-18-

installing new data processing equipment, it might be a
propitious time for taxpayers to disclose voluntarily any
underpayments of tax. The news release also noted that the
likelihood of criminal prosecution was not high in instances
of voluntary disclosure, although the news release offered no
assurances that amnesty from criminal prosecution would be
granted. A more recent policy statement of the IRS includes
voluntary disclosure of tax underpayments as one criterion to
be considered in determining whether a case warrants criminal
prosecution.

The press has reported that the IRS may currently have a
policy (called "Fresh Start") of encouraging individuals who
have never filed tax returns to do so, coupled with providing
amnesty from criminal prosecution (but not from civil
penalties or interest).

Frequency of amnesty

Most advocates of a Federal tax amnesty propose that the
program be offered only once and suggest that it be made
clear that amnesty will not beoffered again. Opponents of
amnesty are concerned that, once a Federal tax amnesty is
offered, the public will expect it to be offered again,
despite official announcements to the contrary. Opponents
are concerned that this expectation of future amnesty
programs may decrease current voluntary compliance.

Arguments pro and con

Proponents of. tax amnesty raise the following points in
favor of their position. First, they argue that amnesty might
raise a significant amount of revenue. Second, they argue
that amnesty would place on the tax rolls individuals and
entities that previously had escaped taxation. Third, they
argue that the success of tax amnesty in several States
suggests that amnesty should be utilized on the Federal
level.

Opponents of tax amnesty raise the following arguments.
The first is fairness. They argue that amnesty is inherently
unfair, and would be widely perceived as unfair, to taxpayers
who have fully paid their taxes for others who have not fully
paid to escape punishment for, and profit from, their
evasion. In addition, it may be unfair that a tax evader
discovered by the IRS (or who voluntarily disclosed the
evasion prior to the amnesty period) is fully subject to
interest, civil penalties and criminal penalties, while a tax
evader not discovered by the IRS may take advantage of the
amnesty. :

Another argument raised by opponents is that tax evaders
who have not yet been caught by the IRS may choose not to
participate, in that they might expect that, since they have



-12-

III. CONSEQUENCES OF INDEPENDENT CONTRACTOR STATUS

Federal tax consequences

Workers who are classified as employees are entitled to
exclude from gross income certain employee benefits that
cannot be excluded by workers classified as independent
contractors. Thus, for example, benefits such as
employer-provided health, dependent care, group-term life
insurance, and pensions are excluded from gross income (and
wages for FICA tax purposes) of employees.

If an individual is not an employee for income tax
purposes, the individual is entitled to establish his or her
own retirement plan (Keogh plan) and deduct contributions to
the plan. The plan can be individually tailored to the
desires of the individual. The amount of deductible
contributicns may be greater than the contributions that an
employer would make under an employer-sponsored plan. Such
flexibility generally is not available to individuals covered
under an employer's plan. In some circumstances, an employer
might wish to treat a worker as an independent contractor in
order to avoid providing the worker with retirement and other
employee benefits.

Independent contractors receive favorable tax treatment
with respect. to business expenses in several respects. For
example, business expenses are deductible by independent
contractors without regard to the amount of the expenses or
whether they itemize deductions. On the other hand, an
employee's ability to deduct business expenses without
itemizing is very limited. Moreover, even for those
employees who itemize, their miscellaneous business
deductions for unreimbursed employee business expenses are
subject to the two-percent-of-AGI floor on itemized
deductions.

As discussed above, employment tax and withholding
obligations also differ depending on whether a worker is an
employee or independent contractor. Thus, for example, no
withholding is required with respect to payment to
independent contractors, but independent contractors are
required to pay estimated taxes.

Other consequences

There may also be non-federal tax consequences of worker
classification. For example, State income tax laws may
follow the Federal classification rules. Also, coverage
under Federal and State workers' compensation plans, wage and
hour laws, and similar worker-related programs may depend on
the classification of a worker as an employee.



-3-

when a Form 1099 was filed, and only 29 percent of income was
reported when no Form 1099 was filed.

One of the most significant issues associated with
misclassification is the revenue loss to the Federal
government that occurs when workers are classified as
independent contractors rather than employees. One possible
explanation for the revenue loss is that such workers are
treated more favorably under the Internal Revenue Code than
are employees. Another explanation is that there is revenue
loss associated with lower compliance rates of independent
contractors and service recipients compared to the compliance
rates of employees and their employers. Possible solutions
to the problem include increased penalties for
misclassification and reporting violations, narrowing the
present-law safe harbor provisions, conditioning the
deductibility of payments to independent contractors on
compliance with reporting requirements, and imposing
withholding requirements with respect to payments to all
workers.



-19-

not yet been caught, there is little likelihood that they
would be caught in the future, and that there is therefore
little benefit to them in participating in amnesty.

Opponents of amnesty also argue that the State
experience is neither uniformly positive nor a good predictor
of success at the Federal level. They note that some States
that havg had an amnesty program have raised very little
revenue.” Also, some States have encountered serious
difficulties in administering their amnesty programs. They
also note that State compliance efforts prior to amnesty have
not been as extensive as those of the IRS and that State
penalties for noncompliance and gvasion have not been as
severe as those under the Code.

In fact, the IRS believes that the success of State
amnesty programs is tied to the use of stepped-up enforcement
tactics or of broadened compliance powers to State revenue
agencies. The IRS has stated that the increased enforcement
efforts that made some State programs successful are not
possible at the Federal level because 9f the IRS history of
consistent and effective enforcement.+

Finally, opponents express concern that continued
discussion of Federal amnesty may have an adverse effect on
current compliance, in that some taxpayers may be unwilling
to comply or to disclose voluntarily noncompliance if they
anticipate that a Federal amnesty might be offered. Thus,
opponents believe that a Federal amnesty will not raise a
significant amount of revenue, particularly over the long
term, because they argue that amnesty will cause a decrease
in, rather than an enhancement of, future voluntary
compliance. Some believe that this decrease in compliance
may in fact cause amnesty to lose revenue over the long term.

9 out of 13 total state amnesty programs, 6 raised less than
$1 million; only 3 raised more than $15 million. Source:

IRS, "Study of Recent Tax Amnesty Programs” (May 1985 draft),
p. 8.

10 For example, prior to its amnesty program, tax evasion
was not a felony in Massachusetts.

11 irs “Study of Tax Amnesty Programs" (August, 1987).



-16-

addition, the Internal Revenue Service could be permitted to
issue guidance on proper classification, which they are now
prohibited from doing by statute.

Another way to increase the number of employees that are
properly classified would be to modify the existing safe
harbor in section 530 of the Revenue Act of 1978. Such
modifications could include removing the ability of employers
to classify workers as independent contractors merely because
such classification reflects the long-standing recognized
practice of an industry or because an audit was performed on
an tax issue unrelated to the proper classification of
workers.

Voluntary compliance might be improved if the perceived
economic incentive to misclassify was removed or reduced.
For example, relief could be provided to employers to ease
the burden of complying with labor (and other) laws that
apply only to employees (e.g., minimum wage laws, workers'
compensation, unemployment taxes). However, it is unclear
what form such relief would take. Alternatively, such laws
could be broadened to.include independent contractors to
equalize the treatment of such workers. The Federal tax
consequences of worker status could also be equalized.

Compliance

It is clear that there is revenue loss associated with
lower compliance rates of independent contractors and service
recipients compared to the compliance rates of employees and
their employers. Tax data indicate that service recipients
often fail to file requisite Forms 1099 for payments made to
independent contractors, and that independent contractors
more often than not fail to report the unreported payments as
income. Even when Forms 1099 are issued, compliance is less
than when workers are classified as employees and withholding
is required.

One way to address this problem would be to minimize the
number of workers that are classified as independent
contractors by encouraging businesses to classify workers as
employees (since compliance rates for employee compensation
is high). Possible methods to achieve this result are
discussed above. Of course, if increased compliance rates
are the only goal, consideration should be given to whether
this can be achieved more efficiently by means other than by
encouraging businesses to classify workers as employees. For
example, a more efficient way to reduce revenue loss might be
to increase compliance by service recipients with the Form
1099 reporting requirements.

One way to increase business's compliance with the
reporting requirements might be to increase the penalties for
failure to’ file a Form 1099, possibly coupled with an amnesty



-8-
a statement setting forth the name, address, and taxpayer
identification number of the service recipient, and the

aggregate amount of payments made to the payee during the
year.

E. Penalties
1. Information reporting penalties

a. Failure to file correct information returns

Any person that fails to file a correct information
return (such as Forms W-2 or 1099) with the Internal Revenue
Service on or before the prescribed filing date is subject to
a penalty that varies based on when, if at all, the correct
information return is filed (sec. 6721). If a person files a
correct information return after the prescribed filing date
but on or before the date that is 30 days after the
prescribed filing date, the amount of the penalty is $15 per
return, with a maximum penalty of $75,000 per calendar year.
If a person files a correct information return more than 30
days after the prescribed filing date but on or before August
1, the amount of the penalty is $30 per return, with a
Maximum penalty of $150,000 per calendar year. If a correct
information return is not filed on or before August 1 of any
year, the amount of the penalty is $50 per return, with a
maximum penalty of $250,000 per calendar year. The Code also
provides a special rule for de minimis failures to include

the required, correct information.

In addition, the Code provides special, lower maximum
levels for this penalty for small businesses. Small
businesses are defined as firms having average annual gross
receipts for the most recent 3 taxable years that do not
exceed $5 million. The maximum penalties for small
businesses are: $25,000 (instead of $75,000) if the failures
are corrected on or before 30 days after the prescribed
filing date; $50,000 (instead of $150,000) if the failures
are corrected on or before August 1; and $100,000 (instead of
$250,000) if the failures are not corrected on or before
August 1.

b. Failure to furnish correct payee statements

Any person that fails to furnish a correct payee
statement to a taxpayer (such as a copy of a W-2 or a 1099)
on or before the prescribed due date is subject to a penalty
of $50 per statement, with a maximum penalty of $100,000 per
calendar year (sec. 6722). If the failure to furnish a
correct payee statement to a taxpayer is due to intentional
disregard of the requirement, the penalty is generally $100
per statement or, if greater, 10 percent”? of the amount
required to be shown on the statement, with no limitation on
the maximum penalty per calendar year.



ish a Ay

-5-

Section 530 of the Revenue Act of 1978

With increased enforcement of the employment tax laws
beginning in the late 1960s, controversies developed between
the IRS and taxpayers as to whether businesses had correctly
classified certain workers as independent contractors rather
than as employees. In some instances when the IRS prevailed
in reclassifying workers as employees under the common-law
test, the employing business became liable for substantial
portions of its employees' FICA and income tax liabilities
(that the employer had failed to withhold and pay over),
although the employees might have fully paid their
liabilities for self-employment and income taxes.

In response to this problem, the Congress enacted
section 530 of the Revenue Act of 1978 (P.L. 95-600). That
provision generally allows a taxpayer to treat a worker as
not being an employee for employment tax purposes (but not
income tax purposes), regardless of the individual's actual
status under the common-law test, unless the taxpayer has no
reasonable basis for such treatment. Under section 530, a
reasonable basis is considered to exist if the taxpayer
reasonably relied on (1) past IRS audit practice with respect
to the taxpayer, (2) published rulings or judicial precedent,
or (3) long-standing recognized practice in the industry of
which the taxpayer is a member. Under the prior-audit rule,
reasonable reliance is generally found to exist if the IRS
failed to raise an employment tax issue on audit, even though
the audit was not related to employment tax matters.

This relief under section 530 is available with respect
to an individual only if certain additional requirements are
satisfied. One of these requirements is that the taxpayer
(or a predecessor) must not have treated any individual
holding a substantially similar position as an employee for

3(continued)

(10) whether the worker must perform services in the order
set by the service recipient; (11) whether reports by the
worker to the service recipient are required; (12) whether
payment is by the hour, week, or month; (13) whether the
service recipient pays the worker's business and/or traveling
expenses; (14) whether the worker is required *> furnish his
or her own tools; (15) whether the worker :avests in
facilities used to perform the work; (16) whether the worker
can realize a profit or loss as a result of the performance
of the services; (17) whether the worker performs services
for more than one service recipient; (18) whether the worker
makes his or her services available to the general public;
(19) whether the service recipient has the right to discharge
the worker; and (20) whether the worker has the right to
terminate the relationship without incurring liability.



-4-

II. PRESENT LAW

A. Classification of Workers

In general

In general, the determination of whether an
employer-employee relationship exists for Federal tax
purposes is made under a common-law test. Under this test,
an employer-employee relationship generally exists if the
person contracting for services has the right to control not
only the result of the services, but also the means by which
that result is accomplished (Treas. Reg. sec.
31.3401(c}-(1)(b)). Whether the requisite control exists is
determined basgd on all the relevant facts and
circumstances.

The IRS has developed a list of 20 factors that may be
examined in determining whether an employee-employer
relationship exists. Rev. Rul. 87-41, 1987-1 C.B. 296. The
20 factors were developed by the IRS based on an examination
of cases and rulings considering whether a worker is an
employee. The degree of importance of each factor varies
depending on the occupation and the factual context in which
the services are performed. The 20 factors are designed as
guides; special scrutiny may be required in applying the
factors to assure that formalistic aspects of an arrangement
designed to achieve a particular status do not obscure the
substance of the arrangement.

2 There are also some persons who are treated by statute as
either employees or independent contractors. For example,
full-time life insurance salesmen and certain travelling
salesmen are treated as employees for purposes of employment
taxes (sec. 3121(d)). Real estate agents and direct sellers
are not treated as employees (sec. 3508).

3 The factors are as follows: (1) whether the worker is
required to comply with instructions about when, where, and
how to perform the work; (2) whether the service recipient
trains the worker; (3) the extent to which the worker's
services are integrated into the business operations of the
service recipient; (4) whether the services must be rendered
personally; (5) whether the service recipient supervises the
worker; (6) whether there is a continuing relationship
between the worker and the service recipient; (7) whether the
service recipient sets the hours of work of the worker; (8)
whether the worker is required to devote substantially full
time to the business of the service recipient; (9) whether
the work is done on the premises of the service recipient;
(Footnote continued)



-17-

program (see discussion below). However, unless audit rates
are significantly increased, it is not clear that increased
penalties would have a substantial effect.

Another option might be to condition the deductibility
of payments made to independent contractors on the filing of
Forms 1099. This could be achieved by requiring payments
made to independent contractors to be aggregated and reported
on a separate line on a business's tax return, which amount
could be no greater than the sum of the payments made to
independent contractors reported on bona fide Forms 1099 for
the year. An IRS matching program could then check to see
that individuals reported the payments reflected on the Forms
1099 on their income tax returns for the year.

The minimum amount to which the reporting requirements
with regard to independent contractors apply also could be
reduced so that Form 1099s are filed with regard to a larger
number of payments.

Another way to increase compliance would be to require
businesses to withhold income and employment taxes from
payments to independent contractors, just as such taxes are
withheld from wages paid to employees. Businesses may object
to the administrative burdens associated with such a new
requirement.

B. Tax Amnesty

Some have suggested that reforms with regard to the
misclassification of employees as independent contractors
should be coupled with a limited amnesty program to encourage
contractors and businesses to comply with the new law without
fear of incurring penalties for past noncompliance.

Background and present law

The Federal Government has never instituted a program
that provided amnesty from both civil and criminal penalties
for taxpayers who both voluntarily disclosed that they had
underpaid their taxes and then paid. those amounts.

gne IRS had an administrative policy, discontinued in
1952,° that in effect provided amnesty from criminal
prosecution (but not from civil penalties or interest) for
taxpayers who voluntarily disclosed that they had underpaid
their ta:.:s. In 1961, the IRS issued a news release
suggesting to taxpayers that, since the IRS was then

8 tt appears that this policy was officially terminated
because of failure to pay the taxes once amnesty had been
granted, increased litigation, and. lack of uniformity in
administering the program.



-7-

No income tax withholdjng is required on payments made
to independent contractors. Independent contractors are
required to make quarterly estimated tax payments.

C. Employment Taxes

If an employer-employee relationship exists, the service
recipient is subject to social security taxes under the
Federal Insurance Contributions Act (FICA) (secs. 3101-3127)
and unemployment taxes under the Federal Unemployment Tax Act
(FUTA) (secs. 3301-3310), and is required to withhold and pay
over FICA taxes imposed on the worker. On the other hand, if
there is no employer-employee relationship, the service
recipient is not subject to employment taxes; the worker pays
self-employment tax under the Self-employment Contributions
Act (SECA) (secs. 1401-1403) in lieu of FICA tax.

Independent contractors are not subject to FUTA, but also
generally are not entitled to related unemployment benefits.

Prior to 1990, the employment tax structure
significantly favored independent contractors. Until 1983,
the combined FICA tax rate on the employer and employee was
significantly higher than the SECA tax rate. The Social
Security Amendments Act of 1983-equalized the tax rates, but
provided a credit for a portion of SECA taxes for years 1984
through 1989. For years after 1989, the tax rates are the
same, and there is no SECA tax credit. A self-employed
person is entitled to an income tax deduction for a portion
of SECA taxes.

Some differences still exist between FICA and SECA
taxes, primarily because the base for calculating the taxes
differs.

D. Reporting Requirements With Respect to
Independent Contractors

The Code contains a separate provision (sec. 6041A)
specifically dealing with payments of remuneration for
services. Under this provision, a service recipient engaged
in a trade or business who makes payments of remuneration in
the course of that trade or business to any person for
services performed must file with the Internal Revenue
Service an information return (Form 1099) reporting such
Payments (and the name, address, and taxpayer identification
number of the payee) if the remuneration paid to the person
during the calendar year is $600 or more. Also, the service
recipient must furnish to the person receiving such payments

4 Payments to independent contractors may be subject to
backup withholding under certain circumstances (sec. 3406).



PRESENT LAW AND ISSUES
RELATING TO
MISCLASSIFICATION OF EMPLOYEES AND

INDEPENDENT CONTRACTORS FOR FEDERAL TAX PURPOSES

Scheduled for a Hearing
Before the
SUBCOMMITTEE ON SELECT REVENUE MEASURES
of the
HOUSE COMMITTEE ON WAYS AND MEANS
on July 23, 1992

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
July 22, 1992
JCX-27-92



-10-
c. Reasonable cause

No accuracy-related or fraud penalty is to be imposed if
it is shown that there was reasonable cause for an
underpayment and the taxpayer acted in good faith (sec.
6664).

3. Penalty for aiding and abetting the understatement of tax
liability

The penalty for aiding and abetting the understatement
of tax liability applies in cases where the person aids,
assists in, procures, or advises with respect to the
preparation or presentation of any portion of a return or
other document if (1) the person knows or has reason to
believe that the return or other document will be used in
connection with any material matter arising under the tax
laws, and (2) the person knows that if the portion of the
return or other document were so used, an understatement of
the tax liability of another person would result (sec. 6701).

4. Penalty for failure to make timely deposits of tax

The penalty for failure to make. timely deposits of tax
is a. four-tiered penalty. The amount of the penalty varies
with the length of time within which the taxpayer corrects
the failure (sec. 6656). A depositor is subject to a penalty
equal to 2 percent of the amount of the underpayment if the
failure is corrected within 5 days after the prescribed due
date. A depositor is subject to a penalty equal to 5 percent
of the amount of the underpayment if the failure is corrected
after the date that is 5 days after the prescribed due date
but on or before the date that is 15 days after the
prescribed due date. A depositor is subject to a penalty
equal to 10 percent of the amount of the underpayment if the
failure is corrected after the date that is 15 days after the
due date but on or before the date that is 10 days after the
date of the first delinquency notice to the taxpayer (under
sec. 6303). Finally, a depositor is subject to a penalty
equal to 15 percent of the amount of the underpayment if the
failure is not corrected on or before the date that is 10
days after the date of the first delinquency notice to the
taxpayer (under sec. 6303).

5. Employer's liability for certain employment taxes as a
result of misclassification of workers

If an employer treats services performed by an employee
as if performed by a nonemployee and fails to withhold income
or social security taxes as required by the wage withholding
provisions of the income tax and social security tax laws,
the employer's liability for those amounts is determined as a
fraction of the employee's wages subject to income tax
withholding or a fraction of the social security taxes



-9-

c. FPailure to comply with other information
reporting requirements

Any person that fails to comply with other specified
information reporting requirements on or before the
prescribed date is subject to a penalty of $50 for each
failure, with a maximum penalty of $100,000 per calendar year
(sec. 6723). The information reporting requirements
specified for this purpose include any requirement to include
a correct taxpayer identification number on a return or
statement and any requirement to furnish a correct taxpayer
identification number to another person.

d. Reasonable cause

The Code provides that any of the informat-on reporting
penalties may be waived if it is shown that the failure to
comply is due to reasonable cause and not to willful neglect
(sec. 6724). For this purpose, reasonable cause exists if
significant mitigating factors are present, such as the fact
that a person has an established history of complying with
the information reporting requirements.

2. Accuracy penalties

a. Accuracy-related penalty

The accuracy-related penalty, which is imposed at a rate
of 20 percent, applies to the portion of any underpayment
that is attributable to (1) negligence, (2) any substantial
understatement of income tax, (3) any substantial valuation
overstatement, (4) any substantial overstatement of pension
liabilities, or (5) any substantial estate or gift tax
valuation understatement (sec. 6662).

If an underpayment of tax is attributable to negligence,
the negligence penalty is to apply only to the portion of the
underpayment that is attributable to negligence rather than
to the entire underpayment of tax.

Negligence includes any careless, reckless, or
intentional disregard of rules or regulations, as well as any
failure to make a reasonable attempt to comply with the
provisions of the Code.

b. Fraud penalty

The fraud penalty, which is imposed at a rate of 75
percent, applies to the portion of any underpayment that is
attributable to fraud (sec. 6663).

5 the penalty is 5 percent for several types of statements.


-6-

purposes of employment taxes for any period beginning after
1977.

Section 530 also prohibits the issuance of Treasury
regulations and revenue rulings on common-law employment
status. Taxpayers may, however, obtain private letter ruling
from the IRS regarding the status of workers as employees or
independent contractors.

The relief granted by section 530, initially scheduled
to terminate at the end of 1979, was extended through the end
of 1980 by P.L. 96-167 and through June 30, 1982, by P.L.
96-541. In the Tax Equity and Fiscal Responsibility Act of
1982 (TEFRA) (P.L. 97-248), the Congress extended the section
530 relief indefinitely, pending enactment of further
statutory rules regarding the classification of workers as
employees or independent contractors. TEFRA also modified
the penalties for misclassification of workers to reduce
burden on employers where workers are reclassified.

Under section 1706 of the Tax Reform Act of 1986 (the
1986 Act), section 530 does not apply in-the case of an
individual who, pursuant to an arrangement between the
taxpayer and another person, provides services for such other
person as an engineer, designer, drafter, computer
programmer, systems analyst, or other similarly skilled
worker engaged in a similar line of work. Thus, the
determination of whether such individuals are employees or
independent contractors is made in accordance with the
common-law test.

B. Income Tax Withholding

The Code requires that employers making payments of
wages to employees withhold Federal income taxes from those
wage payments in accordance with tables or computational
procedures prescribed by the IRS (sec. 3402). Each employee
must file with his or her employer a Withholding Allowance
Certificate (Form W-4) on which the employee claims a
specific number of withholding allowances based on family
size, employment status, itemized deductions, and other
matters. The employer then utilizes tables issued by the IRS
to compute the correct amount of Federal income tax
withholding. This computation is based on the number of
withholding allowances claimed, the taxpayer's wages, and the
frequency of payroll payments. The amount of wages paid and
the amount of income taxes withheld must be reported to the
IRS and to the employee on Form W-2.



-2-

I. SUMMARY

A variety of relationships and job classifications exist
in the American workplace. However, for Federal tax
purposes, there are only two classifications: a worker is
either an employee of the service recipient or an independent
contractor (i.e., self-employed).

Significant tax consequences result from the
classification of a worker as an employee or independent
contractor. These differences relate to withholding and
employment tax requirements, as well as the ability to
exclude certain types of compensation from income or take tax
deductions for certain expenses. Some of these consequences
favor employee status, while others favor independent
contractor status. For example, an employee may exclude from
gross income employer-provided benefits such as pension,
health, and group-term life insurance benefits. On the other
hand, an independent contractor can establish his or her own
pension plan and deduct contributions to the plan. An
independent contractor also has greater ability to deduct
work-related expenses.

Under present law, the determination of whether a worker
is an employee or an independent contractor is generally made
under a facts and circumstances test that seeks to determine
whether the service provider is subject to the control of the
service recipient, not only as to the nature of the work
performed, but the circumstances under which it is performed.
Under a special safe harbor rule (sec. 530 of the Revenue Act
of 1978), a service recipient may treat a worker as an
independent contractor for employment tax purposes even
though the worker is in fact an employee if the service
recipient has a reasonable basis for treating the worker as
an independent contractor and certain other requirements are
met.

There are two main sources of misclassification. First,
because the test for determining whether a worker is an
employee or an independent contractor is to some degree
subjective, taxpayers attempting to classify workers may in
good faith come to a different conclusion than the IRS.
Misclassification may also be deliberate in order to take
advantage of actual or perceived tax and nontax benefits of
independent contractor status.

An IRS survey of 1984 employment tax returns found that
nearly 15 percent of employers misclassified employees as
independent contractors. When employers classified workers
as employees, more than 99 percent of wage and salary income
was reported. However, when workers were misclassified as
independent contractors, 77 percent of income was reported



-13-

IV. REASONS FOR MISCLASSIFICATION

Misclassification of workers can be either inadvertent
or deliberate. At the extremes, it will be clear whether a
worker is properly characterized as an employee or
independent contractor. However, many work situations will
involve the grey area in between -- some of the 20 factors
May support employee status, while some indicate independent
contractor status. Because the determination of proper
classification is factual, reasonable people may differ as to
the correct result given a certain set of facts. Thus, even
though a taxpayer in good faith determines that a worker is
an independent contractor, an IRS agent may reach a different
conclusion by, for example, weighing some of the 20 factors
differently than the taxpayer. Taxpayers wishing certainty
can obtain private letter rulings regarding the status of
workers. However, not all taxpayers may wish to undertake
the expense of obtaining a ruling or may not be able to wait
for a ruling from the IRS. Thus, the prohibition on issuance
of general guidance by the IRS may make the likelihood of
such errors greater; the IRS is not permitted to publish
guidance stating which factors are more.relevant than others.
In the absence of such guidance, not only may taxpayers and
the IRS differ, but different IRS agents may also reach
different conclusions, resulting in inconsistent enforcement.

Misclassification of workers as independent contractors
may also be deliberate. In some cases, workers and service
recipients may prefer to classify workers as independent
contractors, both for tax and nontax reasons. For example,
the worker may wish to take advantage of the ability to
contribute on a deductible basis to a pension plan or to
deduct significant work-related expenses. A service
recipient may wish to avoid administrative problems
associated with withholding income and FICA taxes. The
service recipient also may wish to avoid coverage and
nondiscrimination requirements applicable to qualified
retirement plans by classifying lower-paid workers as
independent contractors.

Workers sometimes argue that they prefer independent
contractor status because it gives them more control over
their own lives. To the extent such reasons exist in
Particular cases, service recipients may feel compelled to
classify workers as independent contractors rather than
employees. In many instances, it may be very difficult to
distinguish whether a misclassification was deliberate or
inadvertent.



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VI. ISSUES

A significant issue with respect to misclassification is
the effect that it has on Federal budget receipts. There are
at least two ways that misclassification could result in
revenue loss, each with a different set of possible
solutions.

A. Enforcement

Treatment under the Code

It is possible that there is a reduction in net Federal
budget receipts attributable to the misclassification of
employees as independent contractors because independent
contractors are treated more favorably under the Internal
Revenue Code than employees. For example, independent
contractors are permitted to deduct business expenses
pertaining to meals and entertainment, a home office, and
transportation, and they are not subject to the 2-percent
floor on miscellaneous itemized deductions imposed on
unreimbursed employee business expenses. Independent
contractors also are permitted to establish individual
pension plans (Keogh plans) to which they can make an annual
deductible contribution of $30,000 or more. This treatment
under the Code may permit an independent contractor to reduce
his or her taxable income below the level that a similarly
situated employee could, resulting in less Federal income tax
revenue.

However, the revenue loss resulting from this favorable
treatment under the Code may be at least partially offset by
other factors associated with independent contractor status.
For example, independent contractors are not eligible for
excludable fringe benefits, such as employer-provided health
and life insurance coverage, that often make up a significant
portion of an employee's total compensation. To the extent
that direct (taxable) compensation to independent contractors
is substituted for tax-favored fringe benefits paid to
employees, Federal income tax revenues will increase
(assuming full compliance).

If there is a net loss in tax revenues associated with
the classification of employees as independent contractors,
then no solution to the problem can be complete unless steps
are taken to ensure that employees are properly classified as
such. One way to do this would be to increase enforcement
efforts by increasing penalties for misclassification and
stepping-up audit rates, possibly coupied with an amnesty
program to encourage reclassification (see discussion below).
To be fair to businesses, this approach could be coupled with
statutory amendments to clarify the definitional standards
used to determine the proper classification of workers. In



-1-
INTRODUCTION

The Subcommittee on Select Revenue Measures of the House
Committee on Ways and Means has scheduled a public hearing on
July 23, 1992, on the issue of misclassification of employees
and independent contractors for Federal tax purposes.

This document,? prepared by the staff of the Joint
Committee on Taxation, provides a discussion of present law
and related issues concerning the classification of employees
and independent contractors for tax purposes.

Part I of the document is a summary. Part II is a
description of present-law rules relating to classification
of workers, income tax withholding, employment taxes,
reporting requirements, and penalties. Part III discusses
consequences of a worker being classified as an independent
contractor. Part IV sets forth some of the reasons workers
are misclassified. Part V presents certain data regarding
misclassification.and.compliance, and Part VI discusses
certain issues and options associated with misclassification.

1 This document may be cited as follows: Joint Committee on
Taxation, Present Law and Issues Relating to
Misclassification of Employees and Independent Contractors

or Federal Tax Purposes (JCX-27-92), July 22, 1992.



CONTENTS

INTRODUCTION. oe esse cece recs cece cece eeeeteenccceer

I.

II.

IIt.

Iv.

Vv.

vi.

SUMMARY... cece eee ee cee eee cece nee c eres esewene
PRESENT LAW... cece cece cere cere cece tence cencees
A. Classification of Workers... .. cece ee ceeees
B. Income Tax Withholding.........cccceseeeee
C. Employment TaxeS... ccc cece cece ccc n encase

D. Reporting Requirements with Respect
to Independent Contractors... ...csseeeeee

E. Penalties....cccccceccccccccceccccrcecscce
1. Information reporting penalties.......
2. Accuracy penaltiesS...... ee cscccecucavee

3. Penalty for aiding and abetting
the understatement of tax liability..

4. Penalty for failure to make timely
deposits Of tax... c.eceececcccccuenee

S. Employer's liability for
certain employment taxes as a result
of misclassification of workers......

CONSEQUENCES OF INDEPENDENT CONTRACTOR
STATUS... sees cece cree cece cee er ese enerneee

REASONS FOR MISCLASSIFICATION......-eeeseeeeee

DATA REGARDING MISCLASSIFICATION AND
COMPLIANCE... cscs cece cece reece cee ceeeeeee

ISSUES. cece cece eee eee eee e creer eset ene eeeee
A. Enforcement .cccsececcecccccccseceecescteees

B. Tax AMNEStY. cee cece eee e cece ec eee ese enenas

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10

16

10

12
13

14
15
15
17



-1ll-

required to be withheld (sec. 3509). The Code applies a
lower fraction if the employer has complied with information
reporting rules consistent with the treatment of the employee
as a nonemployee.

The applicable amounts are 1.5 percent of wages (3
percent where no information returns are filed) where the
employer erroneously treated the worker as a nonemployee for
income tax purposes. The applicable amount where the
employer erroneously treated the worker as a nonemployee for
social security purposes is 20 percent of the social security
taxes required to be -ithheld (40 percent where no
information returns .-e filed). Even where this procedure
applies, however, the employer is still liable for the
employer's share of FICA and FUTA taxes.

These provisions do not apply if the employer treats the
employee as a nonemployee with intentional disregard of the
law. In this case, the employer is responsible for 100
percent of the income and FICA tax required to be withheld.


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V. DATA REGARDING MISCLASSIFICATION AND COMPLIANCE

IRS audits of employment tax returps declined from over
100,000 in 1979 to about 24,000 in 1988. This represented a
decrease in audit coverage from approximately one half of one
percent to less than one tenth of one percent of employment
tax returns filed. Concerned with the decline in auditing of
these returns, both the IRS and GAO undertook surveys to
determine the extent of misclassification of employees as
independent contractors and the effect that this
misclassification had on compliance.

The IRS survey of 1984 employment tax returns found that
nearly 15 percent of empjoyers misclassified employees as
independent contractors. The section 530 safe harbor
protected 2 percent of misclassified employees from being
reclassified as employees. Of those returns using the
section 530 safe harbor protections, nearly half relied on
the prior audit provision.

When employers classified workers as employees, more
than 99 percent of wage and salary income was reported.
However, when workers were misclassified as independent
contractors, 77 percent of income was reported when a Form
1099 was filed, and only 29 percent of income was reported
when no Ferm 1099 was filed.

6 united States General Accounting Office, Information
Returns Can Be Used to Identify Employers Who Misclassify
Workers, GAO/GGD-89-107, September 1989.

7 Internal Revenue Service, "Strategic Initiative on
Withholding Noncompliance (SVC-1) Employer Survey Report
of Findings", June 1989.