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Behind the News: A Problem with Our Tax CodeCWS 30 March 2.6

Contingent Workforce Strategies 30

In mid-February, a plane crashed intentionally into the Internal Revenue Service's office in Austin, Texas. The pilot's suicide note indicated his disturbed mind and the pointlessness of the crash. But in his note, there was a reference to a federal tax law, Section 1706 of the 1986 Tax Reform Act. The pilot, Andrew Joseph Stack III, declared that provision essentially to have ruined his career.

What is that provision referring to? Americans undertake jobs as either employees or as contingents. Under the contingent category are temporary workers and independent contractors (ICs). The common law test used by the IRS to determine IC status is tricky and subjective and often is applied years after a worker is hired, during an audit of the company, regardless of whether the worker has fully paid his taxes.

This led the Congress to adopt a "safe haven" rule under Section 530 of the 1978 Revenue Act. Under this rule, if a company has a reasonable basis to treat a worker as self employed, has filed IRS form 1099 (if required) to report its payment to the worker and has consistently treated similar workers the same way, then the company would not be subject to pay more taxes.

The 1980s saw a plethora of self-employed IT workers. These professionals were ambitious, looking to expand their businesses and were willing to forego employer-provided benefits. These workers were hired by staffing firms that placed them at clients as independent contractors. Then in 1986, Congress changed its mind and rescinded the safe haven status of such workers by passing a new law, Section 1706, which singled out the I.T. staffing industry. The IRS then followed by auditing staffing firms. As a result, many high-tech firms across the country stopped using self-employed workers. Self-employed IT workers suffered.

The rationale for passing Section 1706 was that the government would regain tax revenue that it was losing from self-employed workers who allegedly were not paying their taxes. It was also claimed that few of these workers would qualify as self-employed under the common law test, so it was argued that the safe haven should be eliminated for them.

Over the years, there have been several studies dismissing the factual and legal grounds asserted for the law, but it remains. Here's what changed. "Self-employed workers started incorporating their businesses," says Harvey J. Shulman, a tax and employment lawyer in Washington D.C. "The IRS tended to view someone who had a corporation as more of a valid business than someone who was a sole proprietor," he says.

"Ironically, when you incorporate your business the tax code does not require the person who pays your corporation to issue a 1099," says Shulman. Companies that hire incorporated consultants in any industry don't issue 1099s because legally they are not required to do. By contrast, sole proprietors, partnerships and limited liability companies (LLCs) get form 1099 from the company that pays them and they send a copy of the form to the IRS.

Dealing with Section 1706 issues posed a whole new set of problems for the IRS. Earlier if a company used many consultants who were self employed and issued 1099s for them, the IRS knew about it and could investigate if needed, says Shulman. But once sole proprietors began incorporating and no 1099s were issued, then the IRS remained in the dark. The agency could not keep track receipt of income. "Section 1706 drove ICs to incorporate as legitimate businesses, but what did the IRS gain"?, asked Shulman.

Fast forward to today. Independent contractor compliance enforcement is on top of people's minds. Addressing the issue is proposed legislation by then-Senator Obama as well as a random audit program conducted by the IRS. The government is cracking down on companies that use contractors in an effort to crack down on misclassifying employees and collect on back taxes. And Section 1706 still remains as a law that penalizes only one industry.

Stack's action is indefensible and one cannot condone it. But it doesn't change the fact that there are serious problems in our tax code, leaving companies at serious risk if they misclassify workers as independent contractors.


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