Attention training consultants: If you rely on independent contractors to deliver training, make sure you carefully document their employment status. Otherwise, you could wind up playing an expensive game of 20 questions with the IRS.
Frederick Gilbert, president of Frederick Gilbert Associates in Redwood City, California, found that out firsthand. In 1989, his growing company hired self-employed trainers on a per diem basis.
"We consulted three professionals--our company attorney, our CPA, and a tax attorney--and all three advised us that, according to the law, our per diem trainers were independent contractors," he says.
But in 1990, the classification prompted the IRS to audit the company. Eventually, the case was resolved in favor of Frederick Gilbert Associates.
According to IRS spokesperson Janelle Hunter, misclassification of workers--especially part-time and temporary workers--is a "persistent trouble spot." Companies that misclassify workers must pay back taxes plus interest, as well as stiff penalties.
The potential for misclassification increases when the economy lags, explains Marjorie Joder, a tax adviser in Naples, Florida. That's because employers hire more part-time and temporary workers and misclassify them--either willfully or out of ignorance--as less-costly independent contractors. Employers do not have to file payroll taxes for independent contractors, as they do for employees. The "savings" that employers realize from misclassifying workers gives them an unfair advantage over competitors who absorb the costs of properly classified workers, Joder notes. Also, many workers classified as independent contractors do not understand their tax obligations; later they discover they cannot collect unemployment compensation or Social Security because no money was paid into the system.
Employers have no straightforward test available to determine whether a worker is an employee or an independent contractor. The IRS relies on 20 common-law standards--often put to employers as questions--to determine a worker's status. Cumulatively, the questions supposedly enable an employer to answer the overriding question: How much control does the firm exercise over the worker? But each common-law standard is interpreted differently and carries a different weight in different cases. What constitutes control also varies, by custom, from industry to industry.
"In legal parlance, it's a facts-and-circumstances test, not a bright-light test," says Robert L. Sommers, a San Francisco based attorney who represented Frederick Gilbert Associates.
Don't expect clearer guidance any time soon. Bills have been introduced in Congress to address the confusion legislatively, but they sit on a back burner as Congress deals with more pressing tax issues. For the same reason, the Treasury Department has not proposed regulations to clarify worker classification, says Joder, who served on an IRS advisory committee that studied the issue.
The Gilbert case is apparently the first in which the agency investigated a training company's classification of workers, but it's unlikely to be the last. According to Joder, the IRS in recent years has taken a market-segment approach to business audits; the agency trains agents to conduct audits in certain industries.
The customary practices of the training industry proved to be a key element in attorney Sommers's successful, three-pronged defense of Gilbert Associates. Sommers relied on section 530 of the Revenue Act of 1978, which asserts that the IRS cannot challenge an employer for classifying workers as independent contractors if the employer has a reasonable basis for doing so.
According to section 530, employers have a reasonable basis for classifying workers as independent contractors under any of the following circumstances:
* A previous IRS audit of the company did not dispute worker classifications, or settled such a dispute in favor of the company. …