Independent-contractor rules get friendlier - payroll tax laws and regulations

Nation's Business, Dec, 1996 by Peter Weaver

Recent tax law changes, which go into effect Jan. 1, aim to make life easier for small-business owners who use independent contractors--and to make it harder for the Internal Revenue Service to challenge this practice.

Hiring independent contractors (sometimes called free-lancers or consultants) is appealing because they, not their employers, are responsible for their own payroll taxes; there is no withholding. But when workers classified by employers as independent contractors are later determined by the IRS to be employees, it can trigger an avalanche of back taxes, penalties, and interest charges.

Since 1988, the IRS has reclassified independent contractors as employees in 90 percent of the cases it has audited, changing the classification of 483,000 workers and levying $751 million in back taxes and penalties.

Because of the agency's aggressive auditing practices, it's not surprising that this issue was declared the No. 1 concern by those who attended the 1995 White House Conference on Small Business.

In response, Congress in August tilted the playing field slightly toward business with changes included in the Small Business Job Protection Act, signed by President Clinton on Aug. 20. The law shifts the burden of proof to the IRS when the agency questions an employer's classification of a worker as an independent contractor rather than an employee. Previously in such instances, it was the employer's task to prove that the worker was not in fact an employee.

According to a long-standing 20-point IRS test, a person who provides services can be classified as an independent contractor if certain circumstances apply. For example, the person must be free to work for others; must not be subject to the employer's workplace requirements for employees; and should submit invoices on his or her own stationery. Details of the IRS rules are set forth in IRS Publication 15-A, available by calling 1-800-TAXFORM (1-800-829-3676).

Another change in the law governing independent contractors--Section 530 of the Revenue Act of 1978--makes it easier for a business to claim so-called safe-harbor protection by showing that certain types of workers in a particular industry have been widely regarded for many years as independent contractors.

While tax professionals see these changes as beneficial to companies, they don't expect the IRS to pull in its audit horns. "I don't see these changes slowing down IRS auditors," says Steve Mather, a small-business tax attorney with Kajan, Mather and Barish, in Beverly Hills, Calif. "However, if you are audited, having the burden of proof on the IRS side: should make it somewhat easier to defend yourself."

Tax professionals suggest a number of important steps companies should take to reduce their chances of being penalized as the result of an audit. "One of the best things you can do to protect yourself when you hire an independent contractor is draw up a written agreement for both parties to sign," says Michael J. Knight, chairman of the Small Business Taxation Committee of the American Institute of Certified Public Accountants. According to Knight, the agreement should:

* Describe the services to be provided, the duration of the agreement, and the money to be paid to the contractor, with the understanding that there will be no fringe benefits.

* Specify that the contractor is responsible for paying his or her own federal and state taxes.

* Include acknowledgement by the contractor that he or she has complied with applicable business licensing requirements and maintains a set of books and records.

It's also a good idea, Knight says, to get a written opinion from your accountant covering your working relationship with contractors.