Distinguishing Between Independent Contractors and Employees

Before a business entity pays for services rendered, it should consider this: Is it paying a contractor or has it hired an employee? This question arises every time a business pays a person for services rendered. At times the answer is clear, but often the minute details will present a challenge to the small business owner when classifying the service provider.

When expanding its workforce, a business will either hire an employee or retain an independent contractor. To categorize the “new addition,” consider the relationship between the business (payer) and the individual (payee): Who holds the “right to control”?

The worker’s classification is determined by analyzing three factors:

1. Behavioral control is ascertained by determining which party retains the rights to control where, when, and how a job should be done.
2. Financial control considers the business aspects of the relationship, including which party bears the financial risk, how the payment is structured, and whether or not the worker can realize gain or loss.
3. The type of relationship between the parties is defined by written agreements, contracts, benefit structure, expected time line and recurrence of such agreements, and the relationship of the services rendered to the nature of the business.

The IRS developed a 20-point guide that describes the ideal circumstances under which a worker is an independent contractor (see Rev. Rul. 87-41). The Service also provides a safe harbor to exempt a worker or business from the “20 questions.” To qualify for the safe harbor, the business (1) must have consistently treated others on the workforce (of similar type) as independent contractors, (2) must have filed all necessary forms, and (3) must have reasonable basis in historical rulings, case law, or common practice in the specific industry (Rev. Proc. 85-18).

It is important that each worker is classified correctly so that the business complies with its income and employment tax obligations. The business must withhold employees’ income, Social Security, and Medicare taxes (Secs. 3402(a) and 3102(a)). The business usually does not have these obligations to independent contractors.

The following example illustrates some of the issues surrounding the determination of independent contractor status.

Example: C is a certification company that attests whether companies comply with required industry guidelines. C employs approximately 100 administrative and permanent employees and contracts hundreds of individuals worldwide to inspect certification-seeking companies. C trains these inspectors to examine production and processing plants using a set of guidelines and procedures. An inspector must be present for each certified batch that a manufacturer produces in order to confirm compliance. C pays these inspectors on an hourly basis; they are paid a higher rate for days longer than 10 hours. C treats these inspectors as independent contractors.

Under these circumstances, the inspectors might be viewed as employees for tax purposes, because they follow guidelines and schedules provided by C (behavioral control), receive extra payment for working overtime (financial control), and perform the primary function of C’s business (relationship of the services rendered to the nature of the business).

C contracts with the inspectors and treats them as independent contractors just as a homeowner might contract with an electrician. The customer (C or the homeowner) defines the desired end result but does not dictate how it should be achieved. The contractor (inspector or electrician) then follows industry guidelines to perform the necessary procedures to accomplish the task. C allows inspectors to implement the guidelines however they wish and does not dictate their work schedule. The inspectors are drawn from a pool of qualified professionals, and the manufacturers must coordinate with an individual inspector for each certified batch. The inspector then has the right to determine his or her working hours and may refuse any request. C is not involved in this process until the end, when the inspector submits the post-examination report (behavioral control).

C acts as a middleman for all payments in order to maintain the inspectors’ independence so that reports are not biased (due to direct payment from manufacturers). Because every inspection has different requirements, the inspector can charge a variable rate, based on the complexity of the work required. Even though the monies go through C, the inspector bears the ultimate financial risk; if the manufacturer does not pay C, the inspector does not get paid. Ultimately, the inspector is contracted by the manufacturer, and C is simply the certifying parent (financial control).

C’s line of business is certification, not inspection. Inspectors visit manufacturing plants and send in factual reports. Much like court stenographers, who record courtroom proceedings but do not explain them, inspectors report facts about manufacturing plants and production to C but do not render an opinion as to the compliance of the manufacturer. C’s administrators then analyze the inspectors’ reports and use them to furnish an opinion. Since certification-seeking manufacturers are globally dispersed and their schedules can be sporadic, C uses freelance inspectors. For each inspection, there is a separate contract. C does not control the inspectors’ vacation schedules, cannot prevent them from working for C’s competitors, and cannot force an inspector to take a job. Inspectors maintain control of their own schedules and choose their own contracts (type of relationship between the parties).

In this case, the inspectors control the methods through which they implement industry standard guidelines for their inspections, compensation, and work schedule. They retain behavioral and financial control while they perform a service that facilitates C’s business purpose but does not explicitly perform it. These inspectors are actually independent of C and so are considered independent contractors.

From Rivka Bier, CPA, Ellin & Tucker, Chartered, Baltimore, MD

New Rules Govern Practice Before the IRS

The highly publicized accounting scandals of 2002, such as Enron, WorldCom, and Global Crossing, along with revelations about tax shelter abuses, have had wide-reaching financial effects on investors and the economy. Actions of some unscrupulous tax return preparers have further exacerbated the problem. In response, stricter controls and additional guidance for tax practitioners were issued during 2007, including Notice 2007-39 and the Small Business and Work Opportunity Tax Act of 2007, P. L. 110-28 (SBWOTA). Higher standards will be required in taking tax return positions, and significantly higher penalties will apply to a much broader range of return types. These standards and penalties apply to all paid tax return preparers, including attorneys, CPAs, enrolled agents, and all others who prepare tax returns for a fee.

Regulation of Practitioners Prior to 2007

The Secretary of the Treasury is authorized, under 31 USC Section 330, to regulate practice before the Treasury Department. Those regulations were published in 31 CFR, Subtitle A, Part 10, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers Before the Internal Revenue Service (Circular 230), which regulates practice before the IRS. The provisions of Circular 230 are administered by the IRS Office of Professional Responsibility.

Treasury decisions: TD 9165 adopted proposed regulations (REG-122379-02) on December 20, 2004. The preamble to the proposed regulations states:

The tax system is best served when the public has confidence in the honesty and integrity of the professionals providing tax advice. To restore, promote, and maintain the public’s confidence in those individuals and firms, these final regulations set forth best practices applicable to all tax advisors. These regulations also provide mandatory requirements for practitioners who provide covered opinions. The scope of these regulations is limited to practice before the IRS.

TD 9201 provided additional clarification of TD 9165, effective May 19, 2005.

Circular 230: The current version of Circular 230 has been updated to reflect changes made by the American Jobs Creation Act of 2004, P. L. 108-357 (AJCA). Subpart B of Circular 230 contains information on the duties and restrictions that relate to practice before the IRS, including guidance on knowledge of a client’s noncompliance, error, or omission (Section 10.21) and with respect to tax return positions (Section 10.34). Section 10.34(a) explains the “realistic possibility standard” that was in effect until the enactment of the SBWOTA, discussed later in this item. Section 10.34(b) requires that a practitioner who advises on a tax return position or who prepares or signs a return as the preparer must inform the client of (1) the penalties reasonably likely to apply to the client for taking that position, (2) any opportunity to avoid those penalties by disclosure, if relevant, and (3) the requirements for adequate disclosure.

On February 8, 2006, the IRS issued proposed regulations containing revisions to Circular 230 (REG-122380-02). Areas targeted in the proposed regulations include enrollment procedures, unenrolled return preparers, contingent fees, standards for advice on documents submitted to the IRS, sanctions, and incompetence or disreputable conduct, among others. These proposed regulations also seek to incorporate the final regulations relating to best practices, covered opinions, and other written advice from both TD 9165 and TD 9201. To date, these proposed regulations have not been finalized.

FIN 48: Financial Accounting Standards Board Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, requires taxpayers to recognize, measure, and report uncertain tax positions on their financial statements for fiscal years beginning after December 15, 2006. On April 12, 2007, IRS Large and Mid-Size Business (LMSB) Division Commissioner Deborah Nolan, in a speech at a District of Columbia Bar Taxation Section forum, informed practitioners that the Service will be reviewing taxpayers’ FIN 48 disclosures during IRS examinations. She also stated that the Service is considering possible changes to its current “policy of restraint” (which as of July 2007 is still in effect). According to Robert Adams, senior adviser to Nolan (speaking at a July 2007 Tax Council Policy Institute panel), the IRS is training its examiners on the use of the new FIN 48 disclosures to be used as part of the audit process, along with publicly available SEC correspondence on those disclosures, and has stated that the FIN 48 disclosures are the “centerpiece of our revenue agent training this year.” Further, the Chief Counsel’s Office determined in June 2007 that documentation related to FIN 48 will fall under the definition of “tax accrual workpapers” under IRM 4.10.20.2(2) (AM 2007-0012, 6/8/07).

2007 Tax Legislation and Treasury Guidance

Notice 2007-39: Notice 2007-39 was issued on May 14, 2007, to provide additional guidance on monetary penalties that may be assessed under 31 USC Section 330 and in accordance with Section 822 of the AJCA for prohibited conduct (within the meaning of Circular 230, Section 10.52) that occurs after October 22, 2004. Notice 2007-39 also states that these penalties “may be imposed in addition to, or in lieu of, any suspension, disbarment, or censure of the practitioner” and that the penalties are not to be used as a “‘bargaining point’” to avoid these nonmonetary sanctions.

The amount of these penalties is limited to the gross income to be obtained from the “prohibited conduct” engagement, whether this is for a single act or a pattern of misconduct. Notice 2007-39 defines gross income as the “collective gross income derived by the practitioner and the employer, firm, or other entity in connection with such prohibited conduct.” If this prohibited conduct is included as part of a larger engagement, the gross income amount applies to the fees from the larger engagement. Penalties will be assessed against the employer, firm, or other entity (the EFO)—in addition to the practitioner—if it can be shown that the practitioner acted on behalf of the EFO and that the EFO knew (or reasonably should have known) of the prohibited conduct. Support for this includes proof of an agency relationship, provision of services under the agency relationship in connection with practice before the IRS, and prohibited conduct occurring in connection with that agency relationship. Furthermore, Notice 2007-39 explains that the EFO knows or reasonably should know of the prohibited conduct if (1) any officers or members of the EFO’s principal management know or have “information from which a person with similar experience and background would reasonably know, of the prohibited conduct”; (2) the EFO, “through willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate or ascertain) did not take reasonable steps to ensure compliance with Circular 230”; and (3) at least one individual associated with the EFO “engages in prohibited conduct within the meaning of section 10.52 of Circular 230 that harms a client, the public, or tax administration, or exhibits a pattern or practice of failing to comply with Circular 230.” Notice 2007-39 provides two examples of these provisions.

SBWOTA: The provisions of the SBWOTA further regulate practitioners (see SBWOTA, Section 8246) for returns prepared after May 25, 2007. Some transitional relief has since been provided; this will be discussed in detail later in this item. The new legislation expands the scope of the preparer penalties to include employment, estate, excise, exempt organization, gift, and income tax returns by striking out the term “income” in describing tax return preparers and return types in Sec. 7701(a)(36). Conforming amendments have also been made to other sections of the Code in the 6000 series, along with Secs. 7407 and 7427, to replace the term “income tax return preparer” with “tax return preparer.” Other key changes include revisions to the definition of return preparers, new standards of conduct for positions taken on tax returns, and increases in the penalties that may be imposed.

The “realistic possibility” standard in Circular 230, Section 10.34(a) (discussed above), has now been replaced by new standards of conduct for positions taken. The old “realistic possibility” standard applied to (1) a person knowledgeable in tax law, (2) using a reasonable and well-informed analysis of the law and facts, (3) in which the position had at least a one-in-three likelihood of being sustained, and (4) that was unrelated to the possibility that the tax return would be audited or reviewed upon audit. The new thresholds are significantly more stringent and are to be applied to both undisclosed and disclosed positions. The new threshold for undisclosed positions is the “more likely than not” (MLTN) standard; this means that the position must have a greater than 50% likelihood of being sustained. For disclosed positions, there must be a reasonable basis for the tax treatment; this replaces the “not frivolous” standard. Disclosures required under Sec. 6694(a) continue to be adequate if they are made on either Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, and are attached to the return, amended return, or refund claim or are filed in accordance with the annual revenue procedure authorized in Regs. Secs. 1.6694-2(c)(3) and 1.6662-4(f)(2). It should be noted that the “reasonable cause” and “good faith” exceptions still apply to penalties that could potentially be imposed under Sec. 6694(a).

Penalty amounts under Sec. 6694 have increased significantly. For undisclosed positions in which there is an understatement due to unreasonable positions (Sec. 6694(a)), the $250 penalty has been replaced by a minimum penalty of $1,000, up to a maximum penalty equal to 50% of the fees for preparing the return or refund claim. The “willful or reckless conduct” penalty for disclosed positions under Sec. 6694(b), formerly $1,000, is now at least $5,000 but can be as much as 50% of the fees for preparing the return or refund claim. In either case, the 50%-of-fees penalty applies even if those fees have not yet been collected.

Transitional relief—Notice 2007-54: In response to discussions and correspondence from the AICPA, as well as other concerned parties, the IRS issued Notice 2007-54 on June 11, 2007 (effective May 25, 2007), granting transitional penalty relief “with respect to the new standards of conduct [emphasis added] under section 6694(a).” This transitional relief for the standards of conduct applies to all returns, amended returns, and refund claims due on or before December 31, 2007, including those on extension; estimated tax returns due on or before January 15, 2008; and 2007 employment and excise tax returns due on or before January 31, 2008. No transitional relief applies under Sec. 6694(b) because transitional relief is not appropriate for return preparers who exhibit willful or reckless conduct, regardless of the type of return prepared. It is important to note that the amount of the penalties under Secs. 6694(a) and (b) increased, along with the types of returns subject to those penalties, effective May 25, 2007. The exhibit summarizes the changes and effective dates.

Taxpayer Protection and Assistance Act of 2007: Pending legislation for 2007 that could potentially affect practice before the IRS includes the Taxpayer Protection and Assistance Act of 2007 (S. 1219). This legislation includes provisions that (1) would allow enrolled agents licensed to practice before the IRS to use the designation “EA”; (2) regulate and test paid income tax preparers; (3) contract for the development or administration of examinations for paid income tax preparers; and (4) require the registration of refund anticipation loan facilitators.

Implications of the Tax Legislation

The practitioners’ standard for undisclosed positions (more likely than not) will now be higher than the taxpayers’ standard (substantial authority). The imposition of higher penalty thresholds linked to engagement fees, along with the more stringent standards of conduct for tax return positions taken, will require additional due diligence in tax research and supporting tax positions taken. The MLTN standard is significantly more restrictive than the former one-in-three likelihood standard. Tax practitioners will spend more time on tax engagements in order to obtain the level of documentation that they need to support the MLTN threshold. As a result, tax planning and tax compliance projects will become costlier to clients.

These tax law changes will require revision of numerous documents, including the Statements on Standards for Tax Services (SSTS) No. 1 (on tax return positions); SSTS Interpretation 1-1 (on the realistic possibility standard); Regs. Secs. 301.7701-15 and 1.6694-0 through -4; Circular 230; and various IRS forms and publications.

Summary

The new penalty amounts under Secs. 6694(a) and (b) increased on May 25, 2007. As of that date, more types of returns became subject to the Sec. 6694 penalties; these include employment, estate, excise, exempt organization, gift, and income tax returns. Beginning in January 2008, the new standards of conduct created by the SBWOTA will go into effect. For undisclosed positions, the MLTN standard will apply. In contrast, there must be a reasonable basis for the tax treatment of disclosed positions. Higher standards will require additional due diligence, including the evaluation of FIN 48 disclosures on financial statements, thereby affecting the time spent on engagements and increasing costs to clients. Provisions of upcoming legislation indicate that further oversight and additional regulation of tax return preparers is likely.

From Susan G. Messier, CPA, Bloom, Gettis & Habib, P.A., Miami, FL