USING A CORPORATION TO WIN THE INDEPENDENT CONTRACTOR TAX BATTLE

by

Adam Starchild

In evaluating the facts of each case, the IRS uses a list of twenty factors or criteria to judge whether a given worker is an "employee" or an "independent contractor." A violation of any one of these highly subjective rules allows the IRS to reclassify a worker from the status of independent contractor to that of employee.

The essential test is whether management has the right to supervise and control the manner and means of work done by an individual. The employer need not actually exercise this power; it is enough that he or she has the right to do so. If so, the IRS says the worker is an "employee." If a worker clearly controls his or her own work methods, works for multiple employers, sets his own hours, is liable to suffer loses or make a profit and provides his or her own equipment, the IRS will usually concede this person to be an independent contractor.

On the other hand, an "employee" usually must comply with the boss's instructions, renders personal service, works at his employer's place of business and uses tools or equipment the employer provides. He also can be fired or quit at any time. Another difference: an injured "employee" is covered by statutory workman's compensation laws, but an "independent contractor" is not.

A true independent contractor controls his or her own hours worked and is paid when a product is finished, not by an hourly wage. The client cannot dictate how a contractor reaches a final result and his only legitimate concern is the quality and timeliness of the product. The independent needs more than just one client. Working 90 percent of the time for a former employer is sure to support an IRS finding of an employment relationship.

The independent must have home or other office removed from an employer's business premises and pay for his or her own office supplies and equipment. A written contract covering all these points is essential and may be accomplished by a simple "letter of agreement" outlining the product to be delivered, the due date, and the fee to be paid by the client.

The distinction between these two worker groups is important because the status of a worker defines his or her rights and remedies in various situations, including, most importantly for the IRS, whose obligation it is to pay unemployment, income withholding and Social Security taxes. An independent contractor is responsible for filing and paying his or her own taxes, whereas the employer must do this on behalf of an employee.

Because tax revenue is at stake, the IRS constantly checks business firms to see whether workers listed as independent contractors should really be treated as employees. The tax treatment of the two groups is quite different. The IRS prefers to collect taxes on employees from companies because employers are seen as more efficient and reliable taxpayers and easier to control, compared to independent contractors who are on their own and virtually unchecked (and uncheckable) by the IRS.

Rather than trying to reclassify millions of independent contractors one by one, the IRS takes the easier route of attacking the employment status of workers for the thousands of companies who employ independent contractors.

From 1988 to 1994, the IRS conducted 11,400 audits of firms forcing the reclassification of nearly 500,000 as employees rather than independent contractors, producing an additional $751 million in payroll taxes and penalties. Studies show that IRS rulings support "employee" status 90 percent of the time. The IRS is no respecter of size. Audits range from International Business Machines, Inc. (IBM), right down to the "mom and pop" enterprises.

Special targets have been truckers, florists, travel agents, computer programmers and even ministers of the faith.

Here's some 1995 cases reported in the media: Texas A&M College admitted it had paid 400 farm workers as independent contractors when they were in reality employees. The college was socked with $86,000 in back taxes. A New York City travel agency, Pisa Brothers Travel, had to pay $274,000 after agents were ruled to be workers. Paddock Publications, Inc. of Arlington Heights, Ill. is fighting a $5.6 million retroactive assessment based on reclassification of 1,500 newspaper employees including delivery men. That amount includes a $1 million fine. The company, operating on a small profit margin, says it will have to file bankruptcy if the IRS persists.

Businesses suddenly found to have retroactive liability for "employees" treated as independent contractors face enormous dollar amounts for withholding, Social Security and other taxes, sometimes going back for many years. In IBM's case, as far back as 1986.

Whatever the tax problems faced by employers who hire "independent contractors," for the independent contractor himself his status does reduces taxes indirectly because of the ability to deduct from gross income all legitimate business expenses including personal and fringe benefits.

Of great importance, you should know that an independent contractor doing business as a corporation stands the lowest risk of being audited by the IRS. The major reason for this interesting statistic we explained a moment ago; the IRS is much more likely to audit a payor firm where it has the possibility of reclassifying as "employees" a large number of workers supposedly operating as "independent contractors." That approach gives the IRS lots of back taxes and penalties. An audit at the level of the payee/worker would catch only one worker in reclassification, a waste of time and energy from the IRS viewpoint.

Independent contractors receive a Form 1099 at the end of the year. Like the W2, this form reports to the IRS the amounts paid, but in the case of the report on 1099 there is no tax withheld.

Form 1099 is required for payments over $600 per year, to individuals, partnerships, and other unincorporated entities. Certainly, receiving only one Form 1099 would bolster an IRS argument that an individual was an employee rather than an independent contractor -- so it is important to develop a variety of income sources (in addition to the good business sense of diversifying one's income).

There is no Form 1099 filed for payments to corporations, and as a practical matter this helps the incorporated independent contractor step aside from the entire independent contractor vs. employee debate. A corporation, by definition, cannot be an employee. And the fact that no Form 1099 even appears in the IRS computer next to the individual's name keeps one from even being swept into a random sampling of independent contractors for audit.

For information on forming a corporation in any state, a highly recommended incorporating service is Inc. Plan USA.

Adam Starchild has written over a dozen books and hundreds of magazine articles. Recently published by Paladin Press is his Reviving The American Dream: Stop "Just Getting By" and Build Real Wealth.

More information is available on Asset Protection & Becoming Judgment Proof, and on home businesses at Stop "Just Getting By" and Build Real Wealth.