How the IRS may see it

The comments posted in response to the recent Business Week article "FedEx: They're Employees. No, They're Not" by Michael Orey raise some interesting questions, but they also illustrate some callow assumptions from across the political spectrum.

One poster claims that his company's practice of categorizing employees as independent contractors is legal, in essence, because (1) they make a higher hourly wage as independent contractors and (2) the firm's always done it that way. I don't think I would be alone in suggesting he get a new accountant.

A few posters claim that companies would prefer to outsource every single job, so that the only full-time employee would be the owner. One goes as far to claim that the outsourcing of jobs has undermined the middle class. These are interesting perspectives, but about as focused as I am after a few glasses of wine.

This issue calls for more serious examination. With the IRS intent on auditing thousands more firms in 2010, "targeting Form 1099 independent contractors who should be classified as regular employees," perhaps we should not be shooting from the hip. In short:

• If your company hires independent contractors, seek legal counsel to be sure your firm is in compliance.
  
• If you're an independent contractor who thinks your employer has misclassified you to avoid giving you benefits, spend a little money and get some legal advice.
  

But let's be clear: your opinion and my opinion about what's "right" or "wrong" do not matter. Our workplace anecdotes about a company screwing over workers or an employee who sandbags his or her way all the way to retirement are of little value. We need to consult the law, and a good place to start is the guidelines published by the agency that enforces those laws, the Internal Revenue Service (IRS).

For the 8,929,000 folks like me (Nonagriculture, Self-employed Workers) who labor as independent workers, consultants, and freelancers (October 2009 numbers from the Bureau of Labor Statistics), the IRS provides some guidance on who is self-employed. While this information is helpful, it does not lessen my worries about the an impending train wreck. While I call myself self-employed and pay self-employment taxes, states like Massachusetts and others are jumping into the fray with ideas all their own.

Perhaps it is best if we ground our discussion with the IRS form "Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding," known as Form SS-8 (probably because the abbreviation DWSPFETITW would be particularly unhelpful).

Form SS-8 is divided into five parts, four of which illustrate how the IRS views the relationship between the employer and the worker. Parts II, III, and IV address the three facets of Common Law that are used in "determining whether the person providing service is an employee or an independent contractor":

1. Behavioral Control
2. Financial Control
3. The Type of Relationship

Whether you are a freelancer or an employer, I would suggest you read through the questions on Form SS-8 and the guidance and examples on pages 6-9 of Publication 15-A "Employer's Supplemental Tax Guide."

Then, come back here and comment. This is a discussion we need to have.

A Closer Look at the Massachusetts Law Affecting Freelancers

In 2004, Massachusetts lawmakers amended a labor law to curtail a dubious practice by construction firms that were misclassifying workers as independent contractors. For example, a firm might hire day laborers on a construction site and tell them they'd be payed X dollars per hour as independent contractors. While the word contractor may be a common term in the construction industry, few people are as familiar with the IRS definition of independent contractor, especially laborers who've recently immigrated to this country for job opportunities.

As independent contractors, these workers are not entitled to public and private benefits paid for by employers, such as health insurance and workers compensation. Say that a support beam fell and broke both legs of one of these laborers. Not only would that person be ineligible for medical coverage through his employer, he would also not receive any disability pay. Did such workers know that they needed to provide their own coverage? Who would have informed them?

The crux of the Massachusetts statute is its 3-prong test for determining who is and is not an independent contractor. Let's examine each of the three:

(1) the individual is free from control and direction in connection with the performance of the service, both under his contract for the performance of service and in fact; and

This specification ties directly to a Common Law guideline about how the job is performed. As the IRS site explains it, this determination depends on whether the employer has "the right to control what the worker does and how the worker does his or her job." Here are some questions that might be asked to assess what the IRS calls "behavioral control"

• Who sets the worker's schedule?
• How detailed are the instructions?
• Does the employer control the process by which the work is completed, or is the employer only interested in the finished product?
• Where is the work performed?
• Whose equipment is used?
• Who pays for supplies and services?
• How is the worker trained to perform the work?
  

The second prong of the Massachusetts test is the most problematic one. It attempts to regulate the type of work a firm may lawfully outsource:

(2) the service is performed outside the usual course of the business of the employer; and,

As we have discussed elsewhere in this blog, this prong prohibits accounting firms from outsourcing work to accountants, publishing firms from outsourcing work to indexers, strip clubs from outsourcing work to exotic dancers, and delivery firms from outsourcing work to truck drivers. Any of these firms could hire an interior decorator to give their workplace a makeover as that work would fall "outside the usual course of the business of the employer."

But heaven help us if a company should hire a consultant to contribute to core activities that generate revenue for the company. In theory, this should give businesses pause before they hire professors from the business schools at Babson, Boston College, Boston University, Harvard, MIT, or UMass to do consulting work. Any one of those business professors so engaged could then sue any "entity and the president and treasurer of a corporation and any officer or agent having the management of the corporation or entity." In legal parlance, this is called piercing the corporate veil -- meaning not only would the corporation liable, but its officers would be personally liable as well.

The third prong of the Massachusetts test considers the type of business operated by the worker:

(3) the individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

This final specification would seem to exclude people who work in traditional trades, such as auctioneers, carpenters, electricians, plumbers, and public stenographers. But what authority determines what does and doesn't qualify as an "independently established trade, occupation, profession or business"? For example, self-employed web developers have been around for more than a decade now, but does that qualify? Regardless, we have to turn back to the second prong, which seems to imply that prong three really doesn't matter, because a carpentry firm cannot outsource work to a carpenter, nor can a plumbing firm outsource work to a plumber without offering those workers full-time employment with benefits. In short, the statute provides no guidelines for reconciling conflicts between the type of business and the type of work.

In the existing 3-prong test, all three specifications are applied: prong 1 + prong 2 + prong 3. However, a current bill in the legislature proposes editing one word that would change the test to 2 out of 3: prong 1 + prong 2 OR prong 3. I don't know whether this would be the best solution, but it bears examination. If you are a Massachusetts resident, consider contacting your elected officials to let them know of your interest.

"A trucker, an exotic dancer, and a textbook proofreader walked into a bar..."

Many an apocryphal old joke begins with a priest, a rabbi, and a minister. Like me, you may have heard a mean old alcoholic uncle, since deceased, tell a version in which the players are racial stereotypes. The trope also appears in the playful folk song "Three Men Went A-Hunting," with a none-too-bright Irishman, Scotsman, and Welshman. That's when it's sung by an Englishman, of course.

So it is with some amusement that we find a trucker, an exotic dancer, and a textbook proofreader walking into a bar... no, a legislative debate about "independent contractors" and employment law. I guess a lawyer or politician is telling this joke.

I would like to direct your attention to one section of a legislative alert from Logistics Management from 10/27/2009. Contributing Editor John D. Schulz forecasts that, after the current health care debate in Congress is perhaps concluded -- Is that wishful thinking or what? -- many bills affecting the transportation industry will get legislative attention, among them the "independent contractor or employee" debate.

Robert Digges, deputy general counsel for the American Trucking Associations, said the environment in the political atmosphere "is very treacherous" right now for truckers utilizing independent contractors.

There is activity in at least 23 states concerning misclassification of employees as independent contractors, Digges said. States are concerned over loss of payroll taxes. The unions are an interested third party, as they see independent contractors as a potentially rich area of union organizing.

As independent contractor is described in recent news stories, it relates to a business model used by FedEx, Microsoft, RCN, and other firms which try to lower costs by categorizing a significant proportion of their workforce as independent contractors. The IRS is staffing up to investigate abuses, and, as discussed elsewhere in this blog, Massachusetts legislators amended a law in 2004 to protect workers whose companies were trying to misclassify rightful employees as independent contractors.

The trucking industry relies on some percentage of independent owner-operators to reduce overhead and move freight economically. Strangely enough, strip clubs use a very similar business model, as do book publishers, as do hair salons, and others. If every trucker, exotic dancer, proofreader, and hair stylist required full-time payroll and benefits, the overhead would make many businesses insolvent in short order. For this conclusion, we don't even need to consider skyrocketing health care costs.

At the same time, what percentage of a company's workforce can be made up of independent contractors before the company no longer operates as a company? How do we define a company? What ratio of employees to independent contractors yields the best result -- not just the from the company's P&L perspective but from the divergent perspectives of all its workers? And how does that differ from one industry to the next. Yes, more questions than answers here, but we need to be sure we're asking the right questions -- not saying what we think, but examining how we think about this.

Those of us who work as independent contractors are not all going to agree on what's fair. Some truckers want the independence to work for multiple companies, while others who work solely for one company want to be treated as that company's employees. Some exotic dancers may perform at more than one club, while others don't. The same may be true of freelancers in publishing and hair stylists.

One IRS publication cites three Common Law categories used to examine whether a worker should be an employee or an independent contractor:

1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

One thing Massachusetts gets wrong is when it exceeds these and other IRS guidelines and tries to dictate the type of work that may or may not be outsourced. In order to enforce this statute, the state may need to create a new agency -- next door to the Ministry of Silly Walks -- to categorize the type of work each company does, the type of work each independent contractor does, and make certain that never the twain shall meet. The question, then, is whether the Massachusetts Agency of What Are You Working On (AWAYWO for short) will itself be able to hire independent contractors.

There I go getting snarky, so it must be time to wrap up this post. Let us hope that the debates in the 23 states that are examining the misclassification of employees do not come to 23 different conclusions, like the characters in "Three Men Went A-Hunting":

Three men went a-hunting
And something they did find
They came upon Norton [ed. as in the town of Norton, Mass.]
And that they left behind
The Irishmam said it's Norton
The Scotsman he said nay
The Welshman said it's the end of the world
Let's go back the other way

Of business models and independent contractors

Many company business models have evolved to depend on the outsourcing of work to independent contractors, including Allstate Insurance (news), Microsoft (news), Federal Express (news), Comcast and RCN (news). The simple logic is this: the company's profitability rises as fewer and fewer of its workers are actual employees, therby entitled to workers compensation and other legal benefits.

We may be quite certain Scrooge classified Bob Cratchit as an independent contractor, and that Scrooge's adventures to the past, present, and future, would have been delayed by an IRS audit. Not sure which would be scarier. The IRS guidelines for determining who is an employee, who is an independent contractor, and who is self-employed will be the subject of future posts. But, before we wade into those waters, perhaps we should examine this issue from a perspective of utilitarian ethics.

What responsibilities of an employer to its employees bring the most good to everyone involved? And, visa versa, of course. Actually, that will have to be the subject of a future blog post. For now, let's just consider how that discussion would differ for different types of employers. We might say one thing for IBM, its employees, and the independent contractor Big Blue hires. But what path is both ethical and profitable for a small internet start-up that needs to hire help but lacks cash flow to cover the ever-increasing cost of health care and other benefits?

And what about self-employed white collar stiffs like me, who are supposed to be able to work remotely in this 21st Century, for anyone we choose to? For example, shouldn't I be able to edit a book for a New York publisher and revise copy for a Chattanooga advertising firm? Not according to Massachusetts state law, I can't. That law attempts to protect workers by defining what types of work a company can and cannot outsource.

How else might federal and state laws protect workers who need protection without harming those of us who don't? For example, should the law be about proportions of the workforce rather than the type of work performed? For example, what if FedEx could hire no more than 5% or 10% of its workforce as independent contractors? The IRS site references Common Law practices, one of which is to examine how the work is performed and how much of that process is dictated by the employer. What other strategies might we examine?

Share your "Independent Contractor Misclassification " story here

Have you been adversely affected by the Massachusetts Independent Contractor/Misclassification Law (M.G.L. c. 149, 148B)? The statute makes it nearly impossible for companies to hire independent contractors in Massachusetts unless the outsourced service "is performed outside the usual course of the business of the employer."

Legislators amended this law in 2004 to protect workers whose companies were trying to evade paying unemployment insurance, workers compensation, and other benefits. While their good intentions may help many workers, the language of this statute unintentionally injures two groups:

1. Firms that need to outsource work. Under the law, Massachusetts firms venture out onto thin ice any time they hire a “project employee.”
2. Individuals who work as independent contractors by choice. Why should companies risk hiring independent contractors in Massachusetts when other states have less restrictive laws?

If you are being adversely affected by this Massachusetts statute or legislative activity elsewhere, please add your comments to this blog posting. Thanks.

Who is an independent contractor?

Although the number of independent contractors in the workforce is growing, we are still a minority in the working world’s population. According to the U.S. Bureau of Labor Statistics report Working in the 21st Century:

About 13 million people work under alternative employment arrangements, as independent contractors, temporary help workers, contract workers, or on-call workers.

About 8.6 million of this group identify themselves as independent contractors, sometimes called freelancers.

The bureau’s statistics tell us three things:

1. Roughly one in ten workers is not an employee of the company she works for.
2. Of those, one third are employed by a contract firm (like a programmer) or by a temp agency (like, uh, a temp), or works as an on-call worker (like a substitute teacher).
3. The other two thirds are independent contractors (like the self-employed writer and editor who’s putting a period at the end of this sentence).

About one in 16 workers out there may himself a freelancer. But these are statistics. Let’s put some faces on those statistics. Do you know any people who work as:

• Accountants,
• Advertising copy writers,
• Architects (news),
• Contract lawyers,
• Exotic dancers (news),
• Insurance agents (news),
  
• Stylists in a hair salon,
• Editors or photo researchers in publishing (news),
• Real estate agents, or
• Truck drivers (news)?

Independent contractors are everywhere.

What's wrong with independent contractor laws?

Earlier this year, one of my largest clients, the textbook publisher Pearson Education, which is based in New Jersey, stopped outsourcing editorial work to independent contractors in Massachusetts because of the Massachusetts Independent Contractor Law, (M.G.L. c. 149, 148B). Read the statute here.

The law may have been written to protect workers from unscrupulous businesses that try to minimize their tax burden by misclassifying employees as independent contractors. That way, they avoid paying for employees' disability, healthcare coverage, unemployment benefits, and workers compensation.

However, the law unintentionally injures two parties:

1. Massachusetts firms, both large and small, which cannot respond to changes in demand for their services by outsourcing work to individuals, and
2. All independent professionals in Massachusetts, people like me who have chosen to work as independent contractors.

According to the statute, a law firm can hire an independent contractor to move office furniture but cannot outsource any legal work – without classifying that independent contractor as an employee and therefore entitled to public and private benefits at the expense of the employer. The reason is “prong two” of the 3-prong test established by the law. Prong two requires that an outsourced service "is performed outside the usual course of the business of the employer."

In short, companies avoid hiring independent consultants based in Massachusetts, and Massachusetts companies cannot outsource the work they are in business to perform – without risking litigation.

Too few people in the business community fully comprehend the far-reaching implications this poorly written law. If business owners and independent consultants assume this legislative tornado won’t affect them, they need to think again.