What to Do About Contractor Classification Laws

By D. Jeffrey Craven

Originally published in the February / March 2012 Edition of Hardwood Floors Magazine.

Since 2009, Democrats in Congress along with the Obama Administration—looking for a way to capture more tax revenue—have been attempting to repeal or modify Section 530 of the Revenue Act of 1978. Essentially, Section 530 provides a “safe harbor” that says if a company consistently treats a person as an independent contractor, there is a “reasonable basis” for such treatment, and if the company is consistent in its reporting (e.g., issuance of 1099s) as to that person, then that person should not be deemed an employee. Section 530 is considered a “loophole,” and its repeal would be one way to obtain significantly more tax revenues without having to actually raise taxes—a “win-win” for politicians.

“So what?” you may ask. Well, for many small businesses in the building industry, including wood flooring businesses, this change could substantially impact your pocketbook. Many businesses hire independent contractors as needed to cover their workload. There is a significant savings in not having to pay the employee burden; this way, you’re not responsible for withholding and paying employer payroll taxes. What’s more, when a business hires independent contractors, it retains the flexibility of having workers available without its staff count ballooning.

Employee or Contractor?

Figuring out whether a worker is legally an independent contractor or an employee isn’t easy. There is no clear statute or revenue code defining what qualifies a person as an independent contractor. Instead, there is a body of law developed from cases over centuries that sets criteria to consider in order to determine that status. There is no bright line.

Also, certain industries vary in their treatment of workers. As already stated, the building industry frequently treats its workers as independent contractors. However, there isn’t absolute consistency, even among contractors in the same industry (e.g., flooring contractors). Section 530 allowed for this variance by creating a safe harbor: the “reasonableness” factor.

Under Section 530, factors that could be considered in determining whether a business was reasonable in its treatment of a person as an independent contractor include: prior court determinations, published rulings, a letter from the IRS to the company, prior IRS audits of the company where there was no assessment or penalty issued for treating similar persons as independent contractors, reliance upon a legal opinion from a lawyer hired by the company, and long-standing industry practice.

It is because of the difficulty in determining classification that this code section was created, and for the last 15 years it has been liberally construed by the IRS to give the “benefit of the doubt” to businesses. Further, where the IRS had determined that a business had been misclassified, it had a settlement practice that basically let the business avoid penalty for the prior misclassification if it agreed to reclassify the worker as an employee going forward.

Changes Coming?

Some of the changes proposed in the last couple of years would eliminate most of these “reasonableness” factors and put the burden on the business to show by “a preponderance of the evidence” that it is entitled to relief from treatment of the person as an employee. Other proposed changes would give the IRS greater ability to reclassify workers and eliminate the employer’s ability to rely upon industry practice. Still others created stiff penalties for misclassification. Under the Obama administration’s proposal made earlier this year, the IRS would be permitted to issue guidance on proper classification of workers (something it hadn’t been able to do previously), and states would be given incentives to eliminate “worker misclassifications.”

Reducing the number of independent contractors is very alluring to a Congress and administration desperate to raise revenues and avoid cutting programs. The Department of Labor estimated the Obama proposal would raise $7 billion over 10 years. While technically these changes would not be considered “raising taxes,” the impact on small businesses that rely on independent contractors would be profound. Think about it: What if you lacked the flexibility to bolster your workforce with independent contractors when you want to take on big jobs? Or what if your hands were tied when you needed to bolster your crew in order to get a particular job done quicker than expected?

If your ability to take on independent contractors is hampered, you could be faced with slower job progress. And, as a result, slower progress means fewer jobs overall. What’s more, rolling back your ability to hire independent contractors means you’d probably have to hire more workers, which would cause an increase in wages and payroll taxes. Your business could suffer.

So far these proposals have not been enacted, but businesses that use independent contractors should remain vigilant. While still a senator, President Obama was the sponsor of one of the bills to change this section, and he proposed changes again as part of his administration’s 2011 budget.

What should a contractor do? Have your business structure reviewed by an accountant. Obtain an opinion from a tax lawyer that your workers meet the legal requirement to be considered independent contractors. Doing these things may help in the event of a change in the law. More important than protecting against a change in the law is to keep abreast of proposed changes and to be involved in an industry organization that will help protect modification of the law.