Shaky declaration of independence - dispute with IRS over employee independent contractor status costs man his logging business, but the White House Conference on Small Business fights to help others - WHCSB - includes the Safe-harbor Protection rules and the list of 20-test

Nation's Business, Dec, 1995 by Robert T Gray

Federal penalties for misclassifying service providers as independent contractors rather than employees can crush a firm. Demands are rising for Congress to establish a clear-cut standard.

Billie Vester Rasbury built a very successful business in a very tough industry--logging.

But he later wound up living in an abandoned school bus until he managed to md work repairing refrigerators part time.

His troubles began when the Internal Revenue Service accused him of misclassifying employees as independent contractors while he was running his business. It eventually demanded more than $200,000 as retroactive payment of taxes the agency said he should have withheld, plus other levies.

Two federal courts said the IRS was wrong, and the government backed off on further appeal. "The IRS lost about every way it could lose," an appeals court said of a lower-court decision.

But that didn't save Rasbury's business. His experience is just one of many similar ones that show why the federal government's way of determining whether a worker is an independent contractor or an employee is now officially the No. 1 concern of small business.

Rasbury's company, Bill's Forestry Service of Fayette, Ala., was a logging contractor for big wood-products companies, delivering logs to their local processing plants at a set price per ton. Operating under established practice in the industry, Rasbury contracted with workers to cut the trees and paid them a per-ton rate. As independent contractors, those workers assumed the responsibility for paying income, Social Security, and other payroll taxes.

In 1989, however, an IRS agent held that the workers were employees, not independent contractors. Bill's Forestry received an IRS bill for $161,502.69 for allegedly unpaid taxes, a sum that the agency later raised to $211,776.

At that point, the IRS actually did not know if the workers had paid the taxes. It told Rasbury that he could reduce his tax liability by having individual crew members sign IRS Form 4669, a declaration that they had paid taxes on the payments they had received from Rasbury's company.

Rasbury collected the signed forms from 94 percent of the crew members, but the IRS countered that several of the forms were untruthful.

For a time during the controversy with the IRS, Rasbury tried to operate as an employer, paying the workers as employees, but the added costs proved more than he could handle in a highly competitive field, and he eventually went out of business.

Later, a federal bankruptcy court, upheld by a U.S. District Court, found that the loggers had been independent contractors under the two principal standards in use today--the 20-part common-law test used by the IRS in determining whether a worker is an employee, and a "safe harbor" law that can shield companies from IRS demands for back employment taxes if the firms have met certain qualifications. (See the box on Page 28 for details on the 20-point test and the safe-harbor law.)

Although the IRS lost the case, Billie Vester Rasbury didn't win. "He lost it all--his business and his dignity," says his lawyer, Bruce P. Ely of the Tuscaloosa, Ala., firm of Tanner & Guinn.

Cases such as Rasbury's are behind a new drive to achieve something that has eluded Congress and the IRS for at least 60 years--a clear-cut standard for determining whether a person providing services is an independent contractor or an employee.

The issue's growing importance to small business was dramatically spot-lighted in June when the White House Conference on Small Business put it at the top of its list of recommended policy changes for improving the nation's entrepreneurial environment. "The definition of an independent contractor must be clarified," the conference report said. "Congress should recognize the legitimacy of an independent contractor."

The conference's delegates, who were chosen by their small-business peers in every state and whose conclusions are viewed as a major statement by entrepreneurial America, called for the following changes in federal policy for determining whether a worker is an independent contractor or an employee:

* A narrower, more objective test than the 20-factor standard that is now a principal tool in determining whether an employer/employee relationship exists. (The test, based on common law, was compiled in 1935 to differentiate between employees and independent contractors for purposes of collecting Social Security taxes.)

* A bar against IRS demands for back taxes when Form 1099 has been filed and there is no evidence of fraud. (The form notifies both an independent contractor and the IRS of the amount of payments a company has made to that contractor in the previous year.)

* Permission for arrangements to let companies and independent contractors join in training workers and to let independent contractors use major specialized tools provided by the company. (Under present policy, worker training and worker use of company resources are considered strong evidence of employee status.)