Does this sound familiar? It should. It happens all the time.

Of course, if one could choose how to classify workers, there would be many more independent contractors instead of employees. So why are most workers employees?

The simple answer is that we don’t really have the choice.

The Internal Revenue Service has issued guidelines to help workers and hirers determine the proper classification. Traditionally, the criteria for making this decision could be found in IRS Revenue Ruling 87-41, 1987-1 CB 296, where twenty factors indicating employer-employee relationship are listed. IRS cautioned that all of the factors must be considered as no individual factor is conclusive.

That Revenue Ruling was issued in 1987. Since then, IRS realized that times have changed, as have traditional employment relationships. Although the basic concepts have not been altered, IRS eliminated or modified some of the factors of Revenue Ruling 87-41, 1987-1 CB 296 to reflect current trends. We now refer to Publication 1779 too see what IRS uses for its guidelines.

In creating Publication 1779, IRS tried to simplify what has been a difficult issue for a long time. It points to decisions made in tax court cases over the years. Again, IRS warns that no single fact is conclusive; you must consider all of the relevant facts of each relationship. However, the worker and the hirer can rely on these concepts:

• If the relationship gives the hiring organization the right to provide the worker with instructions, training, assistance, supplies and/or tools in order to complete the job, then it is more likely that the relationship should be considered employer-employee.
  
  
  • Rationale: A clearly independent contractor, such as your attorney, accountant or electrician, requires no such instruction or training, since he/she relies on professional skills to which you can provide no greater authority or knowledge. Furthermore, the contractor usually performs much of the work either in a separate office or without the assistance of your staff.
    
    
• If the worker has invested significant money in his/her business, is at risk for its expenses (except for the reimbursement of client-related expenses), and stands to make a profit or loss from the business, the worker is more likely to be independent.
  
  
  • Rationale: The "average" employee goes to work and gets paid for services on the basis of a set rate per hour, day, week, etc. The employee is not generally required to invest in the employer’s business, nor does he/she stand to benefit from the profits or lose from the expenses of the business.
    
    
• If the factual relationship looks like employment in material ways, then it probably is. As an example, if the worker is given the types of benefits that employees often receive (e.g., insurance coverage, retirement plan participation), then you should probably consider that worker an employee. On the other hand, if the worker gets none of the employee benefits, then it is likely that the worker is independent.
  
  
  • Publication 1779 suggests doing what I have often recommended in my practice to clients setting up an independent contractor relationship: making a written contract. Even a letter from one party to the other could suffice, as long as it includes the major elements of the independent relationship (no need for instruction or control, flexibility in setting the work schedule, no need for insurance coverage, etc.).
    
    
  • I would also suggest, where possible, getting other evidence of independence, such as business cards and copies of the contractor’s Certificate(s) of Insurance related to business, and ask the contractor to send you an invoice on his/her letterhead for each service provided.
    
    

Under current law, independent contractors must receive Form 1099-MISC by January 31 following the year of payments, only if all of the following conditions are met:

• The independent contractor was not incorporated. Therefore, payments to individuals, partnerships, limited liability companies (LLC’s) and other unincorporated entities qualify. Only corporations (including "S Corporations") are exempt from this condition.

  Exception: All payments to attorneys for services will qualify, even if the attorney paid is incorporated. Many law firms set up PC’s (professional corporations) or PA’s (professional associations). Although they are corporations, they must receive Form 1099-MISC if all of the other conditions apply.

• The payments were at least $600 during the year.
  
  
• The payments were for services (other than as an employee). Payments for merchandise are excluded. However, payments for the cost of materials and parts used in providing services are included.
  
  
• The payments were made in the course of the payer’s trade or business. Accordingly, persons paying for services not in connection with a business do not need to issue forms.

  Under this rule, whether you hire an attorney to prepare your will, an accountant to prepare your personal (nonbusiness) tax return, or a repairman to fix a hole in your kitchen ceiling, you are not required to issue Form 1099-MISC since the services are not in connection with your trade or business.

It sounds easy enough to issue the forms by January 31 following the year you made the qualifying payments. However, year after year I hear from my clients that it is hard to get the required information. Often the reason is that they waited until January to try. The best way to get this done properly and timely is to get the information before the first check you make to the independent contractor.

• The payee’s name
  
  
• The payee’s address
  
  
• The payee’s social security number or employer identification number, as applicable.
  
  Note: IRS matches the names of the payees with the tax identification numbers. It is therefore important to make sure that you are getting the proper information from the contractor. For example, if the payee tells you his name is John’s Roof Repair Company and offers his social security number for the business, they will not match. In this situation, it would be wise to make the individual payee’s name the first line of the Form 1099-MISC, followed by the business name and address, such as:

  John Smith
  d/b/a John’s Roof Repair Company
  Street Address
  City, State Zip

Look at it this way. If an employee came to work for your business and didn’t fill out Form W-4, you wouldn’t issue a paycheck, would you? (You really couldn’t since you wouldn’t know the filing status and/or the number of exemptions to use for withholding purposes.) The same should be true for independent contractors. Simply tell the contractor that you cannot issue payment until you receive Form W-9 (or the required information). You could point out that Form 1099-MISC will not be issued unless all of the aforementioned conditions apply. You will notice how much easier it is to get a response when the contractor is awaiting payment.

• Some of the income taxes that should have been withheld. (This could be true even if the individual paid income taxes. In this case, you should be able to assert a claim against the individual for a refund due to overpayment.);
  
  
• Social security and Medicare taxes that should have been withheld;
  
  
• Social security and Medicare taxes that you were required to match, as well as other employer taxes;
  
  
• Penalties and interest for failure to withhold and pay taxes;
  
  
• Penalties for failure to provide workers compensation insurance for the individual;
  
  
• Retirement plan contributions for the individual based on the compensation as if he/she was an employee. (Failure to make the plan "whole" for all required contributions could also jeopardize the tax-favored status of the plan as it pertains to all employees, not just to the reclassified one.); and
  
  
• Other fringe benefits.

"You prefer that I do not withhold tax? Can you do the job without training or assistance from me or my staff? Do you cover all of your own business costs? Do you carry your own business insurance coverage and pay your own employment-related taxes? Are you available to work for other businesses as well as mine?"

"You’ll be willing to sign a contract to that effect? Excellent! Here’s a Form W-9 for you to complete. Today is Independence Day. You are truly independent."