry. You may show this letter to other people, but this letter is not a legal opinion or legal advice to you or any one else. Rather, all other people who read this letter are advised to seek legal advice from their own counsel, and to retain an attorney if they are not presently represented.

Some of the tortured history of this area of the law bears repeating. The Internal Revenue Code (the "Code") does not contain any definition or rules dealing with the issue of when a worker should be characterized for tax purposes as an employee, rather than as an independent contractor ("IC"). In the absence of a statutory definition, the Internal Revenue Service ("IRS") was forced to consider using the "common law" test for determining the tax status of a worker.

The common law test for who is an IC and who is an employee is different from one state to another. Many states have adopted as part of their common law the test that is set out in the Restatement (Second) of Agency at § 220(1), which states than an employee ("servant") is a person "employed in the affairs of another and who with respect to the physical conduct in the performance of the services is subject to the other's control or right to control." In the following provision, § 220(2), the Restatement enumerates ten "matters of fact" that may be considered "among others."

The ten factors considered by the Restatement look at the relationship between the person who provides the services ("service provider" or "provider") and the person who receives the benefit of the services ("service recipient" or "recipient"). The ten factors are:

(a) The extent of control which, by the agreement, the recipient may exercise over the details of the work;

(b) Whether or not the provider is engaged in a distinct occupation or business;

(c) The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the recipient or by a specialist without supervision;

(d) The skill required in the particular occupation;

(e) Whether the provider or the recipient supplies the instrumentalities, tools, and the place of work for the person doing the work;

(f) The length of time for which the provider is engaged;

(g) The method of payment, whether by the time or by the job;

(h) Whether or not the work is part of the regular business of the recipient;

(i) Whether or not the parties believe they are creating an employment relationship; and,

(j) Whether the provider is or is not in business.

No one factor is determinative. All of the factors are weighed, and some factors are given more or less weight depending on the particular facts, the individuals, and the work to be performed.

Some of the factors may be weighed more heavily than other factors in circumstances where independent contractors and employees would be expected to respond differently in the same circumstances. Using factor (e) as an example, where a recipient needs a small program written in a commonly-available computer language to operate on personal computers, and where there is no need or desire for the provider to work in a particular location or during a particular time, an employee will probably want to work at the recipient's site on the recipient's computer, while an IC will probably want to work off-site at the IC's own office on the IC's own computer.

By contrast, some of the factors will be irrelevant in other relationships. Using the same factor (e) as an example, in a case where the recipient needs a fairly complicated program written in a high-level computer language to operate on the recipient's mainframe computer, and where the recipient prohibits dial-up access to the mainframe for security reasons, then factor (e) is no longer relevant. After all, the provider will be forced to work on-site and will be forced to use the recipient's mainframe and programming tools regardless of whether the provider is an employee or IC. In this case, there is no way to differentiate between an employee and an IC because either type of provider would act the same way.

Accordingly, the common law test and the Restatement test require a fair amount of work to apply. The person applying the test (such as a judge) is required to learn a great deal of information about how the provider works, the needs of the recipient, and all of the many options available to the provider and recipient for a particular set of services provided. This turned out to be too much work for the IRS, which needs to make determinations of employee or IC status without gathering so much information about particular relationships. Instead, the IRS promulgated its own test. Not surprisingly, the IRS's interpretation of the common law test is biased in favor of a determination that a worker is an employee.

For many years, the IRS has been on a crusade to recharacterize workers as employees, rather than ICs. Initially, this attitude could be attributed to the circumstance that employment relationships were subject to a higher level of employment (FICA) taxes than independent contractor relationships. Although employment taxes are now effectively the same on both types of relationships (unless a worker has multiple employers), the IRS has continued to view IC relationships with hostility and suspicion. This attitude is now largely attributable to administrative convenience; it is much easier to collect taxes through payroll withholding than by relying on the workers to make estimated tax payments. The IRS also feels that ICs may be claiming inappropriate business deductions.

The IRS's crusade against IC arrangements caused many taxpayers to complain to Congress. In many cases the IRS collected taxes twice because employers were forced to pay the IRS the amount of income and FICA taxes they should have paid or withheld from the "wages" paid to "employees," even though the workers paid their own income and self-employment taxes. In 1978, Congress responded to these complaints by passing a "safe harbor" provision known as Section 530 of the Revenue Act of 1978 ("Section 530"). Section 530 is an uncodified statute (i.e., it is not part of the Code) that was intended to be a short-term solution that would "sun down" or automatically terminate after several years, in order to give Congress time to pass new legislation defining the indications of IC relationships versus employment relationships. Unfortunately, Congress never reached agreement on a more permanent solution, so, instead, Congress removed Section 530's sun down provisions, leaving Section 530 as a regular statute that will be in force until Congress affirmatively removes it from the books.

Very generally, Section 530 provides that even if a worker would be classified as an "employee" under the common law test, the worker may continue to be treated as an IC for tax purposes as long as (i) the employer has consistently treated all individuals holding a substantially similar position as ICs, (ii) the employer provides the appropriate information reports (e.g., Form 1099), and (iii) there is a "reasonable basis" for treating the worker as an IC. Most of the controversy under Section 530 has involved the reasonable basis requirement. The statute provides that the requisite reasonable basis may be provided by a prior audit of the employer, a judicial determination, or a long standing recognized practice of a significant segment of the industry.

In 1986, Congress passed Section 1706 of the Tax Reform Act of 1986, which amended Section 530 by adding a new subsection (d) to Section 530. To this day, computer consultants talk about "Section 1706" when they refer to Section 530 and this area of the law. Section 530(d) provides that the Section 530 will not be available in the case of an individual who, pursuant to an arrangement between the taxpayer and another person, provides services for such other person as an engineer, designer, draftsperson, computer programmer, systems analyst, or similar skilled worker. Although this provision was particularly aimed at "technical services firms" which retain skilled technical personnel and provide technical services to third parties, it is at least arguable that this provision also applies to two-party relationships. In any event, it seems clear that Section 530(d) applies to the majority of computer consulting relationships. Thus, the safe harbor provisions of Section 530 are not applicable to the majority of, if not all, computer consulting business relationships. As a result, there is no safe harbor protection from the IRS targeting WDP, its consultants and clients for audits and other enforcement activity.

There certainly has been a fair amount of lobbying in this area of the law. Several bills have been proposed in the years since the Tax Reform Act of 1986 that would provide the long-awaited definitions of IC and employment relationships, while repealing Section 530. None of these bills has passed, however. In 1996, Congress passed Section 1122 of the Small Business Job Protection Act, which adds a subsection (e) to Section 530. Section 530(e) clarifies some of the safe harbor requirements, and shifts some of the burdens of proof for audits. Unfortunately, Section 530(e) does not affect in any way Section 530(d), which is the exception added for computer consulting services. Thus, the 1996 legislation does nothing to help your industry, which is in the same situation that it has been since Section 530(d) was enacted over ten years ago.

The status quo remains unchanged since 1986. There are no safe harbors available in this area of the law, and no statutory definition of what constitutes an IC relationship or an employment relationship within the computer consulting industry for tax purposes. Instead, the computer consulting industry and its clients are left to rely on the common law definitions of employment and independent contractor relationships.