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We are frequently asked whether it is safe to treat a particular service provider as an independent contractor -- and almost always our answer is "No." Here's why.
What is an Independent Contractor?
The concept of "independent contractor" is first and foremost a concept of tort law. Generally, a person who retains the services of another, but who does not control how the services are performed, is not held liable for any injuries or damages caused by that independent service provider. For example, if your business retains the services of an independent trucker to deliver products to your customers, you should not be liable for any injuries or damage caused by the trucker in the course of delivering your products because you do not control how he carries out his duties. If, on the other hand, you own the trucks and hire and train the drivers of those trucks, you should be liable for their negligent acts -- you have made the delivery of products part of your business.
Independent Contractors and the Tax Code
The concept of "independent contractor" takes on new meaning under the Internal Revenue Code, primarily because of the payroll tax withholding rules. Employers are responsible for payroll tax withholding from employees, but not from independent contractors. (An independent contractors is, by definition, a separate employer.) The Service favors classifying a service provider as an employee rather than an independent contractor because it improves the likelihood of proper payroll tax withholding.
The battle with the IRS over the independent contractor/employee issue has been fought for quite some time. Several tax court cases have listed the factors that determine whether a person is an independent contractor or an employee. Some of the key factors are the amount of control exercised by the employer over the services provided; who supplies the tools; who does the scheduling; who provides specific instructions and training; who hires, supervises and trains assistants; whether regular and recurring services are provided; whether the service provider has his own separate office or business; and whether the service provider performs more than minimal services for others. Unfortunately, evaluation of these factors is a subjective exer- cise, and the IRS and the employer frequently disagree as to the conclusion that should be reached after these factors are considered.
To stem the Service's aggressiveness in re-characterizing independent contractors as employees, Congress enacted Section 530 of the Revenue Act of 1978. That provision states that an employer has a right to treat a person as an independent contractor if it has been the practice of the industry to treat individuals performing such services as independent contractors.
Unfortunately, where the industry practice is clearly to treat certain individuals as independent contractors, the IRS may not agree. In a recent controversy over the status o f emergency room physicians, the Service rejected a study commissioned by the American College of Emergency Physicians that dem- onstrated that the industry practice is to treat emergency room physicians as independent contractors, stating that the employer must prove a "local" stan- dard.
Few taxpayers have been willing to fight for the protection offered by Section 530 because the appeals process is costly. Ironically, as more and more taxpayers settle with the Service, many industry practices have effec- tively been transformed from "independent contractor" to "employee."
The Current State of Affairs
Public comments from IRS officials suggest that the Service is preparing to step up its attacks on independent contractors. The Service's tough public stance and the extraordinarily high cost of fighting the Service over this issue argue against the creation of independent contractor relationships unless the Service has previously ruled in a taxpayer's favor in a very similar situation. If someone insists on contracting with you as an inde- pendent contractor and you are concerned about these tax issues, you should insist that the individual incorporate. It appears that contractual relation- ships with a corporation are less likely to be challenged than contractual relationships with individuals.
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