Taxation of Technical Services Personnel: 

Section 1706 of the Tax Reform Act of 1986 

A Report to The Congress 

Department of the Treasury 

March 1991 
Taxation of Technical Services Personnel: 

Section 1706 of the Tax Reform Act of 1986 

A Report to The Congress 

Department of the Treasury 

March 1991 
• 

DEPARTMENT OF THE TREASURY 

WASHINGTON 

ASSISTANT SECRETARY 

March 1991 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

House of Representatives 

Washington D. C. 20515 

Dear Mr. Chairman: 

Section 6072 of Public Law 100-647, the Technical and 

Miscellaneous Revenue Act of 1988, provides that the Secretary of 

the Treasury shall conduct a study of the treatment provided by 

section 1706 of the Tax Reform Act of 1986 (relating to treatment 

of certain technical personnel). 

Pursuant to that section, I hereby submit the "Taxation 

of Technical Services Personnel: Report on Section 1706 of the 

Tax Reform Act of 1986." 

I am sending a similar letter to Senator Lloyd Bentsen, 

Chairman of the Committee on Finance . 

Enclosure 

Sincerely, . 

~tJ. fo.e_..__ 

Kenneth W. Gideon 

Assistant Secretary 

(Tax Policy) 
• 

DEPARTMENT OF THE TREASURY 

WASHINGTON 

ITANT SECRETARY 

March 1991 

The Honorable Lloyd Bentsen 

Chairman 

Committee on Finance 

United States Senate 

washington D. C. 20510 

Dear Mr. Chairman: 

Section 6072 of Public Law 100-647, the Technical and 

Miscellaneous Revenue Act of 1988, provides that the Secretary of 

the Treasury shall conduct a study of the treatment provided by 

section 1706 of the Tax Reform Act of 1986 (relating to treatment 

of certain technical personnel). 

Pursuant to that section, I hereby submit the "Taxation 

of Technical Services Personnel: Report on Section 1706 of the 

Tax Reform Act of 1986." 

I am sending a similar letter to Representative Dan 

Rostenkowski, Chairman of the Committee on Ways and Means. 

Enclosure 

Sincerely, . 

~--t'ltJ.~ Kenneth w. Gideon 

Assi stant Secretary 

(Tax Policy) 
TABLE OF CONTENTS 

PART ONE: EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 

CHAPTER 1: EXECUTIVE SUMMARY . .. . ..... . ....... . ... . ... . .. . 3 

I. BACKGROUND OF REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 

IT. REPORT MANDATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 

ill. EVALUATION OF ISSUES . .. . . ... .. . .. . . . . . .. ..... . .. 4 

IV. OPTIONS FOR FURTHER CONSIDERATION . . . . . . . . . . . . . . . . 6 

PARI TWO: BACKGROUND INFORMATION . . . . . . . . . . . . . . . . . . . . . . . . 9 

CHAPTER 2: SOURCES OF EMPLOYEE MISCLASSIFICATION . . . . . . . . . . . 11 

I. OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 

IT. DETERMINATION OF EMPLOYEE STATUS . . . . . . . . . . . . . . . 12 

ill. DIFFERENCES IN TAX TREATMENT BE'IWEEN EMPLOYEES 

AND INDEPENDENT CONTRACTORS . . . . . . . . . . . . . . . . . . . 12 

A. Differences Favoring Independent Contractor Status . . . . . . . . . 12 

B. Differences Favoring Employee Status . . . . . . . . . . . . . . . . . 14 

C. Five Hypothetical Examples of Differential Tax Treatment . . . . . 15 

D. Validity of Differences . . . . . . . . . . . . . . . . . . . . . . . . . . 26 

CHAPTER 3: ORIGINS OF SECTION 1706.. . ..... . . . . . . . . . . . . . . . . . . 29 

I. SECTION 530 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 

IT. SECTION 3509 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 

Ill. SECTION 1706 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 

PART THREE: DISCUSSION OF ISSUES ... . .... .. .. . . . . . . . . . . . . . . . 35 

CHAPTER 4: GENERAL POLICY ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . 37 

I. OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 

ll. EFFICIENCY OF LABOR MARKETS . . . . . . . . . . . . . . . . . . . . . 37 

A. Arrangements Between Workers and Firms . . . . . . . . . . . . . . 37 

B. Government Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 

Ill. NEUTRALITY IN I AX TREATMENT . . . . . . . . . . . . . . . . . . . . 40 

A. Maintaining Labor Market Efficiency . . . . . . . . . . . . . . . . . . 40 

B. Tax Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 

IV. ADMINISTRATIVE COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 

V. NON-TAX POLICIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 

CHAPTER 5: TAX COMPLIANCE ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . 4 7 

I. OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 

II. RATE OF MISCLASSIFICATION . . . . . . . . . . . . . . . . . . . . . . . 47 

v 
ill. RATE OF NONCOMPLIANCE . . . . . . . . . . . . . . . . . . . . . . . . . 50 

A. 1985 TCMP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 

B. 1984 SVC-1 Employee Survey . . . . . . . . . . . . . . . . . . . . . . 54 

C. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 

CHAYTER 6: TAX ADMINISTRATION ISSUES . . . . . . . . . . . . . . . . . . . . . . 57 

I. OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 

II. ADMINISTRATIVE PROBLEMS WITH SECTION 1706 . . . . . . . . . 57 

ill. ADMINISTRATIVE PROBLEMS WITH COMMON LAW TESTS OF 

EMPLOYEE STATUS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 

PARI FOUR: APPENPICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 

APPENDIX A: DIFFERENCES IN TREATMENT OF EMPLOYEES AND 

INDEPENDENT CONTRACTORS--DETAILED ANALYSIS . . . . . . . . . . . 63 

I. OVER VIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 

ll. FEDERAL TAX LAW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 

A. Employment Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 

B. Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 

C. Determination of Employee Status . . . . . . . . . . . . . . . . . . . . 75 

ill. OTHER LAWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 

A. Federal Labor Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 

B. Patent and Copyright Laws . . . . . . . . . . . . . . . . . . . . . . . . 80 

C. State Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 

D. Determination of Employee Status . . . . . . . . . . . . . . . . . . . . 81 

IV. SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 

APPENDIX B: COMMON LAW FACTORS USED TO DETERMINE EMPLOYEE 

STATUS . • . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 

APPENDIX C: ADDffiONAL BACKGROUND TO TCMP AND SVC-1 . . . . . . . . 85 

I. TCMP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 

II. SVC-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 

Vl 
LIST OF TABLES 

Chapter 2 

2-1 Major Differences in Treatment of Employees and Independent Contractors for 

Federal Tax and Other Purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 

2-2 Comparison of Income and Taxation of $1,000 of Total Compensation for an 

Employee or Independent Contractor, Worker with a Typical Mix of Fringe 

Benefits and no Worker Expenses .... . .. ......... .... ...... .... 18 

2-3 Comparison of Income and Taxation of $1,000 of Total Compensation for an 

Employee or Independent Contractor, Worker with a Typical Mix of Fringe 

Benefits, no Worker Expenses, and 5 Percent Non-Compliance by the 

Independent Contractor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 

2-4 Comparison of Income and Taxation of $1,000 of Total Compensation for an 

Employee or Independent Contractor, Worker with a Typical Mix of Fringe 

Benefits and Worker Expenses of 10 Percent . . . . . . . . . . . . . . . . . . . . . . . 21 

2-5 Comparison of Income and Taxation of $1,000 of Total Compensation for an 

Employee or Independent Contractor, Worker with Only Statutory Benefits and 

no Worker Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 

2-6 Comparison of Income and Taxation of $1,000 of Total Compensation for an 

Employee or Independent Contractor, Worker with Only Statutory Benefits, no 

Worker Expenses, and a "Wedge" Between Employee and Independent 

Contractor Total Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 

Chapter 5 

5-1 Percentage of Employers with Some Misclassified Employees, by Industry . . . . . 49 

5-2 Reporting of Income and Expenses by Employees and Independent Contractors 52 

Appendix A 

A-1 Tax-Favored Benefits Available to Employees and Independent Contractors . . . . 73 

Vll 
PART ONE 

EXECUTIVE SUMMARY 
CBAPfER 1: EXECUTIVE SUMMARY 

I. BACKGROUND OF REPORT 

Despite the wide variety of relationships between workers and firms, there are generally 

only two classifications of workers for Federal tax purposes: self-employed workers (sometimes 

called independent contractors) and employees. The proper classification is self-evident for 

many workers; for others, it is ambiguous. When the proper classification is ambiguous, the 

potential for worker misclassification increases. Inadvertent misclassification may occur if 

employers lack sufficiently detailed guidance to determine the correct classification. In addition, 

the various legal, economic, and tax consequences of the alternate classifications may provide 

incentives for deliberate misclassification. 

Historically, misclassification of employees as independent contractors was a concern 

because self-employed workers faced significantly lower Social Security and Medicare tax rates 

than the combined rate for employers and employees. Misclassification was perceived as 

producing large losses of employment tax revenues. Now that self-employed workers face 

Social Security and Medicare tax rates comparable to the combined rate for employees and 

employers, concern about misclassification has shifted to potential losses of all tax revenues. 

Income and employment tax revenues may be lower due to differences in the income and 

employment tax bases and differences in compliance between employees and the self-employed. 

In the late 1960s, when significant employment tax rate differentials still existed, the 

Internal Rev~nue Service (IRS) began to increase its employment tax enforcement activities, 

which previously had been sporadic, to address the misclassification of workers. Classification 

of a worker directly affects employment tax obligations and indirectly affects a worker's income 

tax treatment. As a result of the IRS' actions, the number of reclassifications increased 

substantially. Many reclassifications resulted in large retroactive assessments against employers. 

Congress subsequently took several actions to address taxpayer concerns about worker 

reclassification. In section 530 of the Revenue Act of 1978 (section 530), it provided statutory 

relief from reclassification for certain employers involved in employment tax controversies with 

the IRS. Section 530 generally prohibited the IRS from challenging an employer's erroneous 

treatment of an employee as an independent contractor for employment tax purposes if the 

employer had a reasonable basis for such treatment and certain other requirements were met. 

It also generally prohibited the IRS from issuing regulations or publishing revenue rulings 

addressing the status of workers as employees or independent contractors for employment tax 

3 
4 

purposes. Section 530 was initially intended as an interim measure. In 1982, Congress 

extended it indefinitely, and also limited employer liabilities in certain cases of retroactive 

reclassification. 

Section 1706 of the Tax Reform Act of 1986 (section 1706) removed the statutory relief 

of section 530, but only for taxpayers that broker the services of technical services workers, i.e., 

engineers, designers, drafters, computer programmers, systems analysts and other similarlyskilled workers engaged in a similar line of work. Thus, section 1706 only applies in multiparty situations involving (1) technical services workers, (2) companies that use the workers, and 

(3) firms that supply or broker the services of the workers. 

Section 1706 does not change the rules for classifying workers as employees or 

independent contractors, nor does it change the legal status of anyone covered by the provision. 

It only permits the IRS to interpret and enforce the underlying rules for employment tax 

purposes for the covered technical services workers without regard to section 530. However, 

in practice the worker's employment tax classification generally determines whether the worker 

is treated as an employee or independent contractor for Federal income tax purposes. 

ll. REPORT MANDATE 

This report was prepared in response to a congressional mandate in the Technical and 

Miscellaneous Revenue Act of 1988 (fAMRA). Section 6072 ofT AMRA directed the Secretary 

of the Treasury or his delegate to conduct a study of the treatment provided by section 1706 of 

the Tax Reform Act of 1986 (TRA 1986). 

ill. EVALUATION OF ISSUES 

According to the Conference Report on TAMRA, 1 the Treasury report was to include 

an evaluation of five issues. These issues, and the general fmdings of the report with respect 

to each, are described below. 

1 H.R. Conf. Rep. No. 1104, 100th Cong., 2d Sess. 167-68 (1988). 
5 

Administrability of section 1706. The Conference Report questioned whether there were 

difficulties in the administration of the provisions of section 1706. The report finds that: 

• Section 1706 itself presents few administrative problems, particularly in comparison with 

section 530; 

• Section 1706 actually improves the administrability of the present-law rules for 

classifying individuals as employees or independent contractors by partially repealing the 

prohibition in section 530 against the issuance of guidance; but 

• The occupations covered by section 1706 could be clarified (see Chapter 6, section IT). 

Abuses in tbe re,portin" of income by inde_pendent contractors. The Conference Report 

questioned whether there were any abuses in the reporting of income by independent contractors 

that would justify the adoption of section 1706, including any evidence of greater noncompliance 

by independent contractors when compared to employees. The report fmds that 

• Existing IRS data suggest that there are errors in the classification of employees as 

independent contractors and in the reporting of income by such individuals, which may 

call for legislative or administrative changes--

• Underreporting of income by such individuals, and the more favorable treatment 

of independent contractor trade or business expenses, reduce tax revenue; 

Misclassification of employees as independent contractors increases tax revenues, 

however, and tends to offset the revenue loss from undercompliance by such 

individuals, because direct compensation to independent contractors is substituted 

for tax-favored employee fringe benefits; 

• Evidence suggests that compliance is somewhat better for technical services workers who 

are classified as independent contractors than for workers in general who are classifLed 

as independent contractors (see Chapter 5). 

Chillin2 effect of section 1706 on the ability of technical services personnel to get work. The 

Conference Report questioned the effect of section 1706 on the ability of technical services 

personnel to get work. The report concludes that: 

• Section 1706 does not affect the cost to firms of technical services workers relative to 

other workers, and does not affect the demand for firms' products; it is unlikely, 

therefore, that section 1706 affects the overall ability of technical services workers to get 

work; 
6 

• Section 1706 may, however, have had some transitory effects on the ability of some 

workers to find work in their accustomed classification (see Chapter 4). 

Adminjstrability of the present-law standards for classi(yin~ individuals as employees or 

indej>endent contractors. The Conference Report questioned whether the present law standards 

for distinguishing between employees and independent contractors were administrable. The 

report finds that: 

• The task of classifying workers as employees or independent contractors under the 20-

factor common law tests generally used under present law can be difficult, in particular 

in the multi-party situations affected by section 1706; 

• Section 530 has exacerbated this problem by preventing the IRS from issuing guidance 

in this area for over ten years; and 

• Section 1706 may have improved tax administration by permitting the IRS to issue 

guidance with respect to certain workers and by denying the section 530 safe harbors to 

certain employers (see Chapter 6, section Til). 

EQuity of distin~ishin~ between indej>endent contractors who work throu~h brokers and those 

who do not. The Conference Report questioned the equity of providing rules that distinguish 

between independent contractors who work through brokers and those who do not. The report 

finds that: 

• This distinction unnecessarily limits the beneficial effects of section 1706, and may have 

an adverse effect on the efficiency of the labor markets for such workers; 

• Data are not available, however, to determine whether the distinction can be justified on 

the basis of differences in compliance rates between the two groups (see Chapter 4). 

IV. OPTIONS FOR FURTHER CONSIDERATION 

The significance of the effects of section 1706 must be viewed in the context of existing 

substantive tax differences between independent contractors and employees, especially with 

respect to the exclusion of fringe benefits from gross income, the deductibility of employee 

business expenses, and differences in the Social Security and Medicare tax base. In that context, 
7 

and based on the fmdings of this report, the following options are presented for further 

consideration and analysis: 

• Eliminate the difference in treatment under section 1706 between technical services 

workers working through brokers and those not working through brokers. This 

difference is difficult to justify on equity or other policy grounds. (See Chapter 4.) 

• Clarify the occupations covered by section 1706. Difficulties in determining the 

occupations covered by section 1706 present an administrative problem. (See Chapter 

6.) 

• Repeal the prohibition in section 530 against the issuance of guidance by the IRS 

concerning employee status. This prohibition has significantly reduced taxpayers' ability 

to classify workers correctly as employees or- independent contractors and has 

exacerbated the difficulty of applying the 20-factor common law standards. (See Chapter 

6.) 
PART TWO 

BACKGROUND INFORMATION 
CHAPfER 2: SOURCES OF EMPLOYEE MISCLASSIFICATION 

I. OVERVIEW 

A wide variety of relationships between service-providers and service-recipients exists 

in the modern economy. They differ with respect to the degree of control exercised by the 

service-recipient, whether the services are full-time or part-time, the method of compensation 

(e.g., salaried versus hourly), the level of material support provided by the service-recipient, and 

many other factors. Despite this diversity, service-providers are generally grouped into one of 

two broad categories for Federal tax purposes: employees and independent contractors. 

Misclassification of individuals as employees or independent contractors results when 

service-recipients and service-providers misapply the tests used to distinguish employees from 

independent contractors under the Code. Deliberate misclassification of employees as 

independent contractors results in part from the fact that there are numerous differences under 

the Internal Revenue Code (Code) between the treatment of employers and employees, on the 

one hand, and independent contractors and their clients, on the other, and from the perception 

that these differences systematically favor the second group. 

Differences in treatment between employers and employees, on the one hand, and 

independent contractors and their clients, on the other, also occur under a number of other 

Federal and State laws, primarily those dealing with workers' compensation and unemployment 

insurance, labor-management relations, employment discrimination, and other labor issues. 

Misclassifica~on designed to benefit from these differences in non-tax treatment can also 

contribute to misclassification for Federal tax purposes, since inconsistent treatment of an 

individual under these laws and Federal tax laws might invite scrutiny. 

Misclassification of individuals as employees or independent contractors is problematic 

to the extent that it circumvents a policy decision to limit certain tax benefits or burdens to one 

group or the other, or results in a loss of revenue through noncompliance. 

This chapter provides a general description of the factors used to distinguish employees 

from independent contractors under Federal tax and other laws, and of the differences in the 

treatment of employees and independent contractors that may encourage misclassification under 

each. A more detailed description of these issues is provided in Appendix A. 

11 
12 

ll. DETERMINATION OF EMPLOYEE STATUS 

The status of an individual as an employee or independent contractor for purposes of 

Federal employment, income and other tax laws is, with few exceptions, determined under the 

common law tests for determining whether an employment relationship exists. These tests focus 

on whether the service-recipient has the right to direct and control the service-provider, not only 

as to the result to be accomplished by the work, but also as to the details and means by which 

that result is accomplished. Over the years, the IRS has identified 20 important factors useful 

in determining whether the common law tests have been satisfied. These factors are listed in 

Appendix B. 

The status of an individual as an employee or independent contractor for purposes of 

Federal and State labor and related laws is generally determined under standards that resemble 

the control-based common law standards applied under the Code. Depending on the purpose of 

the law involved, however, different factors are often emphasized in making this determination. 

Thus, IRS determinations of employee status based on the common law tests are generally 

persuasive but not determinative in other areas, and it is possible for an individual to be 

classified as an employee for some purposes and as an independent contractor for others. 

m. DIFFERENCES IN TAX TREATMENT BETWEEN EMPLOYEES AND 

INDEPENDENT CONTRACTORS 

Current law does not consistently favor status as either an employee or an independent 

contractor. Employers and employees are treated differently than independent contractors and 

their clients under a number of Federal and State laws, however. Thus, depending on individual 

circumstances, misclassification may sometimes be advantageous to the service-provider, the 

service-recipient, or both. 

A. Differences Favoring Independent Contractor Status 

Federal Tax Law. Prior to 1982, compensation earned by independent contractors was 

taxed at substantially lower rates under the Social Security and Medicare tax provisions of the 

Code than wage income, apparently creating a significant incentive for misclassification. 2 

Subsequent legislation has essentially eliminated this important difference. The Social Security, 

2 To some extent, however, the rate differential may have been offset by differences in the 

compensation base to which the taxes applied. 
13 

Medicare, and income tax provisions of the Code may still favor classification as an independent 

contractor, however, where an individual has a small or unpredictable cash flow or significant 

employee business expenses. This is primarily because: 

(1) Independent contractors face significantly fewer restrictions on their ability to 

deduct trade or business expenses than employees. In particular, employees 

generally may not deduct their trade or business expenses unless they "itemize" 

their deductions on their tax returns, and then only to the extent the expenses 

exceed two percent of their adjusted gross incomes from all sources. They must 

also satisfy additional requirements before they may deduct their automobile 

depreciation, home office, home computer and certain other expenses. These 

requirements are difficult for many employees tO meet and in some cases 

constitute an effective barrier to a deduction. 

(2) The estimated tax system used to collect Social Security, Medicare, and income 

taxes from independent contractors largely avoids the problem of over-withholding that can result when an employee incurs large business expenses, has net 

income that fluctuates during a year, or is employed for only part of a year. It 

also generally permits later and less frequent payments than the withholding 

system used to collect such taxes from employees. 

As an essentially voluntary reporting system, the estimated tax system also provides fewer 

checks against underreporting of income and taxes than the withholding system and may, 

therefore, be favored by service-providers and service-recipients willing to violate the law and 

risk detection on audit; it also does not ensure the collectability of taxes to the same extent as 

the withholding system. Finally, the withholding system involves overhead costs, which 

employers may seek to shift to employees by classifying them as independent contractors. 

The unemployment insurance tax provisions of the Code (and corresponding State laws) 

may in some cases also favor classification as an independent contractor. Independent 

contractors and their clients generally are not subject to unemployment insurance taxes. On the 

other hand, independent contractors generally are not eligible for unemployment insurance 

benefits. Other things being equal, employers will have an incentive to classify a worker as an 

independent contractor in order to avoid unemployment insurance taxes on an employee's wages 

(and the administrative costs of remitting such taxes and complying with other associated 

statutory requirements). Workers may prefer to be classified as independent contractors if they 

are not (or perceive that they are not) dependent on a single employer for their income. 
14 

Other L.aws. State and Federal labor and related laws may in some cases also favor 

classification as an independent contractor. Such laws typically do not apply to independent 

contractors, providing protection only to employees. This is generally beneficial to clients of 

independent contractors, since it may allow them to avoid the direct costs of providing additional 

benefits and protections to the independent contractors, as well as the administrative cost of 

explaining the benefits and assuring that various other statutory requirements have been met. 

Thus, the difference in treatment may provide an incentive for employers to misclassify 

employees as independent contractors. Employees may also prefer to be misclassified as 

independent contractors in order to avoid coverage under these laws, if they are not willing to 

pay the indirect cost for the specific protection provided. 

B. Differences Favoring Employee Status 

The Social Security, Medicare, and income tax provisions of the Code may, on the other 

hand, favor classification as an employee in cases where an individual prefers to receive some 

of her compensation in the form of fringe benefits rather than cash. This is because, under the 

Code, an employer may provide fringe benefits, such as pensions, accident and health and 

group-term life insurance, on a tax-favored basis to its employees but not to its independent 

contractors. Such benefits are generally excluded from employees' gross incomes subject to 

income tax as well as wages subject to Social Security and Medicare taxes. While independent 

contractors can generally establish their own fringe benefit plans, amounts used to purchase such 

benefits generally cannot be deducted or excluded from gross income subject to income tax, or 

from compensation :subject to Social Security and Medicare taxes. Limited exceptions are 

provided for cenain of the most significant benefits, including pensions and accident and health 

insurance; amounts used to purchase these benefits can to some extent be deducted or excluded 

from gross income subject to income tax by independent contractors, although they cannot be 

deducted or excluded from compensation subject to Social Security and Medicare taxes. 

An employer may be reluctant to allow an independent contractor to participate in a plan 

as an employee, however, since that might involve additional costs to the employer. This is 

particularly true if the independent contractor is highly compensated, in which case her 

participation might require the employer to provide additional benefits to its non-highly 

compensated employees under the minimum coverage and nondiscrimination requirements of the 

Code. Also, short-service independent contractors may not derive any significant benefits from 

participation, and may therefore prefer to receive additional cash compensation, instead. 
15 

The various differences in tax treatment between employees and independent contractors 

discussed above are summarized in Table 2-1. 

C. Five Hypothetical Examples of Differential Tax Treatment 

The preceding discussion indicates that Federal and State tax, labor and related laws do 

not systematically favor classification of an individual as an employee or independent contractor. 

The most beneficial classification for a particular individual depends instead on her circumstances, preferences, and negotiating skills. This section illustrates the effects of these differences 

using five hypothetical examples. 

Each example begins with $1,000 which an employer or service-recipient could spend 

on worker compensation. In the employee situation, most of the $1,000 is used to pay the 

employee her normal salary plus holiday, vacation and sick pay. The remainder is used to pay 

employment taxes (including Social Security and Medicare taxes, and State and Federal 

unemployment insurance taxes) and to provide statutorily-required or voluntarily-provided fringe 

benefits (including contributions to retirement plans, health insurance premiums, and workers' 

compensation premiums). The employee pays any Federal and State income taxes and the 

employee share of the Social Security and Medicare taxes due on her salary, and also pays any 

work-related expenses (for tools, etc.).3 

In the independent contractor situation, the $1,000 spent for worker compensation by the 

client is generally assumed to be paid to the independent contractor, although, depending on the 

knowledge and relative negotiating skills of the two parties, some might be retained by the 

client. The amount, if any, retained by the client is assumed to pass directly to the client's 

"bottom line" and, therefore, to be subject to Federal and State corporate income taxes. 

In order to maintain the comparison between the employee and the independent 

contractor, the independent contractor is assumed to incur the same costs as the employee 

(although the tax treatment may be different) and is assumed to purchase directly the same 

3 Since the examples show the impact of additional income to the employee or independent 

contractor, a 28 percent Federal income tax rate and a 7.5 percent State income tax rate are 

assumed to apply to the additional taxable income. The assumed Federal corporate income tax 

rate is 34 percent, and the assumed State rate is eight percent. The various tax rates are based 

on those that would be paid by or for a middle-income worker. 
Table 2-1 

MJVor Differences in Treatment of Employees and Independent Contractors 

for Federal Tu and Other Purposes 

Emoloues Jpdependmt ContrKt:on 

Frince Bmefq1 

Value of many employer-provided fringe benefits 

excluded from income and employment tax buea 

Qualified retirement plan contributions excluded from 

income but not self-employment tax bue 

2S pcn:cnt of health insurance coltS deducted from 

income but not self-employment tax bue 

Few other fringe bcncfitl excluded from income or 

self-c:mploymcnt tax buea 

Trade or Business Expegsa 

May be deducted from income tax bue onJy by itcmizcn 

and only to the extent expcniCI exceed two percent of 

adjusted poss income 

May not be excluded from employment tax bue 

Certain expcniCI subject to additional business purpose 

requirements 

May be deducted from income tax bue 

May be excluded from self-employment tax bue 

Administnti•e Costs 

Wllhholding involves more administrative costa for 

employer but less for employee 

Estimated tax system involves more administrative 

costa for independent contractor but less for client 

Estimated tax syatcm allows modest delay in tax 

payments relative to withholding 

Compliance 

Somewhat more ability to be noncompliant due to lack 

of withholding, larger trade or business CJtpenaea, and 

somewhat more limited business purpose requirements 

with respect to such expenses 

Noo-Tax Dif!emaces2 

Leas flexibility in choosing among fringe benefits; value 

of employer contributions to retirement plan may be lost 

if worker changes jobs frequently 

Administrative (and other) costs usociated with Federal 

and State laws applicable to employees, ~.g., minimum 

wage 

oq;&niiiCIIl 01 & Tn:uwy 

Olf.ce of Tax Poliq 

May be unable to obtain fringe benefits, including 

statutory fringe benefits such u unemployment 

insurance and workers • compensation 

May be unable to negotiate worker protections such as 

minimum wage and overtime 

1. For a detailed comparison of the tax treatment of fringe benefits and business expenses, see Appendix A. Employerprovided fringe beneftts may be subject to nondiscrimination requirements and other lim.ita. 

2. Some of the non-tax differences, such u minimum wage laws, may be more applicable to less advantaged workers than 

to occupations covered by section 1706. 
17 

benefits that the employee would receive as employer-paid fringe benefits.• It is further 

assumed that the independent contractor can purchase these benefits at the same cost an employer 

could when purchasing for all of its employees as a group.5 

Example 1--T)l)ical Mix of Frin2e Benefits. Example 1 (fable 2-2) shows a situation 

in which an employee receives a typical mix of fringe benefits but does not incur any deductible 

trade or business expenses. The employer pays the employer share of Social Security and 

Medicare taxes, as well as the total cost of workers' compensation premiums and Federal and 

State unemployment insurance taxes. The employer also makes contributions to retirement and 

medical insurance plans for the employee, each costing six percent of total compensation. The 

employee receives regular, vacation, holiday and sick pay of $806, out of which the employee's 

share of Social Security and Medicare taxes, as well as Federal and State income taxes, are paid. 

The independent contractor receives the entire $1,000 in cash. Out of that, she pays Federal and 

State income taxes, Social Security and Medicare taxes, buys health insurance, and contributes 

to a tax-favored "Keogh" retirement plan. As shown in Table 2-2, the independent contractor 

pays $12 more in Federal income tax, $4 more in State income tax, and $18 more in Social 

Security and Medicare tax. 

Taxes are higher for the independent contractor in Example 1 because the part of her 

cash income that was used to provide fringe benefits in the case of the employee is subject to 

Social Security and Medicare taxes, and some is also subject to income taxes. Current Federal 

law attempts to equate the tax rate for employees and self-employed persons for Social Security 

and Medicare tax purposes. Nevertheless, there are differences in the tax base. Self-employed 

persons may not exclude the value of fringe benefits they purchase for themselves from the 

Social Security and Medicare tax base (other than the employer portion of Social Security and 

Medicare taxes), while the value of employer-provided fringe beneftts is typically excluded from 

that base in the case of employees. Hence, in Example 1, the Social Security tax is $18, or 15 

percent, higher for the independent contractor than for the employee. The income tax system 

does provide deductions for self-employed persons for contributions to retirement plans (and for 

the equivalent to the employer portion of Social Security and Medicare taxes), but it only 

4 In practice, the lower after-tax price for voluntarily-provided fringe benefits would likely 

result in greater expenditures for these items in the employee case. Conversely, the lower aftertax price of certain trade or business expenses for independent contractors would likely result 

in higher trade or business expenses for such individuals. 

5 This assumption is made for simplicity and may be approximately correct for small 

employers. For large employers, economies of scale are probably important. 
Table 2-2 

EXAMPLE 1: COMPARISON OF INCOME AND TAXATION OF $1,000 OF TOTAL COMPENSATION 

FOR AN EMPLOYEE OR INDEPENDENT CONTRACTOR, 

WORKER WITH A TYPICAL MIX OF FRINGE BENEFITS AND NO WORKER EXPENSES 

Employer/Employee 

Servic:e 

Employer Employee Combined Recipient ~ Combine< 

Money Paymeat or Regular Salary................................... 733 733 

HolidayNacatioa/Sict Pay •.. ..........•..•....... ..•........•.......•. _____ ___;73;...._ __ 7..;;.3_ 

MONEY PAYMENT OR TOTAL SALARY...................... 806 806 

Employer-Paid Taxa and BcDcfJta................................... 194 194 

TOTAL COMPENSATION TO WORKER.... .................... ----------------~~~ 1,000 

RctaiDcd by Service Recipicat ....................................... .. 

TOTAL COMPENSATION ...................... ..................... ---------~1,-::-000~ 

TAXES AND STATUTORY BENEFITS, TOTAL ............ .. 

FcdenllDc:ome Tax 11 21 

State lucome Tax 1/ 3/ 

Social Security (FICA/SECA) 41 

Unemploymeot Iuurao.ce (FUT A and State) 5/ 

Worken' Compcuation 61 

VOLUNTARY FRINGE BENEFITS, TOTAL ................... . 

Rctiremcot!Keogh Cootributioo 

Health lusurancc Premiums 

WORKER EXPENSES (DEDUCTIBLE), TOTAL ............. . 

Income and Social Security Tax Compliance R.ab: ............... .. 

For Worker 

Total Compensation 1~ 

Taxes and Statutory.Bcnefu ..................................... . 

Moocy Income leu 

Worker Taxea .......... ............. ................................ . 

Money lllc:ome lou Worlcer Taxea, 

Worlcer-Paid Bcoefd.l, and Worlcer Expensea ..•............•. 

For Employer (Service Recipient) 

Retained by Service Recipient leu Taxa ...•.....•.......•..•...... 

Department of the Treuury 

Offace of Tax Aoaly1il 

Note: Detail may not add to totall due to rounding. 

74 

62 

4 

s 

120 

60 

60 

331 

209 

60 

62 

0 

0 

405 

209 

60 

123 

4 

s 

120 

60 

60 

100 0~ 

595 

475 

475 

0 

0 

0 

0 

0 

0 

0 

1,000 

1,000 

427 

221 

64 

141 

120 

60 

60 

0 

1,000 

1,000 

1,000 

1,000 

427 

221 

64 

141 

120 

60 

60 

100.0% 

573 

573 

453 

0 

1/ Taxable amount iJ money payment to the worker leu deductiona co01ilteot with worker ltatul. Employee bu itemized deduction

for atat.c income taxea (for federal tax purpoaea but not for atat.c tax purpose~) and for worker expenaea io exceu of 2 percent of 

adjusted grou income (usumcd to be 4 percent of money payment). Independent contractor deduct.l worker expenses, Keogh 

contributions, 25 perca1t of bcalth ioJUrao<:e premium, and SO perca~t of SECA tax. 

21 28 percent rate for the worlcer, and 34 percent nte for the eervice T"CCipient. 

31 1.5 perca~t rate for the worker, and 8 percent rate for the eervice T"CCipient. 

4/ 7 .65 percent rate for the employee and for the employer, or 14. 12955 percent rate ({100~ 65~]xl5 3~) paid entirely by the 

independent cootnletor. 

51 Assumed to be 0.55 percent of totallalary. 

61 Aasumed to be 1 percent of total lalary. 
19 

permits a deduction for 25 percent of medical insurance costs (and then only in some 

circumstances), and it does not permit a deduction for the cash equivalent of other fringe 

benefits, which in this example only consist of the costs of unemployment insurance and 

workers' compensation. 

Example 2--Noncompliaoce. Independent contractors may have greater opportunity than 

employees to be less than fully compliant with tax laws. Employees are subject to withholding, 

and the amount of their wage income is reported with great precision to the IRS. Independent 

contractors may be able to omit some of their income on their tax returns, although that becomes 

more difficult when their gross income is reported to IRS on information returns (generally 

Forms 1099-MISC). Even if independent contractors report 100 percent of their income, 

however, they may be able to lower their reported tax liability by overstating expenses. Since 

the workers in Example 2 do not have trade or business expenses, the noncompliance consists 

solely of the failure to report all of gross income. Example 2 (Table 2-3) illustrates the effect 

of a lower compliance rate on the independent contractor's tax liabilities. Example 2 is the same 

as Example 1, except that the independent contractor is assumed to report only 95 percent of her 

net income from self-employment. As a result of this underreporting by five percent, the 

independent contractor's Federal and State income taxes are now virtually the same as for the 

employee, although the Social Security tax is still $11, or nine percent, higher. 6 At greater 

levels of noncompliance, the taxes of the independent contractors would be lower than those of 

the fully compliant employee. 7 

Example 3--Trade or Business Expenses. Employee business expenses can also 

differentially affect the tax treatment of employees and independent contractors. Example 3 

(Table 2-4) is similar to Example 1, except that the worker is now assumed to have expenses 

equivalent to ten percent of total compensation. The independent contractor is able to deduct all 

of these expenses in calculating income subject to both income and Social Security and Medicare 

taxes. In contrast, the employee's Social Security and Medicare taxes are not adjusted at all to 

reflect these expenses. For income tax purposes, these expenses may be reflected if the worker 

itemizes deductions on her income tax return, but, even then, they are only deductible to the 

extent that they, together with other miscellaneous deductions, exceed two percent of her 

6 See Table 5-3 for a summary of the compliance rates found in one recent IRS study. 

7 See Table 5-2 for a summary of compliance rates actually found in one IRS study. For 

technical services workers in that study, reporting of gross receipts was 97.0 percent, and 

reporting of net income (i.e., gross receipts minus business expenses) was 83.4 percent. 
Table 2-3 

EXAMPLE 2: COMPARISON OF INCOME AND TAXATION OF $1,000 OF TOTAL COMPENSATION 

FOR AN EMPLOYEE OR INDEPENDENT CONTRACTOR, 

WORKER WITH A TYPICAL MIX OF FRINGE BENEms, NO WORKER EXPENSES, 

AND 5 PERCENT NON-COMPLIANCE BY THE INDEPENDENT CONTRACTOR 

Employ~ !Employee lndepeodent Contractor 

Employ~ Employee Combined 

Mooey Paymeat or Regular Salary................................... 733 733 

HolidayNacaboa/Sict Pay............................................ 73 73 ----------~~----~~ MONEY PAYMENT OR TOTAL SALARY...................... 806 806 

Employer-Paid Tax. and Bcuefita ................................. .. 

----------------~~~ TOTAL COMPENSATION TO WORKER........................ 1,000 

RctaiDod by Servi&:c Recipient ........................................ . 

----------------~~~ TOTAL COMPENSATION........................................... 1,000 

TAXES AND STATUTORY BENEFITS, TOTAL ............. . 

Federal Iocome Tax I/ '1J 

State IAc:ome Tax II 3/ 

Social Security (FICAISECA) 4/ 

Uacmploymeat IDswucc (FUT A and State) 51 

Worbra' Compeoution 6/ 

VOLUNTARY FRINGE BENEFITS, TOTAL .................. .. 

RetireiiiCIItiKeo&)l Contributioo 

Health lllluraoce Premiums 

WORKER EXPENSES (DEDUCTIBLE), TOTAL ............ .. 

Income and Social Security Tax Compliance Rate ............... .. 

For Worker 

Total Compenution 1~ 

Taxea and Statutory Beneflls ....................... ............. .. 

Mooey Income lea 

Worbr Taxea ....................................................... . 

Mooey Income lea Worker Taxea, 

Worker-Paid Bcuefltl, and Worker Expenaea ................. . 

For Employer (Service Recipient) 

RctaiDod by Service Recipient leu taxea ........................... . 

Dcputmeot of the Treasury 

Office of Tax Analysis 

Note: Detail may not add to total• due to rounding. 

62 

.. 

8 

120 

60 

60 

0 

331 

209 

60 

62 

0 

0 

405 

209 

60 

123 

4 

8 

120 

60 

60 

100.0~ 

595 

475 

475 

0 

Service 

Recipient Worker Combine 

0 

0 

0 

0 

0 

1,000 

1,000 

404 

209 

61 

134 

120 

60 

60 

0 

1,00 

1,00 

1,00 

1,00 

40 

20 

6 

13: 

9s.o

59 

59 

47 

11 Taxable amount is money payment to the worbr leas deduction• c:onaistent with worbr ltatua. Employee bu itemized deductio 

for atatc income taxea (for federal tax purpoaea but not for ltate tax purpo~e~) and for worbr expen~e~ in exccu of 2 percent of 

adjuated grott income (assumed to be 4 percent of money payment). Independent contractor deducts worbr expenses, Keogh 

cootributiona, 25 percent of health inlurance premium, and SO percent of SECA tax. 

'1J 28 percent rate for the worker, and 34 percent rate for the ICrVice recipient. 

3/ 7.5 perc:eot rate for the worbr, and 8 percent rate for the service recipient. 

4/ 7 .65 percent rate for the employee and for the employ~. or 14. 12955 perceot rate ([ 00~ 6S~]x15 3~) paid entirely by the 

indepeodcnt cootractor. 

51 Auumed to be O.SS percent of total ulary. 

6/ Auumed to be I percent of total aalary. 
Table 2-4 

EXAMPLE 3: COMPARISON OF INCOME AND TAXATION OF $1,000 OF TOTAL COMPENSATION 

FOR AN EMPLOYEE OR INDEPENDENT CONTRACTOR, 

WORKER WITH A TYPICAL MIX OF FRINGE BENEFITS 

AND WORKER EXPENSES OF 10 PERCENT 

Employer/Employee 

Employer Employee Combined 

Money Payment or Regular Salary................................... 733 733 

HolidayNK&tion/Siclc Pay ............................................ -----~7~3::-- ~~73-:-

MONEY PAYMENT OR TOTAL SALARY...................... 806 806 

Employer-Paid Taxes and Benefits ................................... _ _ _ 1_94 ______ --::-194:-::-

TOTAL COMPENSATION TO WORKER. ....................... 1,000 

Retained by Service Recipient ......................................... - - ---------::-:-::-

TOTAL COMPENSATION........................................... 1,000 

TAXES AND STATUTORY BENEFITS, TOTAL ............. . 

Federal Income Tax 11 21 

State Income Tax 11 31 

Social Security (FICAISECA) 4/ 

Unemployment Insurance (FUT A and State) 51 

Workers' Compensation 6/ 

VOLUNTARY FRINGE BENEFITS, TOTAL ................... . 

RctircmentJKcogh Con.tribution 

Health Insurance Premiums 

WORKER EXPENSES (DEDUCTIBLE). TOTAL ............. . 

Income and Social Security Tax Compliance Rate ................ . 

For Worker 

Total CompensationJoss 

Taxes and Statutory Benefits ..................................... . 

Money Income less 

Worker Taxes ....................................................... . 

Money Income less Worker Taxes, 

Worker-Paid Benefli.S, and Worker Expenses ................. . 

For Employer {Service Recipient) 

Retained by Service Recipient less Taxea ................ .......... . 

Department of the Treasury 

Office of Tax Analysis 

Note: Detail may not add to totals due to rounding. 

74 

62 

4 

8 

120 

60 

60 

0 

308 

191 

55 

62 

0 

100 

382 

191 

55 

123 

4 

8 

120 

60 

60 

100 

100.0% 

618 

498 

398 

0 

Independent Contractor 

SeTvice 

Recipient Worker Combined 

0 

0 

0 

0 

0 

0 

1,000 

1,000 

381 

197 

51 

127 

120 

60 

60 

100 

1,000 

1,000 

1,000 

1,000 

381 

197 

57 

127 

120 

60 

60 

100 

IOO.O'k 

619 

619 

399 

0 

1/ Taxable amount is money payment to the worker less deductions consistent with worker status. Employee has itemized deductions 

for state income taxes (for federal tax purposes but not for state tax purposes) and for worker expenses in excess of 2 percent of 

adjusted gross income (assumed to be 4 percent of money payment). Independent contractor deducts worker ellpenses, Keogh 

contributions, 25 percent of health insurance premium, and SO percent of SECA tax. 

2/ 28 percent rate for the worker, and 34 percent rate for the service recipient. 

31 1.5 percent rate for the worker, and 8 percent rate for the service recipient. 

41 1.65 percent rate for the employee and for the employer, or 14 . 12955 percent rate ([100%-7.65%]x15.3%) paid entirely by the 

independent contractor. 

Sf Assumed to be 0.55 percent of total salary. 

61 Assumed to be I percent of total salary. 
22 

adjusted gross income from all sources. In Example 3, it is assumed that the effective deduction 

floor is equivalent to four percent of total compensation, so that only the excess over that level 

is deductible. As a result of the differential treatment of these trade or business expenses, the 

extra Federal income tax paid by the independent contractor has been reduced from $12 to $6, 

and the extra State income tax has been reduced from $4 to $2. The extra Social Security tax 

has been reduced from $18 to $4, however. 

Effect of Expenses on Noncompliance Rates. The noncompliance rate for net income 

generally does not equal the noncompliance rate for gross income. The rates are equal only 

when gross income and net income are equal because the worker has no trade or business 

expenses. When the worker has such expenses, the noncompliance rate for net income exceeds 

the noncompliance rate for gross income. The higher the level of expenses, the greater the 

difference between noncompliance rates becomes. Consider a worker with gross income of 

$1,000 and expenses of $400; net income is $600. If the worker understates gross income by 

ten percent, net income will be understated by 16.7 percent.• 

The noncompliance rate for net income and the difference between the gross and net 

income compliance rates will be greater if the worker can use the existence of trade or business 

expenses to understate net income further by overstating expenses. In the example above, if the 

worker both understates gross income by ten percent and overstates expenses by ten percent, net 

income will be understated by 23.3 percent.9 

Example 4-Statutorily-Required Frin~e Benefits Only. In Example 4 (fable 2-5), the 

employer is assumed not to provide any voluntary fringe benefits. In addition to salary, the 

employer pays only for the employer portion of Social Security and Medicare taxes, the Federal 

and State unemployment taxes, and workers' compensation insurance premiums. Since fringe 

benefits, which cause the disparity between Social Security and Medicare tax levels for 

employees and independent contractors, have been greatly reduced, there is only a $1 difference 

in Social Security and Medicare taxes between the employee and the independent contractor. 

The additional Federal income tax paid by the independent contractor is $4, and the additional 

8 Net and gross income are both understated by $100. The noncompliance rate on gross 

income is $100/$1,000; the noncompliance rate on net income is $100/$600. 

9 Gross income is understated by $100. Expenses are overstated by ten percent, or $40. 

Net income is understated by $140. The noncompliance rate on net income is $140/$600. 
Table 2-S 

EXAMPLE 4: COMPARISON OF IN COM£ AND TAXATION OF $1,000 OF TOTAL COMPENSATION 

FOR EMPLOYEE OR INDEPENDENT CONTRACTOR, 

WORKER WITH ONLY STATUTORY BENEFITS AND NO WORKER EXPENSES 

Employer/Employee 

Employer Employee Combined 

Money Paymcot or Regular Salary................................... 916 916 

Holiday/Vacatioa/Siclt Pay ............................................. _______ o ___ _ MONEY PAYMENT OR TOTAL SALARY...................... 916 916 

84 

1,000 

Employer-Paid Tax01 and Bcoefata ................................... ___ 84--------,-~~ 

TOTAL COMPENSATION TO WORKER ....................... . 

1,000 

Retained by Service Recipicot. ........................................ -----------,-~~ 

TOTAL COMPENSATION .......................................... . 

TAXES AND STATUTORY BENEFITS, TOTAL ............ .. 

Federallncome Tax 1/ 21 

State lncome Tax 1/ 3/ 

Social Security (FICAISECA) 4/ 

Uoemploymcot Inauraocc (FUT A and State) Sf 

Worker•' Compcoutioo 61 

VOLUNTARY FRINGE BENEFITS, TOTAL .................. .. 

Rctiremeot!Kcogh Contribution 

Health loiUrance Premiums 

WORKER EXPENSES (DEDUCTIBLE), TOTAL ............ .. 

Income and Social Security Tax Compliance Rate ............... .. 

For Worker 

Total Compcn~~~tion leu 

Taxes and Statutory BenefitS .................................... .. 

Money lnc:ome le.~ 

Worker Taxes ...................................................... .. 

Money Income l011 Worker T<CI, 

Worker-Paid Benefits, and Worker Expen101 .. ............... . 

For Employer {Service Recipient) 

Retained by Service Recipient l011 Tax01 ......................... .. 

Department of the Treasury 

Office of Tax Analyail 

Note: Detail may not add to total• due to rounding. 

70 

s 

9 

0 

0 

0 

0 

376 

237 

69 

70 

0 

0 

460 

237 

69 

140 

s 

9 

100 0~ 

S40 

S40 

S40 

0 

Independent Contractor 

Service 

Recipient Worker Combined 

0 

0 

0 

0 

0 

0 

1,000 

1,000 

452 

241 

70 

141 

0 

0 

0 

0 

1,000 

1,000 

1,000 

1,000 

452 

241 

70 

141 

100.0% 

548 

548 

548 

0 

II Taxable amount il money payment to the worker less deductions consistent with worker status. Employee bas itemized deductions 

for state income taxes (for federal tax purposes but oot for 1tate tax purposes) and for worker expenaea in excess of 2 percent of 

adjusted grou income (assumed to be 4 perccot of money payment). lodepcndent contractor deducta worker expenses, Keogh 

contributions, 2S percent of health insurance premium, and SO perceot of SECA tax. 

21 28 percent rate for the worker, and 34 perccot rate for the aervicc recipient. 

3/ 7 .S percent rate for the worker, and 8 percent rate for the aervice recipicot. 

41 7.65 percent rate for the employee and for the employer, or 14.12955 percent rate (fi00~-7 6S~)xiS.3~) paid entirely by the 

independent contractor. 

Sl Assumed to be O.SS perccot of total salary. 

61 Assumed to be I percent of total salary. 
24 

State income tax is $1. The situation illustrated in Example 4 is typical of many temporary 

employees, whose fringe benefits are often restricted to those required by law. 10 

Note that in Example 4, as a result of higher cash wages exactly offsetting the reduction 

in fringe benefits, both workers' total current tax bills have increased compared with the workers 

in Example 1. For the employee, the sum of the Federal and State income taxes and the 

combined employer-employee Social Security and Medicare taxes has increased by $53, or 13 

percent. For the independent contractor, the combined bill has increased by $25, or six percent. 

. Example S-Lower lndcaxmdent Contractor Compensation. Example 5 (Table 2-6) is 

similar to Example 4, except that the independent contractor's compensation is slightly lower 

because she has been unable to negotiate from her client the equivalent of the value of the 

employer's costs for workers' compensation and unemployment insurance (i.e., her bargaining 

power is lower than in Example 4). Since this wedge between total employee compensation and 

total payments to the independent contractor is small, the resulting tax differences are also small. 

Because the independent contractor now has less income, her Social Security and Medicare taxes 

are now slightly lower ($1) than those paid by the employer and the employee. Also, the 

independent contractor's Federal and State income taxes are now the same as those of the 

employee. However, because the client must pay income tax on the funds it has retained, the 

combined income taxes of the independent contractor and her client are still $6, or two percent, 

higher than those of the employee. 

11 

Summary. These examples illustrate that the difference in income, Social Security and 

Medicare taxes paid by employers and employees, on the one hand, and independent contractors 

and their clients, on the other, on the same amount of total compensation depends on the 

proportion of compensation the individual takes as fringe benefits, the extent of the individual's 

work-related expenses, and the relative compliance of employees and independent -contractors. 

With typical patterns of fringe benefits and worker expenses, independent contractors and their 

clients tend to pay higher levels of taxes, especially Social Security and Medicare taxes, than 

10 U.S. Department of Labor, Bureau of Labor Statistics, BLS Reports on its First Survey 

of Pay and Employee Benefits in the Temporary Help Supply Industry, 88-260, page 8 (1988). 

11 Employees with substantial trade or business expenses and sufficient bargaining power 

may be able to negotiate with their employers to structure computer and auto expenses as 

required business expenses. In such a situation, the worker would still be subject to the twopercent floor, but would be able to deduct expenses that would normally not be deductible. 
Table 2-6 

EXAMPLE 5: COMPARJSON OF INCOME AND TAXATION OF $1,000 OF TOTAL COMPENSATION 

FOR EMPLOYEE OR INDEPENDENT CONTRACTOR, 

WORKER WITH ONLY STATUTORY BENEFITS, NO WORKER EXPENSES, 

AND A •WEDGE• BETWEEN EMPLOYEE AND INDEPENDENT CONTRACTOR TOTAL COMPENSATION 

Employer/Employee Independent Contractor 

Employer Employee Combined 

Mooey Paymeat or Regular Salary................................... 916 916 

HolidayNacatioo/Sidt Pay............................................. 0 ----------~~----~~ MONEY PAYMENT OR TOTAL SALARY............... .. ..... 916 916 

Employer-Paid Tuca and Bcoefata .••.•••••.•.•••••.•..•••••••••.•••. ____ 84:...._ ____ ---:--=-:::-=-

TOTAL COMPENSATION TO WORKER ....................... . 

84 

1,000 

Retained by Service Recipi~t. ........ .. .............. ................ ------------------....,....,..~ 

TOTAL COMPENSATION .......................................... . 1,000 

TAXES AND STATUTORY BENEFITS, TOTAL .......•...... 

Fedcrali.Dcom.c Tax 11 21 

State locomo Tax II 31 

Social Security (FICAISECA) 41 

Uoemploymoot lnluraoc:c (FUT A and State) 51 

Workcn' Compeuaatioo 61 

VOLUNTARY FRINGE BENEFITS, TOTAL ................... . 

Retiremeot/Koogb Contribution 

Health Insurance Premiums 

WORKER EXPENSES (DEDUCTIBLE), TOTAL ............. . 

Income and Social Security Tax Compliance Rate ...•.•..•.••••••. 

For Worker 

Total Compenution )qa 

Taxes and Statuto.ry Benefiu ................................... .. . 

Money Income less 

Worker Taxes ....................................•................... 

Money lncomo leu Worker Taxes, 

Worker-Paid BeaefJ.ta, and Worker Expenaca ................. . 

For Employer (Service Recipient) 

Retained by Service Recipient lcaa Taxes .......................... . 

Deputment of the Treasury 

Office of Tax Analysis 

Note: Detail may not add to totals due to rounding. 

84 

70 

s 

9 

0 

0 

0 

0 

376 

237 

69 

70 

0 

0 

460 

237 

69 

140 

s 

9 

100.0% 

S40 

S40 

S40 

0 

Service 

Recipient Worker Combined 

14 

6 

4 

0 

0 

986 

986 

445 

237 

69 

139 

0 

0 

0 

0 

986 

986 

986 

14 

1,000 

451 

242 

70 

139 

100.0% 

541 

541 

541 

9 

11 Taxable amount is money payment to the worker lea deductions consistent with worker status. Employee hu itemized deductions 

for state income taxes (for fede.ral tax purpoaea but. not for state tax purpoaea) and for worker expenses in excc:as of 2 percent of 

adjusted grou income (uaumed to be 4 percent of money payment). Independent contractor dcducu worker expenses, Keogh 

contributions, 2S percent of health insurance premium, and SO percent of SECA tax. 

21 28 percent rate for the worker, and 34 percent rate for the ICfVice recipient. 

31 7.5 percent rate for the worker, and 8 percent rate for the ICfVice recipient. 

41 1.65 percent rate for the employee and fo.r the employer, or 14. 12955 percent rate ({100% -7.65%]xl5.3%) paid entirely by the 

independent contractor. 

51 Auumcd to be 0.55 percent of total aalary. 

61 Auumed to be I percent of total aalary. 
26 

employees and employers, provided that the income and expenses are reported correctly. 12 

When independent contractors receive few fringe benefits that are not statutorily-required (as is 

typical for temporary workers), however, and have few or no trade or business expenses, they 

and their clients may pay about the same level of taxes as employees and employers, provided 

that the income and expenses are reported correctly. 

D. Validity of Differences 

It is evident from the preceding discussion that a mere change in classification of an 

individual as an employee or independent contractor can result in differences in the total tax 

liability of the individual and the service-recipient, regardless of whether there has been any 

change in their economic circumstances. While such differences may seem arbitrary or unfair 

in the case of individuals whose relationship with a service-recipient places them close to the line 

between employee and independent contractor status, these differences can generally be justified 

for more "typical" employees and independent contractors. For example, withholding, the 

partial disallowance of trade or business expense deductions, and the imposition of additional 

business purpose requirements on those deductions, may be more administratively appropriate 

for employees than independent contractors, on the assumption that independent contractors 

typically have more volatile net incomes and larger trade or business expenses, and typically 

change jobs more frequently than employees. Similarly, the special treatment accorded to 

employee fringe benefits under the Code, and the special protections for employees found in 

Federal and State labor laws, may be justified if employees typically have less bargaining power 

than independent contractors and are more dependent on a single business for their livelihoods. 

Even if these assumptions regarding "typical" employees and independent contractors are 

correct, the fact that a single broad distinction is drawn under the Code between employees and 

independent contractors means that some •atypical" individuals may not be treated properly. 

For example, withholding and the partial disallowance of trade or business expense deductions 

may not be appropriate (except as a compliance measure) for an employee who regularly incurs 

large expenses and changes jobs frequently: in such situations it might be preferable to treat the 

individual as an employee for one purpose and an independent contractor for another. Similarly, 

independent contractors who lack significant bargaining power or financial sophistication may 

be better off being treated as employees under the fringe benefit provisions of the Code and 

under Federal and State labor laws. Nevertheless, the costs of such inappropriate results in 

12 The higher levels of Social Security taxes may in some cases result in a comparable 

increase in Social Security benefits. 
27 

some cases must be balanced against the benefits of maintaining a single standard that applies 

for all purposes. 

Of course, it may be that these assumptions regarding the characteristics of "typical" 

employees and independent contractors are not generally correct. If this is the case, and the 

current scheme therefore results in inappropriate results in too many cases, it may be desirable 

to develop new definitions of employee or even to reexamine the need for the current-law 

distinctions between employees and independent contractors. For example, if most independent 

contractors lack the means or the foresight to provide for their own retirement income or health 

insurance coverage, there may be no reason to limit the fringe benefit provisions of the Code 

to employees, except perhaps in the case of wealthier or more sophisticated individuals. 

Similarly, there may be no reason for the differences in treatment of employees and independent 

contractors with respect to the excludability of fringe benefits from the Social Security and 

Medicare tax base, which arose at a time when fringe benefits made up only a small portion of 

total income. 
CHAPTER 3: ORIGINS OF SECTION 1706 

I. SECTION 530 

In the late 1960s, the IRS began to increase its employment tax enforcement activities, 

which had previously been sporadic, to address the misclassification of employees as independent 

contractors. Since, as noted above, independent contractors and their clients at that time faced 

significantly lower Social Security and Medicare tax rates than employers and employees, such 

misclassification was perceived to produce large revenue losses. As a result of the IRS' action, 

the number of reclassifications increased substantially. 13 Many of these reclassifications 

resulted in large assessments against the employers involved for employer Social Security, 

Medicare, and Federal unemployment insurance taxes, and unwithheld employee Social Security, 

Medicare, and income taxes. 

Taxpayers complained to Congress that the reclassifications amounted to a change of 

position by the IRS in how it was applying the common law tests for determining an individual's 

status as an employee or an independent contractor. 14 House and Senate conferees reporting 

on the Tax Reform Act of 1976 urged the IRS •not to apply any changed position or any newly 

stated position which is inconsistent with a prior general audit position in this general area to 

past, as opposed to future[,] taxable years" until the completion of a study by the Joint 

Committee on Taxation on the independent contractor issue. 15 

The Joint Committee asked the General Accounting Office (GAO) to examine the IRS 

administrati~~ of employment taxes. This study was completed by the GAO in 1977.'6 The 

study recommended that a safe harbor test of independent contractor status dealing with 

situations where an individual carries her own trade or business be added to Code, and that 

13 See IRS Annual Repons for 1971-1978. 

14 See Staff of the Joint Committee on Taxation, 96th Cong., 1st Sess., General Explanation 

of the Revenue Act of 1978, 300-01 (Comm. Print 1979); H.R. Conf. Rep. No. 1800, 95th 

Cong., 2d Sess. 271 (1978); H.R. Rep. No. 1748, 95th Cong., 2d Sess. 5-6 (1978); S. Rep. 

No. 938, 94th Cong., 2d Sess. 604 (1976). 

15 H.R. Conf. Rep. No. 1515, 94th Cong., 2d Sess. 489 (1976). 

16 GAO, Tax TreatmenJ of Employees and Self-Employed Persons by the Imernal Revenue 

Service: Problems and Solutions, GGD-77-88 (1977). 

29 
30 

certain other changes be made to reduce the financial burden of retroactive employment tax 

assessments. The study also found that employees misclassified as independent contractors on 

average reported 96 percent of their wages. This fmding, however, was based on payments by 

a sample of only five employers involved in employment tax audits.17 Noting limitations in 

the GAO sample, the IRS undertook its own study. Based on payments by a sample of 2,600 

employers to 7,109 individuals that it had previously proposed to reclassify as wages, the IRS 

found an average income tax reporting compliance rate of 76.2 percent and an average 

employment tax reporting compliance rate of 70.0 percent.

11 It also found that compliance 

rates varied less by industry than by the size of payment and other factors, with small payments 

and those likely to have been made in cash much less likely to be reported. 

In the Revenue Act of 1978, Congress, without mentioning the GAO study, provided 

statutory relief for certain taxpayers involved in employment tax controversies with the IRS. 

Section 530 of the Act prohibits the IRS from challenging an employer's treatment of an 

individual as an independent contractor for employment tax purposes if the employer (1) has a 

reasonable basis for such treatment and (2) consistently treats the individual, and any other 

individual holding a substantially similar position, as an independent contractor. 19 Section 530 

does not merely provide relief from retroactive assessments: as long as these requirements are 

met with respect to an individual, the IRS is prevented from correcting an erroneous 

classification of that individual. Section 530 applies solely for purposes of the employment tax 

provisions of the Code (e.g., Social Security, Medicare, unemployment insurance taxes, and 

income tax withholding). It does not affect an individual's classification as an employee for 

income tax purposes; treatment of an individual as an employee for income tax purposes may, 

however, violate the consistency requirement noted above and thereby cause the employer to lose 

17 Jd. at 25 and 71 . A larger sample showed compliance rates of only 87 percent. Id. at 

25. 

18 See id., Appendix V; Hearings Before the Subcommittee on Select Revenue Measures 

of the House Ways and Means Committee, 96th Cong., 1st Sess. (June 20, 1979) (Statement of 

Donald C. Lubick, Assistant Secretary of the Treasury (fax Policy)). 

19 Revenue Act of 1978, Pub. L. No. 95-600, § 530, 92 Stat. 2763, 2885 (1978). These 

requirements must be met before the commencement of any IRS compliance procedures with 

respect to an individual. Rev. Proc. 85-18, § 3.03(C), 1985-1 C.B. 518. 
31 

protection under section 530. Section 530 treats reasonable reliance on any of the following as 

a reasonable basis for treating an individual as an independent contractor: 

(1) judicial precedent, published rulings, or letter rulings or technical advice memoranda 

issued to or with respect to the taxpayer; 

(2) a past IRS audit in which there was no assessment attributable to the employment tax 

treatment of the individual or of individuals holding positions substantially similar to that 

of the individual; or 

(3) a long-standing recognized practice of a significant segment of the industry in which the 

individual was engaged. 

The IRS has issued a series of revenue procedures since 1978 explaining the application of 

section 530.20 

Section 530 was originally described as an interim measure to provide relief until 

"Congress ha[d] adequate time to resolve the many complex issues involved in this area" ,

21 and 

was scheduled to expire after 1979. It was instead extended through a series of public laws, and 

was made permanent in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).22 

ll. SECTION 3509 

In TEFRA, Congress added section 3509 to the Code to mitigate the problem of large 

retroactive employment tax assessments faced by employers who were not entitled to relief under 

section 530.23 Under prior law, in the event of a misclassification an employer could be held 

liable for the full amount of unwithheld income taxes and the unwithheld employee share of 

Social Security and Medicare taxes. In addition, the employer remained liable for Federal 

unemployment insurance tax and the employer share of Social Security and Medicare taxes. 

20 Rev. Proc. 78-35, 1978-2 C.B. 536, was issued soon after enactment. The current 

version is Rev. Proc. 85-18, 1985-1 C.B. 518. 

21 Staff of the Joint Committee on Taxation, 96th Con g., 1st Sess., General ExplanaJion 

of the Revenue Act of 1978, 300-01 (Comm. Print 1979). 

22 Pub. L. No. 96-167, § 9(d), 93 Stat. 1275, 1278 (1979); Pub. L. No. 96-541, § 1, 94 

Stat. 3204 (1980); Pub. L. No. 97-248, § 269(c), 96 Stat. 325, 552-53 (1982). 

23 Pub. L. No. 97-248, § 270(a), 96 Stat. 325, 553 (1982). 
32 

Penalties and interest could also be assessed. The employer bore the burden of proving that the 

employee had paid income and Social Security and Medicare taxes on the wages in order to 

abate any liability .

24 

Section 3509 generally limits an employer's liability for failure to withhold income, 

Social Security or Medicare taxes on payments made to an individual whom it misclassified as 

an independent contractor to 1.5 percent of the wages paid to the individual plus 20 percent of 

the employee portion of Social Security and Medicare taxes on those wages.25 Section 3509 

has no effect on an employer's own liability for Federal unemployment insurance taxes or the 

employer portion of Social Security and Medicare taxes; it also does not apply in cases of 

intentional disregard of the withholding requirements. 26 As a quid pro quo for limiting the 

employer's liability for failure to withhold employee taxes, section 3509 prohibits the employer 

from reducing its liability by recovering any tax determined under the section from the 

employee, and gives the employer no credit for any income taxes ultimately paid the 

employee. n 

m. SECTION 1706 

Section 530 affects different taxpayers differently, depending on whether they satisfy the 

conditions for relief contained therein. In particular, some taxpayers that have consistently 

misclassified their employees as independent contractors are entitled to relief under section 530, 

while other taxpayers in the same industry (that, for example, have sometimes taken more 

24 In many cases, the misclassified employee had paid SECA taxes on the wages. The 

employer could not require the employee to provide evidence of this payment, however. 

25 If the employer did not comply with the information reporting requirements associated 

with the treatment of an individual as an independent contractor, these percentages are doubled 

to 3.0 and 40 percent, respectively. 

26 If an employer's liability is determined under section 3509, the employee is liable for the 

entire amount of unwithheld Social Security and Medicare taxes, unreduced by any amount paid 

by the employer. Rev. Rul. 86-111, 1986-2 C.B. 176. 

n Code § 3509(d)(l). In some instances, an employer would be better off under the old 

rules, e.g., if it can establish that its workers have paid their income taxes in full despite its 

failure to withhold, and therefore have its liability abated. Section 3509 is a mandatory 

provision, however. 
33 

conservative positions on classification issues) are not, because they cannot satisfy the 

consistency requirements of the section. 

In the mid-1980s, some employers in the technical services industry complained that this 

difference in treatment under section 530 created an unfair advantage for certain of their 

competitors. According to the staff of the Joint Committee on Taxation, 

Congress was informed that many employers in the technical services industry 

that did not qualify for relief under section 530 nonetheless had claimed that their 

workers were independent contractors, despite the fact that such workers would 

be classified as employees under the common-law test. It is further contended 

that some of these employers were relying on erroneous interpretations of section 

530, while others simply perceived that the IRS would not aggressively enforce 

employment tax issues. 

28 

The dispute was primarily between two groups of taxpayers, both of which were engaged in the 

business of arranging for the provision of services by technical services personnel to other 

companies. One group (sometimes called "technical service firms") generally treated the 

service-providers as their employees, and they argued that the other group (sometimes called 

"brokerage firms" or "job-shops") achieved unfair cost savings by treating the service-providers 

as independent contractors. 29 As explained in Chapter 2, however, misclassification of an 

employee as an independent contractor does not necessarily result in any cost savings unless the 

misclassification is accompanied by underreporting of income or similar compliance problems 

by the independent contractors, or unless the client is able to pay the independent contractor less 

than the sum of the cash compensation and fringe benefits it would have paid to an employee. 

As a result of these complaints, Congress inTRA 1986 excluded taxpayers that broker 

the services of engineers, designers, drafters, computer programmers, systems analysts and 

"other similarly skilled workers engaged in a similar line of work" from the safe harbor 

28 Staff of the Joint Committee on Taxation, lOOth Cong. , 1st Sess. , General Explanation 

of the Tax Reform Act of 1986, 1344 (Comm. Print 1987). 

29 The frrst group is represented in part by two trade associations, ADAPSO and the 

National Technical Services Association (NTSA). The second group is represented in part by 

the National Association of Computer Consultant Businesses (NACCB). 
34 

provided by section 530, effective for payments made after December 31, 1986.30 Section 

1706 applies exclusively to multi-party situations, i.e., those involving (1) technical services 

workers, (2) a company that uses the workers, and (3) a firm that supplies the workers. The 

effect of section 1706 is to deny relief solely to the firm that supplies the workers. Section 1706 

did not affect the application of section 3509 to such firms. 

Congress may have believed that the denial of section 530 relief to this group of 

taxpayers would cause most or all technical services workers to be reclassified as employees. 31 

Section 1706 does not, however, actually require that the individuals listed in the provision be 

treated as employees: it merely requires them to be classified as employees or independent 

contractors for employment tax purposes under the usual common law tests, and permits the IRS 

to issue guidance with respect to such classification. 32 

Since the enactment of section 1706, the IRS has increased its enforcement activity in the 

employment tax area across the board, including the technical services industry. It has also 

issued guidance on the proper classification of technical services workers as employees or 

independent contractors. 

33 

30 Pub. L. No. 99-514, § 1706, 100 Stat. 2095, 2781 (1986). 

31 See H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. 11-834 (1986); 132 Cong. Rec. 

S8088-89 (June 20, 1986) (floor Statement by Sen. Moynihan introducing predecessor to section 

1706). 

32 Notice 87-19, 1987-1 C.B. 455. As described in footnote 57, however, there was some 

initial confusion over this point after the enactment of section 1706. 

33 Rev. Rul. 87-41, 1987-1 C.B. 296. 
PART THREE 

DISCUSSION OF ISSUES 
CHAPTER 4: GENERAL POLICY ISSUES 

I. OVERVIEW 

Differences in treatment between employees and independent contractors under Federal 

and State tax and other laws were described in Chapter 2. This chapter addresses the policy 

issues underlying these differences in treatment. This report proceeds from the assumption that 

the government's basic role is to maintain the efficiency of labor markets by not interfering in 

the natural diversity of firm/worker arrangements unless specific policy goals require 

intervention. The source of this diversity and its importance to the efficient functioning of labor 

markets is discussed in Section n of this chapter. Neutrality in the tax treatment of employees 

and independent contractors, addressed in Section m, in most circumstances is necessary to 

maintain the efficiency of labor markets and is required to insure tax equity between the two 

groups of workers. These tax policy issues are illustrated using the examples presented in 

Chapter 2. An additional goal of tax policy, addressed in Section IV, is to minimize tax 

compliance costs for firms, workers, and tax administration agencies while maximizing taxpayer 

compliance. Finally, the non-tax policies of the Federal and State governments affecting labor 

markets are described in Section V. 

II. EFFICIENCY OF LABOR MARKETS 

Well-functioning labor markets have a diversity of arrangements between workers and 

firms. The diversity arises naturally from differences in workers' skills and preferences and 

differences iJ:l firms' organizations and production processes. Workers search out firms that 

offer arrangements that best match the worker's skills and preferences. Likewise, firms search 

out workers whose skills and preferences best match the firms' needs. Searching by workers 

and firms is accomplished through labor markets, which may be informal or well organized. 

However organized, the more efficiently labor markets work-that is, the more closely workers' 

skills and preferences are matched to firms' needs--the greater will be workers' real income and 

firms' productivity. 

A. Arrangements Between Workers and Fli"IDS 

Workers' Skills and Preferences. The significant differences in the level and range of 

workers' skills are important determinants of the occupations and industries that workers enter, 

as well as the particular firms for which they choose to work. There are also significant 

differences in preferences across workers. For example, some workers prefer a stable 

37 
38 

relationship with a firm, with a low risk of being laid off, while other workers prefer greater 

variety in their work or greater autonomy over their work, than could normally be provided by 

a single employer. Other things being the same, workers with the first set of preferences are 

more likely to enter long-term employer/employee arrangements with fmns. Workers with the 

second set of preferences, in contrast, are more likely to work as independent contractors for 

a number of firms (service-recipients), perhaps working for none of the firms for any extended 

period of time, and perhaps working for more than one simultaneously. It is important to 

recognize that these differences in arrangements between workers and firms would arise in a 

well-functioning labor market even in the absence of any government policies that affect the 

~r market. The different arrangements exist because they are to the mutual benefit of 

workers and firms. 

Workers' preferences vary in many other respects. Workers may differ in their 

preferences about the timing of work. For example, some workers may want to alternate 

between long periods of intense work effort and leisure rather than working conventional 40-

hour weeks. 

Workers may also have different preferences over the form of compensation they receive. 

Workers may prefer cash compensation because they place a low value on the fringe benefits 

supplied by the employer, or because employers provide more of the fringe benefits than 

workers prefer. For example, some workers may consider themselves unlikely to need medical 

care, so place little value on employer-paid health insurance. Other workers may already have 

health insurance coverage through a spouse's employer and as an employee be unable to decline 

the coverage and receive the employer's savings in the form of cash compensation. Workers 

may also value pensions quite differently. A worker who knows she will change employers 

before eligibility for pension benefits becomes vested would place no value on the employer's 

pension contributions. Each of these preferences increases the likelihood that a worker would 

prefer to be an independent contractor. 34 

Finally, workers may differ in their aversion to possible health and safety risks associated 

with certain jobs. Since the insurability of such risks are quite different for employees and 

independent contractors, workers who are risk-averse are more likely to be employees. 

34 Note that cafeteria plans blur the distinction between the benefit flexibility of employees 

and independent contractors. 
39 

Firms' Or2anization and Production Processes. Just as individuals have preferences 

about the characteristics of firms, finns have preferences about the characteristics of workers. 

These preferences are detennined by a finn's organization and production processes and 

therefore vary widely across finns. A finn's preference for workers determines the mix of 

worker skills and preferences best suited to the firm. 

Firms may differ in the amount of firm-specific knowledge they require of their workers. 

Firms that require relatively little fum-specific knowledge may be less willing to make long-term 

employment commitments to their workers than firms that require relatively high levels. Firms 

may also have different costs of providing fringe benefits to their employees; larger firms 

generally can provide benefits at lower costs. 

Variability in the demand for their product may also differ among firms. Firms 

experiencing greater variability may be less willing to make long-term employment commitments 

to their workers, or at least to some of their workers, than finns with relatively more stable 

product demand. Firms may differ in the production processes they use to produce similar 

goods, leading to differences in the most suitable skill levels of their workers. Differences in 

the way that firms organize themselves also can result in differences in the fmns' abilities to 

determine whether their workers actually accomplish the tasks for which they are paid. Firms 

with higher monitoring costs may hire those workers they believe will require less monitoring 

and supervision, or workers who are more willing to be monitored. 

Arran:ements Between Workers and Firms. The differences in workers' skills and 

preferences and in firms' organization and production processes will lead to a diversity of 

arrangements between workers and finns. These differences in workers and firms are found in 

numerous combinations, so that a simple characterization of the diversity in firm/worker 

arrangements is not possible. 

Generally, frrms that demand a high degree of control over their production process or 

require workers to have a high level of fmn-specific knowledge are more likely to enter into 

long-term employer/employee arrangements with workers. Such arrangements are also more 

likely for firms that have a sufficient scale to provide fringe benefits to workers at a lower cost 

than the worker faces purchasing similar benefits directly. The workers who enter such 

arrangements are likely to be more risk-averse, or to have higher preferences for fringe benefits. 

Conversely, firms that can provide fringe benefits only at high costs or that have high costs of 

monitoring and supervising workers are more likely to prefer independent contractor 

arrangements with workers. Finns are also more likely to enter independent contractor 
40 

arrangements in circumstances where they have a high degree of variability over time in their 

need for workers with specific skills. The workers who enter such arrangements generally 

prefer more variety and autonomy, greater flexibility in scheduling work, and more cash 

compensation than they would receive as employees. 

Although firms generally enter into arrangements with workers directly, third parties may 

be involved in certain circumstances. For example, short-term arrangements for experienced 

or higher-skilled workers are often a small segment of these labor markets, so the cost to fmns 

and workers of locating each other and making matches may be quite high. Third parties such 

as temporary worker organizations and brokers reduce such costs by gathering the necessary 

information and making it available to firms and workers. 

B. Government Policy 

The diversity of arrangements between workers and firms reflects the outcome of well 

functioning labor markets. This report proceeds from the assumption that a fundamental goal 

of government policy should be to maintain the efficiency of labor markets, which generally 

requires noninterference with diversity. Government intervention in labor markets is warranted 

only in those relatively narrow and well-defined instances in which imperfections in the markets 

result in inefficiencies or in which overriding social goals can be achieved, cost effectively, 

through such intervention. Section V of this chapter briefly discusses such government 

interventions. 

ill. NEUTRALITY IN TAX TREATMENT 

A. Maintaining Labor Market Efficiency 

Tax treatment that is neutral between employee and independent contractor status is 

necessary to maintain labor market efficiency. Tax treatment that is not neutral creates artificial 

incentives for workers to be classified as employees rather than independent contractors, or vice 

versa. Although particular firms and workers may gain by responding to such artificial 

incentives, the economy as a whole does not; aggregate labor market efficiency is reduced, as 

are aggregate worker real income and frrm production. 

Determining the efficiency effects of section 1706 on the market for technical services 

workers is difficult because the underlying efficiency of the market to which section 1706 applies 

is unknown, and because that market had already been affected by prior legislation by the time 
41 

section 1706 was enacted.35 Thus, the previous efficiency of the market could not be taken for 

granted. 

Determining the efficiency effect of section 1706 is also complicated by the fact that 

section 1706 is limited to situations involving a third-party broker. The limitation creates a 

separate category of workers for employment tax purposes; depending on the effect of prior 

legislation, the limitation could cause a non-neutrality in the market. 

Section 1706 may also have indirectly affected worker classification. Publicity 

surrounding section 1706 made workers and firms aware of the common law tests and the 

correct interpretation of section 530. Workers and fmns that had incorrectly believed that 

section 530 required certain workers to be classified as independent contractors learned that it 

did not. At the same time, by removing the relief in section 530 from employer penalties for 

misclassifying technical services workers as independent contractors, section 1706 increased the 

risk to some employers of misclassification. 

It is reasonably certain that section 1706 reduced efficiency in some cases and increased 

it in others. There is not enough information, however, to reach any conclusions about the 

overall effect of section 1706 on labor market efficiency. 

The T AMRA conferees requested an evaluation of the extent to which Section 1706 has 

had a chilling effect on the ability of technical services personnel to get work. Assuming that, 

prior to the enactment of section 1706, the compensation level of technical services workers did 

not depend on their worker classification (although the compensation mix may have varied), 

section 1706 should not have affected the total demand for technical services workers. As long 

as the total compensation of independent contractors and employees is the same (although 

perhaps paid in different forms), there is no reason to expect the total demand for technical 

services workers to decline. 

Although section 1706 probably did not reduce the overall demand for technical services 

workers, it may have resulted in some workers being unable to find work with their accustomed 

form of compensation and working conditions. Removing the safe harbor provision of section 

35 The prior legislation includes income and employment tax and labor law, section 530 

restrictions on issuing guidance about classification under employment laws, and section 3509 

reductions in employer costs for misclassification. Each of these pieces of legislation may have 

reduced or increased the underlying market efficiency. 
42 

530 for technical services workers focused employers' attention on the need to classify workers 

correctly. Some independent contractors may have been able to continue their current work only 

as employees. If the classification change required the workers to accept a package of fringe 

benefits in lieu of some amount of cash compensation, the value to them of their entire 

compensation package may have changed. They would have been better off to the extent that 

they considered the fringe benefit package and its accompanying tax-preferred benefits more 

valuable than the loss in cash income. For example, workers who would previously have 

preferred to be classified as employees, but were not because of resistance from servicerecipients, would be better off. Conversely, workers who did not find the substituted fringe 

benefit package more valuable may have found the value of their income reduced. Similarly, 

workers who would not have preferred to be classified as employees include those with 

considerable trade or business expenses, whose opportunity to deduct -these expenses would have 

become constrained, and those who tended to understate receipts or overstate deductions. In 

addition, workers whose classification was questionable and who were used to working through 

brokers may have found that work as independent contractors could no longer be secured 

through a broker; these workers may have been able to continue work as independent contractors 

by contacting service-recipients directly. 

B. Tax Equity 

Equitable tax treatment requires that taxpayers in equivalent situations, with the same 

incomes, be taxed equally. Thus, providing equivalent tax treatment to employees and independent contractors is required to insure tax equity between the two groups of workers. The 

examples presented in Chapter 2 can be used to illustrate potential inequities in the tax treatment 

of employees and independent contractors. 36 As the discussion in Chapter 2 concluded, section 

1706 does not systematically favor either status. 

Worlcer with J'.)l>ical Mix ofFrin~:e Benefits. Example 1, which is summarized in Table 

2-2 in Chapter 2, shows the situation of an employee who receives total compensation of $1,000, 

consisting of wages and a typical mix of fringe benefits. The worker does not have any 

potentially deductible work-related expenses, such as union dues, home office expenses, or travel 

expenses. The independent contractor receives the entire $1,000 in cash, out of which Federal 

and State income taxes and the Social Security and Medicare taxes for self-employed workers 

36 See Section ill. C of Chapter 2 for a description of the approach taken in developing these 

examples. 
43 

are paid, health insurance is purchased, and contributions to a tax-favored "Keogh" retirement 

plan are made. 

As shown in the bottom portion of Table 2-2, the money income of the self-employed 

worker, after paying taxes and purchasing medical and retirement benefits, is $22 or about five 

percent ($22/$475) lower than that of the employee. The $22 is the net of $34 of additional 

taxes less $12 saved by not purchasing unemployment insurance and workers' compensation. 

Thus, the self-employed worker' has $22 less money income despite not having the protection 

of either unemployment insurance or workers' compensation. As explained in Chapter 2, taxes 

are higher for the self-employed worker because that part of cash income which would have 

purchased employer-paid fringe benefits is subject to Social Security and Medicare taxes and 

some is also subject to income taxes. Thus, in Example 1, the differential treatment of certain 

fringe benefits for tax purposes, especially for Social Security and Medicare taxes, causes an 

inequitable distribution of taxes between employees and independent contractors. 37 

Noncompliance. The administrative rules governing the form and timing of tax payments 

and where income is reported on tax returns differ for employees and independent contractors, 

with stricter rules generally applying to employees (see Chapter 2 and Appendix A). Thus, 

independent contractors may have greater opportunity than employees to be less than fully 

compliant with tax laws. If the situation in Example 1 is maintained, except that the independent 

contractor understates net income from self-employment by five percent, the after-tax money 

income of the independent contractor and the employee would be equal. That situation is 

illustrated in ·Example 2 (Table 2-3). If the underreporting of net income were to exceed five 

percent, the independent contractor would have a higher after-tax money income than the 

employee. 

Worlcer Expenses. Because worker expenses are treated more favorably for independent 

contractors than for employees, workers who have such expenses are not taxed equally. 

Example 3 (Table 2-4) illustrates the same situation as Example 1, except that the worker has 

work-related expenses equal to ten percent of gross compensation. This level of worker 

expenses is just sufficient to make the money income net of taxes and worker expenses of the 

independent contractor equal to that of the employee. At higher levels of worker expenses, the 

independent contractor would have a higher after-tax income. 

37 Note, however that because the independent contractor's Social Security taxes are being 

paid on a higher level of income, his or her future Social Security benefits might also be slightly 

higher. 
44 

No Voluntacy Frin&e Benefits. In Example 4 (Table 2-5), the employer provides only 

those fringe benefits mandated by Federal or State law: Social Security and Medicare; 

unemployment insurance, and workers' compensation. Otherwise, the facts are the same as in 

Example 1. In Example 1, the net after-tax income of the independent contractor was $22, or 

about five percent, lower than that of the employee. In Example 4, with no voluntary fringe 

benefits, the results are reversed; the independent contractor's money income is $8, or 1 percent, 

greater than the income of the employee. The independent contractor's greater after-tax income 

is due to the cost of the employee's coverage under unemployment insurance and workers' 

compensation and the income tax treatment of the employer's payments for that coverage. 

Inequity does not arise directly from the difference in income stemming from the cost of 

unemployment insurance and workers' compensation. Although the independent contractor has 

a higher after-tax income because she does not make payments for such coverage, the 

independent contractor also is not eligible for the benefits from these programs. The inequity 

is due to the exclusion from the employee's taxable income of the employer payments for 

unemployment insurance and workers' compensation. 

Summacy. The examples indicate that the difference in after-tax income between 

employees and independent contractors would typically be quite small, if firms classify workers 

correctly. The differences may be significant, however, for certain sets of worker preferences. 

Thus, a worker who has substantial business expenses and no desire for employee benefits may 

have much higher after-tax income as an independent contractor. Conversely, a worker who has 

few business expenses and a strong desire for all the employee benefits that a firm offers may 

have much higher after-tax income as an employee. 

While it is possible for one set of tax differentials to offset another exactly, as Examples 

2 and 3 illustrate, such exact offsets are unlikely in practice. The typical situation is for the 

combined effects of the various differentials in tax treatment not to leave employees and 

independent contractors treated exactly equally, and, therefore, to create inequities. 

Even in cases where differences in the after-tax income of the worker are small, the 

consequences of a retroactive IRS determination of misclassification may be significant for the 

firm. Because the firm did not provide employee benefits to the independent contractor, the cash 

compensation to the independent contractor generally had equalled the sum of the wage payment 

which would have been received by an employee and the amount the employer would have spent 

for employee benefits. With reclassification, the entire amount of cash compensation paid to the 

independent contractor is deemed to have been wages that the firm would have paid to the 

worker as an employee, and the employer's liability for Social Security and Medicare taxes and 
45 

for the withholding of income taxes is larger than if the firm had treated the worker as an 

employee and divided the worker's compensation into taxable wages and non-taxable fringe 

benefits. 

Classifying workers as employees nominally shifts much of the tax compliance burden 

to employers and permits tax collection through withholding, which is extremely efficient. 

Similarly, employers incur the direct compliance costs of supplying legally-required as well as 

voluntary, but somewhat regulated, fringe benefits. However, the extent to which such 

compliance burdens are shifted to employees through reduced levels of compensation is not 

known. 

IV. ADMINISTRATIVE COSTS 

Although compliance with tax laws is necessary, the administrative costs of compliance 

divert resources from other uses. A goal of tax policy is, therefore, to minimize tax compliance 

costs while achieving the desired level of efficiency and equity in the tax system. While the 

principles are clear, implementing them can be difficult. The inherent tradeoffs between low 

compliance costs, efficiency, and equity help explain some of the differentials in the tax 

treatment of employees and independent contractors. 

For example, the Federal Social Security and Medicare system generally taxes employees 

on their stated salaries; it does not permit adjustments for various work-related expenses which 

employees may incur. As a result of this simplification, the income to which the Social Security 

and Medicare taxes are applied in the case of employees may be mismeasured: that is, it may 

differ from their economic incomes. The mismeasurement may be significant in a small 

percentage of cases, and both the tax liability and the effective tax rate may be higher than if 

employees were taxed, as independent contractors are, on their net income from employment. 

In this situation, the compliance burdens of employees are greatly reduced as a result of the 

simplification, but at the cost of a certain degree of equity.38 

31 However, the benefits of excluding employer-paid fringe benefits from Social Security 

and Medicare income bases for employees but not completely for independent contractors may 

reduce or even outweigh the extra tax burden on employees from the failure to exclude 

employees' work-related expenses from the employee's Social Security, Medicare, and income 

tax bases. Moreover, workers' eventual disability or retirement benefits may be increased as 

the result of the differential in Social Security tax treatment, thus partially offsetting any 

potential equity loss. 
46 

Similarly, for income tax purposes, an employee cannot deduct any employment-related 

expenses unless she itemizes deductions on her income tax return and unless these expenses 

exceed two percent of income from all sources. Moreover, there are classes of expenses for 

which a deduction is further limited or effectively prohibited. In contrast, an independent 

contractor has much greater freedom to take such deductions for income (and Social Security 

and Medicare) tax purposes. There are, however, compliance costs to the independent 

contractor associated with this freedom. The costs include the burden of maintaining complete 

sets of records which might not otherwise have to be maintained, the burdens and expense of 

filing more complicated tax returns, and the costs of being excluded from using the highly 

efficient payment system provided by the withholding of taxes by, and payment through, an 

employer. In addition, the costs to the government of assuring compliance with tax laws through 

examination of a sample of workers' tax returns and matching information from various 

information documents against the information reported on workers' tax returns is usually higher 

for self-employed taxpayers. 

V. NON-TAX POLICIES 

Federal and State governments have a number of non-tax policy objectives which affect 

labor markets. Some of these may increase the efficiency of labor markets by reducing or 

removing imperfections, and others may achieve various politically-determined goals. While 

these policies may have important effects on workers' choices of arrangements with firms, 

because this report focuses on specific tax policies, these non-tax policies are merely listed here. 

The policies are: retirement security; access to health care; protection of workers (occupational 

health and safety); unemployment security; employment standards (minimum wage and hours); 

and nondiscrimination in employment practices. 39 

Much of the legislation implementing non-tax policies applies only to employees, not to 

independent contractors or other self-employed workers. The definition of an employee may 

vary under different legislation, however, so that, for example, a limited number of workers 

might be deemed independent contractors for tax purposes, while being deemed employees under 

wage and hours legislation. Such differences may be warranted by the differences in policies 

of the various legislation, but they do impose additional compliance costs on both firms and 

workers. Much of the additional cost stems from the confusion caused by seemingly inconsistent 

treatment, as Examples 2 and 3 illustrate. 

39 Legislation implementing these policies is summarized in Chapter 2 and Appendix A. 
CHAYI'ER 5: TAX COMPLIANCE ISSUES 

I. OVERVIEW 

The T AMRA conferees questioned whether there were abuses in the reporting of income 

by independent contractors (as compared to employees) that justified the adoption of section 

1706. This question has been evaluated in terms of whether there was a significant revenue loss 

attributable to noncompliance that section 1706 could have been expected to reduce. 40 Whether 

this is true depends in part on ( 1) the extent of the misclassification of technical services workers 

covered by section 1706 and (2) the noncompliance rate of such misclassified employees relative 

to the rate that would be expected if they were properly classified. This chapter provides data 

relevant to these questions. 41 

U. RATE OF ~CLASSIFICATION 

IRS studies suggest that misclassification of employees as independent contractors is 

significant.42 Recent studies of this problem include the IRS' Strategic Initiative on Withholding Noncompliance (SVC-1). 

40 The revenue effect also depends on the existence of other differences in the level of tax 

paid by employees and independent contractors, e.g., the proportionately larger tax expenditures 

associated with employee fringe benefits. These differences are discussed in Chapter 2 and 

Appendix A to this report. They are not taken into account here, however, because their use 

is not considered abusive within the meaning of the T AMRA conferees. 

41 At the initial stage of this study, it was determined that existing IRS data would be used 

in addressing these questions, and that no new surveys would be undertaken to measure the 

compliance of technical services workers or the population of those who had been affected by 

section 1706. 

42 See also GAO, Information Returns Can Be Used to Identify Employers Who Misclassify 

Workers Appendix II, GGD-89-1 07 (1989). In that study, individuals receiving more than 

$10,000 in income reportable on Form 1099 from one payor were identified. A random sample 

of 408 of the payors was interviewed. The interviews indicated that 157 (138-176 at a 95 

percent confidence level), or 38 percent, misclassified at least some of their employees as 

independent contractors. 

47 
48 

The employer portion of SVC-1 examined employment tax and withholding compliance 

for tax year 1984 for a sample of 3,331 employers.'0 It includes an estimate of the percentage 

of employers that misclassified at least some of their employees as independent contractors. 44 

Some of the results for different sectors are shown in Table 5-1. For purposes of the table, 

employees were considered misclassified if they were determined to be employees under the 

common law tests (regardless of whether section 530 applied), but had been treated as 

independent contractors by their employers. Employers were considered to have misclassified 

employees if they misclassified one or more of their employees, regardless of the total number 

they misclassified. 

Table 5-1 does not provide definitive proof that misclassification is a bigger problem 

among employers subject to section 1706 than among other employers. The table indicates that 

misclassification rates among employers in the service sector were not much higher than among 

employers in other sectors in the sample population. 45 It is difficult to estimate the percentage 

of misclassified employees in each sector reliably because the SVC-1 survey was designed to 

determine the frequency of employers that misclassify, rather than the frequency of misclassified 

employees. It appears, however, that the percentage of service sector employees who were 

misclassified was higher than in other sectors in the sample population, suggesting that 

employers in the service sector that had misclassified employees tended to misclassify a larger 

43 The employers were selected at random from employers with previous employment tax 

records (Form 940 or 941E) listed on the business master file (BMF) for 1984. Form 941 is 

the Employer's Quarterly Federal Tax Return. State and local governments and other employers 

that generally only withhold income taxes and do not pay FICA or FUTA taxes instead file 

Form 941E, Quarterly Return of Withheld Federal Income Tax. Thus, the employer sample 

does not include organizations with no employees or those that were legally required to ft.le a 

Form 941 or 941E for 1984, but had no previous records on the BMF. 

44 The employer portion of SVC-1 also measured compliance with reporting requirements 

with respect to employment tax returns and W-4 submittals, and compliance of U.S. citizens 

claiming exemption from withholding on foreign-source income. 

•s Misclassification rates were not separately calculated for the section 1706 group because 

the SVC-1 sample contained very few workers in technical fields (only about 0.4 percent), and 

because the SVC-1 survey did not gather sufficient data to identify employers in these fields that 

were actually subject to section 1706. 
Table 5-l 

Percentage of Employers with Some Misclassified Employees, by Industry 

Number of Employers Percentqe or 

with Misdassified Employers in Total 

Number of Employers, Employees, Weighted Population with 

Number of Employers Weighted to Represent to Represent Total Misclassified 

fndusta in Sample Total Population PoPulation Employees 

Agriculture 286 36,435 6,080 16.7,; 

Mining, Oil, Gas 260 16,819 3,324 19.8,; 

Mining, Other 276 7,624 1,228 16. 1,; 

Construction, Heavy 288 13,247 1,571 11.9,; 

Construction, Other 205 249,409 50,446 20.2,; 

Manufacturing 261 235,593 37,154 15.8,; 

Transport, Air 272 2,662 529 19.9,; 

Transport, Other and Public Utilities 264 79,995 8,700 10.9,; 

Wholesale and Retail Trade 121 781,123 74,855 9.6,; 

Finance, Insurance and Real Estate 255 241,665 46,629 19.3,; 

Services 124 848,514 130,828 15.4,; 

Government 282 68,521 6,595 9.6,; 

Not Elsewhere Classified 437 2,569,958 324,550 12.6,; 

TOTAL 3,331 5,151 ,525 692,489 13.4,; 

Dep1rtment o f ihe Treuury 

Source: Strategic lniti1tive on Withholding Noncompliance (SVC-1) Employer Survey. 
50 

percentage of their employees. 46 This may reflect the fact that the service sector contains a 

disproportionate number of smaller employers, and studies suggest that smaller employers 

misclassify a larger percentage of their employees. (It may also reflect somewhat greater 

difficulty in applying the common law tests of employee status in the service sector.) 

For several reasons, no strong conclusions can be drawn from the SVC-1 data regarding 

current misclassification patterns among employers subject to section 1706. First, there have 

been significant changes in the tax laws and IRS enforcement activity since 1984, which may 

have affected employers' abilities and incentives to misclassify workers. 47 Second, the SVC-1 

survey covered a relatively small sample of employers and has a relatively high sampling error 

for small populations. Third, the population from which the sample was drawn included mainly 

service-recipients that reported having at least some employees, and did not include servicerecipients that treated all of their workers as independent contractors. 

Finally, misclassification rates for employers subject to section 1706 could not be 

specifically determined from the data. The service sector misclassification rate may be 

indicative of the rate for employers subject to section 1706, since service brokers would tend 

to be classified in the service sector. The service-recipients may be in any industry, however, 

including manufacturing or government. There may be reason to believe that, regardless of the 

sector to which they are allocated, the relatively independent nature of the work done by 

employees covered by section 1706, and the frequently temporary nature of the employment 

relationship, may create a misleading appearance of independent contractor status under the 

common law tests. · In addition, the particular importance of computers in this area, and the 

greater ease with which independent contractors can deduct their legitimate computer-related 

expenses, may create an incentive to misclassify such employees as independent contractors. 

m. RATE OF NONCOMPLIANCE 

Misclassification can cause compliance problems if misclassified employees have a 

greater tendency to underpay their taxes, whether due to underreporting of income, overstate46 Service firms in the SVC-1 sample accounted for about 19 percent of reclassified workers 

but only ten percent of W-2 forms. ln contrast, the percentage of employers in the service 

sector that had at least one misclassified employee was only slightly higher than for all 

employers in the survey (Table 5-l). 

47 See generally Appendix A. 
51 

ment of deductions, nonpayment of reported liabilities, or other factors. In fact, IRS studies 

consistently find lower compliance rates for non-wage compensation income than for wage 

income. 41 Recent studies include the 1985 Tax Compliance Measurement Program (TCMP) 

and the employee portion of the 1984 SVC-1 survey. The 1985 TCMP is more comprehensive, 

but is less useful for the specific purposes of this report than the 1984 SVC-1 survey because 

the former covers all workers rather than just misclassified employees-the only group actually 

affected by section 1706. 

A. 1985 TCMP 

The 1985 TCMP measured wages, Schedule C gross profit, and other categories of 

income and deduction reported by a randomly-selected sample of 50,000 individual taxpayers, 

compared them to the correct amounts (determined after an examinations of the taxpayers' 

returns), and expressed the ratios as voluntary reporting percentages (VRP).'69 Data from the 

survey were then used to estimate the values for the entire population of taxpayers from which 

the sample was selected. The results are shown in Table S-2. For purposes of this table, the 

sample data have been divided between employees and independent contractors, so and between 

technical services workers and other workers. 51 

41 In addition to the IRS and GAO studies cited above, these include IRS studies of (1) 1975 

and 1976 information returns (covering filers receiving commissions or fees); (2) 1979 Forms 

1099-NEC (covering filers receiving nonemployee compensation); and (3) 1977 delinquent 

Forms 1099-MISC (follow-up study covering U.S. residents required to flle Form 1040). 

49 See generally Fratanduono & Bucci, Trends in the Voluntary Compliance of Taxpayers 

Who File Individual Income Tax Returns, in Department of the Treasury, Internal Revenue 

Service, 1989 Update, Trend Analyses and Related Statistics, Document 6011 (1989). 

so For this purpose, employees are defined as individuals with over $10,000 in wage income 

(as examined), and more wages than Schedule C income, while independent contractors are 

defined as those with over $10,000 in Schedule C income (as examined), more Schedule C 

income than wage income, and less than $5,000 in wage payments. Using this definition, 

approximately three percent of the taxpayers in the entire weighted TCMP sample were 

independent contractors, 55 percent were employees, and 41 percent did not fall into either 

category. For technical services workers, two percent of the sample were independent 

contractors, 92 percent were employees, and six percent did not fall into either category. 

51 See Appendix C for a definition of technical services worker used for this purpose. 
Table S-2 

Reporting of Income and Expenses by Employees and Independent Contractors 

.. Technical Senices Workers Other Workers 

As As Voluntary As As Voluntary 

Reported Examined Reporti .. . Reported Examined Reportil'll 

($billions) ($billions) Peruntue ($billioml fSbillionsl Pen:mtue 

Employees 

Wages, Salaries and Tips 171.1 171.1 100.0~ 1521.9 1534.1 99.2~ 

Schedule C Gross Receipts 3.0 3.1 9S.2" 37.9 39.2 96.S" 

Schedule C Gross Profit 2.2 2.4 94.3~ 23.9 2S.4 94.1~ 

Schedule C Total Deductions 1.9 1.6 117.3~ 22.1 18.9 116.9~ 

Schedule C Net Profit 0.4 0.9 S0.6~ 3.0 7.8 38.7" 

Adjusted Gross lncome 170.9 173.0 98.8" I,S66.9 l,S92.0 98.4~ 

Total Taxable Income 178.6 180.4 99.0~ 1,638.4 1,660.0 98.7~ 

Independent Contncton 

Wages, Salaries and Tips l.l 1.1 100.4" 17.2 16.9 101.0~ 

Schedule C Gross Receipts 4.4 4.S 97.0. 190.2 202.0 94.2~ 

Schedule C Gross Profit 3.8 4.0 9S.9" 113.4 124.9 90.8~ 

Schedule C Total Deductions 2.0 1.8 113.4" 72.1 6S.S 110.0~ 

Schedule C Net Profit 2.1 2.S 83.4" 47.3 6S.6 72.1" 

Adjusted Gross Income 3.1 3.7 83.9" 74.0 9S.O n.3~ 

Total Tauble lncome 3.4 4.0 8S.1" 79.1 100.2 79.0~ 

Department of ille Treuury 

Source: Taxpayer Compliance Meuuremenl Protram (TCMP) for Tax Year 1911S. 
53 

Table 5-2 shows that the VRPs for the Schedule C income (and total taxable income) of 

the independent contractors included in the 1985 TCMP were generally worse than the 

comparable VRPs for the wages (and total taxable income) of employees, but that both measures 

were generally better for technical services workers than for other workers. It also shows that 

underreporting of income was not the only reason for the independent contractors' low VRPs: 

in particular, the low VRPs for their net Schedule C income also resulted from the overstatement 

of the cost of goods sold and/or operations (resulting in underreporting of Schedule C gross 

profit), and the overstatement of other Schedule C deductions (resulting in underreporting of 

Schedule C net profit). The overstatement of Schedule C deductions contributes about two-thirds 

of the total understatement of net profit shown for technical services independent contractors. 

Some of the reported overstatement of deductions may have been attributable to inadequate 

record-keeping. 

For independent contractors, the actual reporting of Schedule C income may have been 

slightly better than indicated. Table 5-2 shows that wages and salaries tend to be slightly 

overreported by independent contractors, whereas Schedule C gross receipts tend to be slightly 

underreported. Some of the wage and salary overreporting may be due to Schedule C income 

being reported incorrectly as wage or salary income, however, which may lead to failure to 

collect any Social security or Medicare tax on that income. Thus, actual Schedule C VRPs may 

be somewhat higher than shown on Table 5-2. Also, it may be particularly hard for IRS 

examiners to detect wage and salary underreporting when the underreporting is due to collusion 

between employers and employees. Thus, actual wage and salary VRPs may not be as high as 

reported as .shown on Table 5-2. 

General conclusions drawn from the TCMP data with respect to workers actually covered 

by section 1706 are subject to several reservations. First, it was impossible to calculate separate 

VRPs for such workers, so a broader group of technical services workers was used a proxy.52 

The compliance patterns in the two groups may have been different. Second, there have been 

significant changes in the tax laws and IRS enforcement activity since 1985 that may have 

affected individuals' incentive and ability to underreport their income or overstate their 

deductions. Specifically, the tightening of the requirements for certain business deductions in 

TRA 1986 may have reduced the extent to which itemized deductions and Schedule C deductions 

52 See Appendix C for a description of the occupations included in this group. 
54 

are overstated. 53 Third, the population from which the sample was drawn includes only 

individuals for whom a return was filed, and thus the data do not measure compliance in the socalled "underground" economy. Fourth, as indicated above, it was not possible to distinguish 

misclassified workers from other workers in the TCMP sample. Therefore, the data relates to 

the relative compliance of independent contractors generally, rather than the narrower group of 

misclassified employees actually affected by section 1706. Finally, the VRPs are not adjusted 

to reflect TCMP audit sustension rates and, therefore, may not indicate the actual revenue 

potential from legislative or administrative changes affecting compliance. 

B. 1984 SVC-1 Employee Suney 

As explained above, the SVC-1 survey examined employment tax and withholding 

compliance for a sample of businesses for tax year 1984. The employer portion of the survey 

identified employees who were misclassified (by their employers) as independent contractors. 

A follow-up survey of 3,260 misclassified employees was also conducted to determine their level 

of individual reporting compliance. Data covering the 2,406 employees for whom a Form 1099 

had been filed were then weighted to represent values for the entire population of misclassified 

employees. 54 Misclassified technical services workers were found to have reported 92.6 

percent of their misclassified compensation. For other workers, the VRP was 77 percent of 

misclassified compensation. Other data from the employee portion of the SVC-1 survey suggest 

that information reporting may also play a substantial role in subsequent compliance by 

misclassified employees. 

55 

53 See, e.g., the discussion of the two-percent floor on itemized deductions and sections 

280A and 280F in Appendix A. 

54 Forms 1099 had been filed for 37 of the 43 technical services workers and 2,369 of the 

3,217 other workers in the misclassified employee sample. The sub-sample used to generate the 

estimates in the table was limited to employees for whom a Form 1099 had been filed because 

these are the only employees covered by section 530, and the issue for resolution is whether 

seetion 530 protection for misclassified workers has permitted significant compliance problems 

to develop. 

55 The survey found that information returns were filed for 84 percent of misclassified 

employees in the sample whose payments exceeded $600. While 77.2 percent of the 

misclassified compensation for which a Form 1099 was filed was reported, only 28.8 percent 

of the misclassified compensation for which no Form 1099 was filed was reported. This 

contrasts with the results of a 1977 study, in which misclassification was not an issue, which 
55 

The data from the employee portion of the SVC-1 generally suffer from the same 

problems as the TCMP data described above. In addition, the small number of technical 

services workers covered by the survey means that any differences found between them and 

other workers have a high sampling error. The TCMP data also indicate that Schedule C 

reporting of both income and deductions for workers whose primary source of income is 

Schedule C income is superior to that of workers who have only occasional Schedule C income. 

This is true for both technical services workers and other workers. There is no way to 

determine from the data whether there are differences in Schedule C reporting for correctly 

classified independent contractors and those who are incorrectly classified. Furthermore, 

workers covered by section 1706 may have more than one job during a year, and may be 

misclassified in one job but not another. Thus, correct classification may not result in correct 

reporting of the entire Schedule C amount. 

C. Summary 

The 1985 TCMP and the 1984 SVC-1 misclassified employee survey suggest that there 

is more underreporting of income by independent contractors than by employees. They do not, 

however, support assertions that technical services workers are less compliant than other 

workers. Taken together, the 1985 TCMP and 1984 SVC-1 data suggest that the reporting of 

non-wage income by workers covered by section 1706 is at least as good as, and perhaps 

superior to, reporting by other misclassified workers, but not as good as the reporting of wage 

and salary income. The 1985 TCMP also indicates that overstatement of deductions is 

responsible for much of the understatement of net profit for independent contractors in technical 

services (and independent contractors in general). 

found that 83.2 percent of the compensation for which no Form 1099 MISC was filed was 

reported. 
CHAFfER 6: TAX ADMINISTRATION ISSUES 

I. OVERVIEW 

The T AMRA conferees questioned whether there were problems with the administration 

of section 1706 itself, or with the common law tests that employers subject to section 1706 must 

generally use in classifying workers as employees or independent contractors. This chapter 

addresses these issues and concludes that both the scope of section 1706 and the common law 

tests could be further clarified. 

ll. ADMINISTRATIVE PROBLEMS WITH SECTION 1706 

Compared to section 530, section 1706 raises few administrative or interpretive issues. 

Those that have arisen concern primarily its effect (including its relationship to the common law 

tests for determining employee status) and its scope (including the occupations covered under 

it). 

Many taxpayers were initially confused about the effect of section 1706, believing that 

it required that the individuals covered by the provision be treated as employees. Apparently, 

some service-recipients reacted by treating all their technical services workers as employees, 

even though that was sometimes contrary to the results under the common law_ tests. This 

misconception probably sprang from some imprecise language in the legislative history of the 

provision 56 and an IRS publication issued soon after enactment, 57 plus the common misconception that sec~on 530 had previously required that these individuals be treated as independent 

contractors regardless of whether there was a basis for doing so. This misconception has been 

largely corrected through a combination of industry education and IRS guidance, which 

56 See footnote 31 above. 

57 In January, 1987, the IRS published a revised Publication 15 (Circular E) which 

discussed section 530 and Stated that "[i]f you have any reason for treating a worker other than 

as an employee you will not be liable for employment taxes on payments to the worker. This 

relief is not available, however, for any arrangement you may have for services provided to you 

by certain technical personnel, such as engineers, computer programmers, and systems analysts." 

In Resource Technical Consultants (U.S.A.), Inc. v. Baker, 88-1 U.S.T.C. 1 9111 at 83,033 

(S.D.N. Y. 1987), the district court found that "the Circular makes no misstatements and is at 

worst confusing." 

57 
58 

explained that technical services workers would "be classified as independent contractors or 

employees under generally applicable common law standards. "51 

Many taxpayers are still confused about the scope of section 1706, in particular about the 

occupations it covers. The provision mentions "engineers, designers, drafters, computer 

programmers, systems analysts and other similarly skilled workers engaged in a similar line of 

work." These terms are not defined in the legislative history, however, and are not well defined 

in other sources. 59 Nor do they correspond well to industry usage or to the occupational 

categories used by the IRS for Schedule C purposes. The phrase "similarly skilled workers 

engaged in a similar line of work" is particularly vague, since it is not clear how much similarity 

is required. For example, are scientists included if they are engaged in engineering-type 

activities, such as oil exploration, or are they excluded because they do not have similar skills 

to engineers? Are architects included because they often perform drafting, or was the term 

"drafting" meant to be read more narrowly for purposes of section 1706'1 These problems have 

made it difficult in some cases for employers to identify covered workers and for the IRS 

systematically to target such workers for enforcement or even to gather sufficient data on their 

levels of compliance. 

ill. AD"MINISTRA TIVE PROBLEMS WITH COMMON LAW TESTS OF EMPLOYEE 

STATUS 

As explained in Chapter 2, whether an individual is an employee for Federal tax purposes 

is generally determined under the common law tests for determining whether an employment 

relationship exists. As explained in Chapter 3, section 530 allows employers to rely on their 

own erroneous classification under some circumstances. Section 1706 denies this relief to 

certain employers in the technical services field, and thus requires these employers to apply the 

common law tests in all cases. In a sense, section 1706 restores pre-section 530 law for these 

employers. 

58 Notice 87-19, 1987-1 C.B. 455; News Release IR-87-8 (January 21, 1987); News Release 

IR-87-68 (May 21, 1987). This guidance also clarified that section 1706 applies only to brokers 

or job-shops, and does not apply to service-recipients generally. 

59 See, e.g., U.S. Department of Labor, Employment & Training Administration, 

Dictionary of Occupational Titles (4th ed. 1977 & Supp. 1986). 
59 

The common law tests, like most facts-and-circumstances tests, lack precision and 

predictability. Since they were developed in an entirely different context from Federal tax law 

(primarily the law of employer liability for employee torts), they may also produce inappropriate 

results for some tax purposes. As then-Assistant Secretary (Tax Policy) John Chapoton stated 

in 1982, "[i]n many cases, applying the common law test in employment tax issues does not 

yield clear, consistent, or satisfactory answers[,] and reasonable persons may differ as to the 

correct classification. "

60 

Although the subjectivity of the common law tests is no doubt one problem,61 a bigger 

problem may be the large number of factors with which taxpayers and the IRS must contend, 

and the consequent difficulty in determining the relative weight of any one factor.61 Thus, an 

important feature of many proposed legislative solutions has been to limit the number of factors 

to be taken into account.63 

The common law tests may be particularly difficult to apply in the multi-party contract 

situations, which are the only situations covered by section 1706. This is because the servicebroker and the service-recipient often share control over the service-provider's performance of 

60 Hearings Before the Subcommittee on Oversight of the Internal Revenue Service of the 

Committee on Finance, 97th Cong., 2d Sess. (April 26, 1982). See also Hearings Before the 

Subcommittee on Commerce, Consumer and Monetary Affairs of the Committee on Government 

Operations, l01st Cong. , lst Sess. (May 16, 1989) (acting Commissioner of Internal Revenue 

stating that "[o]ne of the most difficult and controversial issues in the employment tax area is 

the definition of 'employee' under the so-called 'common law rules' ... . IRS' preference has 

been and continues to be for a legislative solution."). 

61 See, e.g., GAO, Information Returns Can Be Used to Identify Employers lWw Misclassify 

Workers 3, GGD-89-107 (1989). 

62 In an August 5, 1987 letter to Lawrence B. Gibbs, Commissioner of Internal Revenue, 

FrankS. Swain, the U.S. Small Business Administration Chief Counsel for Advocacy, requested 

that the IRS clarify which factors are important, and which are not important, in determining 

employee status in the technical services area. 

63 See, e.g., the proposals described in Hearings Before the Subcommittee on Select 

Revenue Measures of the Committee on Ways and Means, 97th Cong., 2d Sess. (June 11, 1982) 

(joint Statement of John E. Chapoton, Assistant Secretary of the Treasury (Tax Policy), and 

Roscoe L. Egger, Jr. , Commissioner of Internal Revenue). 
60 

services, as well as sharing other incidents of employment.64 In some cases, both may 

legitimately be considered the individual's employer. While the parties may request a 

determination letter from the IRS, this may be too difficult and time-consuming to be 

practical. 65 Moreover, even if the service-recipient is considered the individual's sole 

employer, the broker may have sufficient control over payments made to the individual to be 

treated as her •imputed employer• and be subject to a withholding requirement. 66 Finally, even 

if the broker is considered the sole employer, the client may be treated as the employer for 

certain employee fringe benefit purposes under the leased employee rules. 

67 

Problems with the common law tests have been exacerbated by the fact that labor markets 

have undergone significant changes-including the proliferation of multi-party arrangementssince the enactment of section 530 in 1978, during which period section 530 has virtually 

prevented the IRS from issuing any general guidance reflecting its interpretation of the common 

law tests. This has made it very difficult for taxpayers and IRS personnel alike to analyze 

employment relationships consistently, and has greatly reduced employers' ability to predict 

when the common law tests require a particular worker to be treated as an employee or 

independent contractor. The enactment of section 1706 has permitted the IRS to issue 

guidance61 in some very narrow circumstances, only, and significant gaps therefore remain. 

64 The situation becomes even more complicated when the individual operates through a 

corporation. See Appendix A for a discussion of the relevance of incorporation in this context. 

65 For a third-party broker with dozens of independent contractors at many different clients, 

the number of determination letter requests (Form SS-8) to be completed--even if a sampling is 

used-can be very large if the firm wants to cover all typical factual settings. Moreover, client 

projects often last only weeks or months, making it difficult to obtain a ruling before the 

independent contractor changes job settings. 

66 Code§ 3401(d)(1); Treas. Reg. § 31.340l(d)-1(f). See Otte v. United States, 419 U.S. 

43 (1974). 

67 See Code§ 414(n). Section 1706 does not affect the application of section 414(n). Staff 

of the Joint Committee on Taxation, 100th Cong., 1st Sess., General Explanation of the Tax 

Reform Act of 1986, 1345 (Comm. Print 1987). 

61 See, e.g., Rev. Rul. 87-41, 1987-1 C.B. 296. 
PART FOUR 

APPENDICES 
APPENDIX A 

DIFFERENCES IN TREATMENT OF EMPWYEES AND 

INDEPENDENT CONTRACTORS-DETAILED ANALYSIS 

I. OVERVIEW 

Employees and employers face significantly different treatment from independent 

contractors and their clients under a wide range of laws, including Federal and State employment 

tax, income tax and labor laws. Differences that significantly favor one group over the other 

may encourage deliberate misclassification of an individual as an employee or independent 

contractor. This appendix describes the major differences in treatment between employees and 

employers on the one hand and independent contractors and their clients on the other, and the 

factors used to distinguish between them. It also compares the relative advantages of both types 

of treatment and attempts to determine whether current law creates unnecessary incentives for 

misclassification. It concludes that current law does not consistently favor one classification 

over the other. 

U. FEDERAL TAX LAW 

A. Employment Taxes 

Social Security and Medicare. Wages paid to employees are generally subject to Social 

Security an~ Medicare taxes under the Federal Insurance Contribution Act (FICA). 

Compensation paid to independent contractors, by contrast, is generally subject to Social 

Security and Medicare taxes under the Self-Employment Contributions Act (SECA).69 

Since 1990, the combined tax rates on employees and their employers on the one hand 

and independent contractors and their clients on the other have been virtually identical under 

both FICA and SECA.70 Prior to 1983, the tax rates on independent contractors were 

69 See Code Subtitle A, Chapter 2, and Subtitle C, Chapter 21. 

70 The combined Social Security and Medicare tax rate for 1991 is the same (15.3 percent) 

under both. Code§§ 1401, 3101 and 3111. Under both, only the first $53,400 of compensation 

is subject to Social Security tax, while the first $125,000 is subject to Medicare tax. Code 

§§ 1402(k) and 3121(x), as added by the Omnibus Budget Reconciliation Act of 1990 (OBRA 

1990), Pub. L. No. 101-508, 104 Stat. 1388 (1990); Notice, 55 Fed. Reg. 45856 (October 31, 

63 
64 

significantly lower, even though they were generally eligible for the same Social Security and 

Medicare benefits as employees.

71 In 1982 testimony, Treasury recommended that the rate 

differential be reduced to "help neutralize the decision whether to hire an independent contractor 

or an employee, and relieve pressure on the question of employment status. "72 1983 legislation 

mostly eliminated the rate differential effective in 1984, and made other conforming changes that 

became fully effective in 1990.73 

Some differences still remain, however. In some cases they can be significant. While 

the gross tax base is generally the same under FICA and SECA, 74 items that reduce FICA 

wages generally do not reduce compensation subject to SECA tax unless they are deductible on 

Schedule C for income tax purposes. In particular, contributions to a qualified pension plan or 

an accident and health plan generally are not includible in employee FICA wages, but are subject 

to SECA tax.75 Contributions to certain nonqualified plans may also receive more favorable 

1990). While, technically, the employer pays half of the FICA taxes imposed on an employee's 

wages, the economic effect is the same as if the employee paid the entire amount. Special 

deductions are also provided to self-employed individuals subject to SECA, which produce 

nearly the same effect as the fact that employees are not subject to income or FICA taxes on the 

employer's share of FICA. Code §§ 164(f) and 1402(a)(12). 

71 In 1980, for example, the combined FICA tax rate (employer and employee) was 12.26 

percent, while the combined SECA tax rate was 8.1 percent. 

72 Hearings Before the Subcommittee on Oversight of the Internal Revenue Service of the 

Committee on Finance, 97th Cong., 2d Sess. (April26, 1982) (Statement of John E. Chapoton, 

Assistant Secretary of the Treasury (Tax Policy)). 

73 Social Security Amendments of 1983, Pub. L. No. 98-21, § 124, 97 Stat. 65, 89 (1983). 

See also H.R. Conf. Rep. No. 47, 98th Cong., 1st Sess. 125-26 (1983). 

74 Commissioner v. Braddock, 95 T.C. No. 45 (1990). 

15 Compare Code§§ 1402(a) and 3121(a)(5); see Code§ 62(a)(6). Health and accident plan 

contributions are included in SECA compensation even though they are partially deductible for 

income tax purposes. See Code §§ 162(1)(4). The treatment of pension plan contributions may 

be explained by viewing contributions by self-employed persons as essentially elective. 

Employee elective contributions are includible in FICA wages. Code § 3121(v)(l). This 

explanation does not apply to accident and health plan contributions, however, since these may 

be excluded from FICA wages even when provided under an elective arrangement. Code 

§ 3121(a)(5)(G). 
65 

treatment under FICA.76 These advantages are to a limited extent offset, however, by the fact 

that trade or business expenses may be deducted from compensation before SECA compensation 

is calculated, but cannot be so deducted for FICA purposes, and that excess FICA taxes may be 

imposed on the employer when an employee changes jobs in mid-year.77 Finally, unlike 

employees, independent contractors who are eligible for Social Security benefits can sometimes 

avoid application of the Social Security earnings test through the use of deferred compensation.71 

Unemployment Insurance. The first $7,000 of wages paid to an employee is generally 

subject to tax under the Federal Unemployment Tax Act (FUTA).

79 Under the integrated 

Federal/State system, part of the tax is ordinarily paid to the State of employment, while part 

is paid to the Federal government; the combined rate averaged approximately 2.8 percent in 

76 There is no analogue to section 312l(v)(2) in SECA. OBRA 1990 deleted an analogous 

rule for corporate directors in section 1402(a) for tax purposes; however, a similar rule still 

exists for purposes of the Social Security earnings test. See Social Security Act § 21l(a), 42 

U.S.C. § 41l(a). 

77 This results from the fact that, in computing FICA taxes on a new employee's wages, 

an employer generally may not take into account the fact that the employee has already earned 

wages in excess of the taxable wage base. Treas. Reg. § 31.312l(a)(l)-l(a)(3). If this results 

in an overpayment, the employee may be entitled to a refund, but not the employer. Code 

§ 6413(b); Treas. Reg. § 31.6413(c)-l; Rev. Rul. 55-584, 1955-2 C.B. 394. SECA taxes are 

also considered income taxes, which are collected through the estimated tax system. Thus, while 

FICA taxes are generally collected and deposited with the Federal government every pay period, 

SECA taxes are generally paid quarterly. Compare Treas. Reg.§§ 1.1401-l(a) and 31.6302(c)-

l. Similarly, SECA taxes may be contested in the Tax Court, while FICA taxes may not. 

71 Under the Social Security earnings test, benefits through age 69 are reduced by a fraction 

of the payee's other earnings in excess of an exemption amount. Social Security Act§ 203, 42 

U.S.C. § 403. In the case of an independent contractor, deferred compensation is generally 

taken into account for this purpose when it is received, whereas, in the case of an employee, 

deferred compensation is generally taken into account when earned. Compare Social Security 

Act §§ 209 and 211, 42 U.S.C. §§ 409 and 411 (as noted above, an exception is provided for 

deferred directors' fees). Therefore, some independent contractors defer receipt of compensation 

that would otherwise reduce their Social Security benefits until after age 70. 

79 See generally Code Subtitle C, Chapter 23. 
66 

1990. The Federal portion of the tax is paid quarterly. Independent contractors are not subject 

to FliTA tax, but likewise generally are not eligible to receive any unemployment benefits.10 

B. Income Taxes 

Collection Mechanisms. Income taxes on employees are collected mainly through the 

withholding system, whereas income taxes on independent contractors are collected mainly 

through the estimated tax system. Both systems are backed up by information reporting 

requirements imposed on service-recipients. 

Employers are generally required to withhold a portion of their employees' wages as they 

are paid and remit it to the Federal government as payment of the employees' income taxes.11 

Withholding rates are specified in tables and procedures published by the IRS, and are calculated 

to collect approximately the same amount of tax as the employees will ultimately owe with 

respect to the wages if they work all year at the same wage level. 82 Withholding must 

generally be done at the same rate each pay period, 13 and the amounts withheld must generally 

be deposited, along with FICA taxes, soon thereafter in a Federal depositary. 84 Withholding 

can generate significant overhead expenses. 85 Independent contractors and their clients 

10 Eligibility is a matter of State rather than Federal law. See footnotes 140 and 143 below 

for a discussion of State eligibility standards. 

81 See generally_ Code § 31 and Subtitle C, Chapter 24. 

12 See generally Code§ 3402; IRS Publication 15 (Circular E), Employer's Tax Guide (Rev. 

January, 1991). Withholding rates are generally based on the employee's rate of compensation, 

marital status, and the number of allowances claimed on Form W-4. Withholding rates may be 

increased if an employee anticipates receiving additional income during a taxable year that is not 

subject to withholding, or reduced if large deductions are anticipated. 

83 But see, e.g., Announcement 85-113, 1985-31 I.R.B. 31 (special accounting rule for 

fringe benefits); cf. Code § 350l(b). 

84 The actual schedule depends on the size of the payroll. See Treas. Reg. § 31.6302(c)-l. 

85 Some argue that the government is the main beneficiary of withholding, in that it enables 

tax authorities to shift a large portion of the collection burden to the private sector. On the other 

hand, it is not clear that withholding is any more burdensome on employers than increased 

estimated tax payments (which would be necessary without withholding) would be on employees. 

Withholding may also provide benefits to some employers because they have the use of withheld 

funds for a short period of time before they must remit them to the government. Moreover, 
67 

generally are not subject to a withholding requirement with respect to their compensation 

income. 

Unless certain exceptions apply, both employees and independent contractors must pay 

their estimated income tax liabilities for the current year in quarterly installments throughout the 

year. 16 The installments are due on April 15, June 15, September 15, and January 15 of the 

following year. The amount of each installment is generally one quarter of the lesser of the 

taxpayer's income tax liability for the prior year, or 90 percent of her liability for the current 

year. Because of withholding, however, employees generally do not have to make any estimated 

tax payments. This is because withholding generally requires earlier payments than would be 

necessary under the estimated tax system, and these amounts are credited towards employees' 

estimated tax obligations.17 Thus, employees are generally only required to make estimated 

tax payments if they have significant non-wage income. 

Employers generally must report all wages paid to an employee annually on Forms 

W-2. 11 Similarly, clients must generally report all compensation paid to independent 

contractors annually on Form 1099-MISC; no Form 1099-MISC is generally required, however, 

for payments to a corporation, payments that are not made by a business (e.g., homeowners' 

payments to a house painter), or payments to a service-provider aggregate less than $600 in a 

calendar year. 89 The administrative burden is about the same for each. 

Copies of Form W-2 must be sent to the employee and to the Social Security 

Administration. 90 The Social Security Administration subsequently sends information from the 

forms to the IRS. Also, the employee is required to attach any copies she receives to her 

income tax return. Using this information, the IRS can determine whether wages have been 

employers may be able to shift some of their administrative costs of withholding to the worker 

in the form of lower compensation. 

16 See generally Code §§ 6315 and 6654. 

r7 Code § 6654(g). 

11 Code § 6041A; Treas. Reg. §§ 1.6041-l(a) and 1.6041-2. 

89 Code § 6041; Treas. Reg. §§ 1.6041-1 and 1.6041-3. 

90 Code§ 6051; Treas. Reg. §§ 31.6051-1 and 31.6051-2. 
68 

underreported. While 1099s must be sent to the independent contractor and the IRS, there is 

no requirement that they be attached to an individual's return. 

Trade or Business Expense Peductions. Under current law, independent contractors face 

significantly fewer restrictions on their ability to deduct trade or business expenses than 

employees. In particular, employees (but not independent contractors) generally may not deduct 

their trade or business expenses unless they itemize their deductions on their Federal income tax 

returns, and even then only to the extent they exceed two percent of their adjusted gross income 

from all sources. Also, they must satisfy additional requirements before they may deduct their 

automobile, home office and certain other expenses. 

Independent contractors' trade or business expenses are generally deductible "above-theline", i.e., as a direct reduction in their business income reported on Schedule C. Employees' 

trade or business expenses, by contrast, are generally only deductible .. below-the-line•, i.e., as 

itemized expenses. 91 Especially for lower-income employees, use of the standard deduction 

is often more favorable than itemization of expenses; such individuals effectively get no tax 

benefit from their trade or business expenses. 92 In addition, since 1986, employees' trade or 

business expenses have generally been deductible only to the extent they (plus any other 

miscellaneous itemized deductions) exceed two percent of the employee's adjusted gross income 

from all sources. 93 

The two-percent floor generally does not apply to an employee's trade or business 

expenses to the extent they are reimbursed by her employer: in such case, generally no 

deduction is necessary, because the reimbursement is not included in the employee's taxable 

income in the first place. Only reimbursement arrangements that require the employee to 

account to the employer for any expenditures are eligible for this treatment, bowever.

94 This 

91 Code § 62(a). 

92 See Rev. Proc. 90-64, 1990-531.R.B. 27, for the standard deductions in effect for 1991. 

93 Code § 67. This requirement reversed the earlier trend to conform the treatment of 

employees and self-employed persons as much as possible. 

94 Code § 62(c); Treas. Reg. § 1.62-2; cf. Treas. Reg. § 1.132-S(a)(l)(v) (similar rules for 

working-condition fringe benefits). Somewhat different accounting rules apply depending on 

whether the expense is subject to the substantiation requirements of section 274(d), and whether 

the arrangement is a per diem or mileage plan. See Code § 62(c); Treas. Reg. §§ 1.62-2(e) and 

1.274-ST(g) and (j). 
69 

prevents employees from excluding from income amounts greater than that which they could 

have deducted. 95 Client reimbursements are always included in an independent contractor's 

gross income, and the expenses for which they are made must be deducted. Inadequate 

accounting by the independent contractor to the client is therefore generally irrelevant in this 

context.96 

Unlike independent contractors, employees may not deduct interest expenses incurred in 

their trade or business of being an employee: such interest is considered a personal expense. 97 

Entertainment expenses generally may not be deducted unless they satisfy the business 

purpose requirements of section 274(a). The rules applicable to employees and their employers 

on the one hand and independent contractors and their clients on the other are about the same 

for this purpose.91 Special exemptions are provided, however, for food or beverages furnished 

on an employer's business premises primarily for its own employees, and for recreational or 

95 Excess reimbursements must be returned to the employer. If the accounting requirements 

are not met, the employee may still be able to deduct the underlying expenses. They will, 

however, be subject to the two-percent floor. In addition, failure to account will shift the burden 

of complying with various requirements of section 274, including the business purpose 

requirement of section 274(a), the substantiation requirement of section 274(d), and the SOpercent deduction limit of section 274(n), from the employer to the employee. Code 

§ 274(e)(2), (e)(3)(A) and (n)(2)(A); Treas. Reg. §§ 1.274-2(t)(iv), 1.274-5T(t)(2) and 

31.340l(a)-4: 

96 As with employees, however, if an independent contractor does not adequately account 

to her client, the burden of complying with various requirements of section 274 will shift from 

the client to her. Code § 274(e)(3)(B) and (e)(9); Treas. Reg. § 1.274-2(t)(2)(iv); see Treas. 

Reg. § 1.274-5T(h)(3) for the defmition of an adequate accounting for this purpose; see also 

Treas. Reg. § 1.274-2(f)(2)(iv)(a) and (c)(l) (definitions of adequate accounting and 

reimbursement arrangement). The substantiation requirements of section 274(d) are an 

exception; an independent contractor continues to be subject to these requirements even if she 

makes an adequate accounting to her client. See Treas. Reg. § 1.274-5T(h)(2); Rev. Proc. 63-4, 

Q&A-28 and 29, 1963-1 C.B. 474; Smith v. Commissioner, 80 T.C. 1165 (1983). This 

distinction presumably reflects the fact that, while employees generally need not deduct 

reimbursed expenses because the reimbursements are simply excluded from their gross income, 

independent contractors must generally deduct the amounts. 

97 Code § 163(h)(2)(A). 

98 See footnotes 95 and 96 above for rules relating to the allocation of the burden of 

substantiation in the case of reimbursed expenses. 
70 

social activities primarily for their benefit. 99 Independent contractors may, however, benefit 

from both as long as they are not provided primarily for the contractors' benefit. 

Travel and entertainment expenses, business gifts, and expenses associated with •listed 

property• (including automobiles, computers, cellular telephones and property used for 

entertainment) also may not be deducted unless the taxpayer has adequate records or other 

evidence to substantiate their amount and business purpose, within the meaning of section 

274(d). 100 Again, the rules applicable to employees and their employers on the one hand and 

independent contractors and their clients on the other are about the same. Employers may use 

certain simplified substantiation methods that are unavailable to clients of independent 

contractors, however. In particular, they may rely on records maintained by their employees 

with respect to the use of listed property, and they can avoid any substantiation requirements 

with respect to the use of vehicles by adopting a policy statement prohibiting personal use and 

meeting certain other requirements. 101 Presumably, these methods are denied to clients of 

independent contractors because clients generally do not provide them with the property 

necessary to perform their jobs, and, in any event, cannot supervise their use of the property 

very closely. 

Finally, business meal expenses generally may not be deducted unless the taxpayer or one 

of its employees is present. Independent contractors may be treated as employees for this 

purpose only if they render •significant services• to the taxpayer. 102 

Home office expenses and rental and depreciation expenses associated with listed property 

(as described above) may be subject to special deduction limits unless they meet certain business 

99 Code § 274(e)(l) and (e)(4). 

100 See footnotes 95 and 96. 

101 Treas. Reg. §§ 1.274-5T(e)(2) and 1.274-6T. The latter rule applies to both employees 

and sole-proprietors. Treas. Reg. § 1.274-6T(e)(2)(i). The employer can also shift the burden 

of compliance to its employees by treating the use of listed property as personal use and 

including it in the employees' incomes without regard to the working condition fringe benefit 

rules of section 132. 

102 Code § 274(k); Staff of the Joint Committee on Taxation, lOOth Cong., 1st Sess., 

General Explanation of the Tax Reform Act of 1986, 69 (Comm. Print 1987). 
71 

use requirements. 103 These limits were significantly tightened in TRA 1986. The limits for 

employees and independent contractors are generally the same except that, in the case of home 

office expenses, the employee's business use must also be "for the convenience of the 

employer", 104 and, in the case of listed property such as home computers, such use must be 

"for the convenience of the employer and required as a condition of employment. "

105 These 

standards are difficult for many employees to meet. 106 

Frin~e Benefits. Independent contractors are generally not taken into account under the 

employee fringe benefit provisions of the Code. On the one hand, this means that independent 

contractors' clients generally are not required to include them in any pension or welfare benefit 

plans they provide for their employees in order to maintain the plans' tax-qualified status, and 

the independent contractors have correspondingly greater freedom to structure their own benefit 

arrangements. On the other hand, this means that independent contractors may be unable to 

participate in such plans even if they want to (and their clients agree), and some of the benefit 

arrangements they establish for themselves as sole proprietors or partners may not be taxfavored. (Such arrangements may also be more costly, since they usually cannot benefit from 

the economies that some employers able to achieve through group purchase arrangements.) 

The Code provides tax-favored treatment for a wide range of common employee fringe 

benefits, including pension plans, life insurance and health and accident plans. In many cases, 

such treatment is not available for benefits provided to highly compensated workers unless the 

employer also provides comparable benefits to a minimum number of its nonhighly compensated 

workers. Generally, only an employer's common law employees (and individuals treated as such 

103 See generally Code §§ 280A and 280F. Generally, in the case of a home office, the 

space must be used exclusively on a regular basis as the taxpayer's principal place of business. 

In the case of listed property, the property must be used predominantly (i.e., more than 50 

percent of the time) in the taxpayer's trade or business. 

uM See Code§ 280A(c)(l). 

105 See § 280F(d)(3)(A); Treas. Reg. § 1.280F-6T(a)(2). 

106 See, e.g., Rev. Rul. 86-129, 1986-2 C.B. 48. On the other hand, the Tax Court's "focal 

point" test has made it difficult for independent contractors to establish their home office as their 

principal place of business if they render services elsewhere. E.g., Baie v. Commissioner, 74 

T.C. 105 (1980); but see Soliman v. Commissioner, 94 T.C. 20 (1990) (apparent abandonment 

of "focal point" test). 
72 

under the Code)107 are taken into account for this purpose. In addition, these same provisions 

generally prohibit an employer from offering tax-favored benefits to its independent contractors. 

A list of tax-favored benefits, and the conditions under which they may be offered to employees 

and independent contractors, are shown in Table A-1. 101 (The table does not include 

statutorily-required benefits such as workers' compensation.) 

Taken together, these rules tend to encourage employers to admit a new worker into an 

existing fringe benefit plan if she is classified as an employee, and to discourage (if not actually 

prohibit) them from doing so if she is classified as an independent contractor. Classification as 

an independent contractor may, therefore, be beneficial to the client; in cases where the worker 

would prefer additional cash or a different benefit package to the fringe benefits offered under 

the employer's plan and can negotiate to receive some or all of the compensation the client 

would otherwise have spent on the benefits, classification as an independent contractor may also 

be beneficial to the worker. 

An independent contractor who is unable to participate in her client's plans generally can 

establish her own benefit arrangements in her capacity as a sole proprietor (or as a partner, if 

she is in business with other individuals).109 As indicated in Table A-1, the most significant 

types of fringe benefits may be available on a tax-favored basis. For example, sole proprietors 

can generally establish their own pension plans, subject to essentially the same rules as 

107 These include leased employees subject to section 414(n) and so-called "statutory 

employees" treated under sections 312l(d) and 770l(a)(20) as employees for purposes of FICA 

and certain employee benefit provisions of the Code. q: Staff of the Joint Committee on 

Taxation, 100th Cong., 1st Sess., General Explanation of the Tax Refonn Act of 1986, 1345 

(Comm. Print 1987) (section 1706 not to affect application of section 414(n)). Note that, in 

some cases employees may also be deemed to be self-employed. See, e.g., Code§ 1372 (certain 

S corporation shareholders treated as partners). 

101 Provisions that merely specify the accounting treatment of benefits provided to 

employees, and do not grant tax-favored treatment, generally also apply to independent 

contractors. E.g., Code §§ 83, 280G and 457; Treas. Reg. §§ 1.83-l(a)(l) and 1.457-2(d); 

Prop. Treas. Reg. § 1.2800-1, Q&A-15. 

109 Sole proprietors and partners are proprietors of unincorporated businesses. The 

treatment of proprietors of incorporated businesses is discussed in section n.c. below. 
Table A-1 

Tax-Favored Benefits Available to Employees and Independent Contractors 

Employee acbievcment awardl" 

Group-term life in.auranc:e~ 

Death beoefitl" 

Accident and health inauranc:e• 

Tuition remiuion• 

Meala and lodging' 

Group legal acrvic:ea' 

Cafeteria plans' 

Educational auiatancel 

Dependent cuei 

No-additional-cost fringe.k 

Qualified employee discount.J 

Working condition fringesDe minimis fringe&" 

Free parlcing" 

On-premises athletic facilitid 

New-product testing' 

Qualified pcnaions and annuitict 

T~-~bcl1ered annuitict 

Qualified and incentive ltOclc options 

Employee ltOclc purchase plans" 

Voluntary employees' beneficiAry 

usocialiona• 

nq;;tliiCil1 01 & ,_,., 

Office of Tu PoUcy 

To Employee 

ip Emp!oxcr's P1aa 

May be required 

May be required 

Gcocrally optional 

Generally optional 

May be required 

Optional 

May be required 

May be required 

May be required 

May be required 

May be required 

May be required 

Optional 

Generally optional 

Optional 

Optional 

Optional 

May be required 

May be required 

Optional 

May be required 

May be required 

Availability 

To IDdepeadeat 

Coatrador iQ C!ieat's 

Plap 

Optional 

Optional 

To IDdepeadeat 

Coatnctor ia Owu Plaa 

Limited deduction only 

Optional 

Optional 

Optional 

Optional 

Optional 

Optional 

Optional 

Optional 

Optional 

Optional 

Optional 

In this table, "optional" mcana that the benefit is not required to be provided under any minimum coverage or nondiacrimination rules, 

while "may be required" mcana that it may have to be provided. 

Notes 

a. Code §§ 74(c) and 274(j)(3)(B). 

b. Code§ 79(d); Trcu. Reg. § 1.79-0(b). 

c. Code I 10 1(b}(3}(A}; Trcu. Reg. I 1. 101-2(0(1}. Diacrimination rulca may apply if the benefits arc provided under a qualified 

pcoaion plan, however. 
d. Code ti10S(&), 106, and 162(1)(1); Trcu. Reg. I l.IOS-1(a). Covcraac and diac:riminadon rCIQUiremcota may -wly if the plan 

ia ICir-fUDdod. Code I 10S(h). 

c. Code I 117(d)(2)(A). 

r. Code 1 119. 

g. Code I 120(c:)(l), (c:)(2) and (d)(l). 

h. Code I 12S(b)(1) and (d)(1)(A); Prop. Trcu. Reg. I 1.125-1, Q&.A-4. 

i. Code I 127(b)(2) and (c:)(2); Trcu. Reg. I 1.127-2(b)(1)(iii). 

j . Code I 129(d)(2), (d)(3), (d)(B) and (c)(3). 

k. Code I 132(b), (f) and (h)(1); Trcu. Rc&. I 1.132-1(b)(1) and (3). 

I. Code I 132(c:), (f) and (h)(1); Trcu. Reg. I 1.132-l(b)(1) and (3). 

m. Code I 132(d); Trcu. Reg. I 1.132-l(b)(2) and (4). 

n. Code I 132(c); Trcu. Rc&. I 1.132-1(b)(2) and (4). CaWo ooodilc:riminltion ruiCI apply to catin& fac:ilitiCI, however. 

o. Code I 132(h)(4); Trcu. Reg. I 1.132-(b){2) (fluah language). 

p. Code I 132(h)(S); Trcu. Reg. I 1.132-l(b)(1) and (3). 

q. Trcu. Reg. It 1.132-1(b)(2)(fluab language) and 1.132-S(n). 

r. Code It 401(a)(4), 401(c:) and 410(b); Trcu. Reg. U 1.72-17(a) and 1.401-10(b). 

a. Code I 403(b); Trcu. Reg. I 1.403(b)-l(a)(l). 

t. Code U 421-22A; Trcu. Rc&. I 1.421-7(h). 

u. Code I 423; Trcu. Reg. I 1.423-2(c)(2). 

v. Code I SOl(c:)(9); Treas. Reg. I I.SOI(c:)(9)-2(b). 
75 

employer-sponsored plans. 110 In lieu of the exclusion from income for employer-provided 

accident and health insurance, they can often deduct up to one-quarter of their medical insurance 

expenses, without regard to the 7.5 percent floor in section 213 (unless they are covered under 

an employer-sponsored plan directly or through their spouse). 111 They can also provide 

themselves certain fringe benefits, including working condition and de minimis fringes, on a pretax basis. Other benefits must generally be purchased out of after-tax income. In addition, as 

explained in Section TI above, the tax benefits for sole proprietor and partnership plans are 

generally limited to the income tax provisions of the Code, and do not apply for Social Security 

and Medicare tax purposes. 

C. Determination of Employee Status 

The status of an individual as an employee or independent contractor for purposes of the 

Federal tax laws is, with few exceptions, determined under the common law tests for 

determining whether a master-servant (employment) relationship exists. 

Back~round. The common law tests frrst assumed importance under the employment tax 

provisions of the Code. The original Social Security Act simply defined an "employee" as 

including "an officer of a corporation" .

112 Treasury regulations issued in 1936 used common 

law standards to determine employee status. 113 The lower courts, however, applied a variety 

of different standards, some relying less than others on common law precedents. 114 In 1947 

110 In a sense these rules are more favorable: plans of sole proprietors who have no 

nonhighly compensated employees resemble elective arrangements like IRAs and section 401(k) 

plans, but are subject to higher dollar limits on contributions. 

111 Code§ 162(1)(6), as amended by OBRA 1990 § 11410. This provision is due to expire 

December 31, 1991, however. 

112 Social Security Act§ 110l(a)(6), Pub. L. No. 74-271, 49 Stat. 620, 647 (1935). FICA 

was in Title Vlll of the original act. SECA was enacted on August 28, 1950. 

113 Reg. 91, article 3, 1 Fed. Reg. 2049, 2052 (Nov. 11, 1936). The regulations state, inter 

alia, that "[i]n general, if an individual is subject to the control or direction of another merely 

as to the result to be accomplished by the work and not as to the means and methods for 

accomplishing the result, he is an independent contractor. An individual performing services 

as an independent contractor is not as to such services an employee." This closely resembles 

the language in the current regulations. 

114 See United States v. Webb, 397 U.S. 179 (1969), for a description of this case law. 
76 

the Supreme Court issued a pair of opinions that attempted to clarify the governing standards. m In them, the Court applied an "economic reality" test that resembled the common 

law tests, under which "employees are those who as a matter of economic reality are dependent 

on the business to which they render services. "116 

The IRS (and the Social Security Administration) proposed amendments to their 

regulations to incorporate the Court's new economic reality test, but these never took effect: 

Congress reacted immediately by passing (over President Truman's veto) the so-called Gearhart 

Resolution, endorsing the use of common law tests. 117 

Current Rules. Current Treasury regulations provide that an individual is generally an 

employee if, under the usual common law tests, the relationship between the individual and the 

person for whom she performs services is the legal relationship of employer and employee. 

Such a relationship generally exists if the person for whom the services are performed 

has the right to control and direct the individual who performs the services, not 

only as to the result to be accomplished by the work but also as to the details and 

means by which that result is accomplished. That is, an employee is subject to 

the will and control of the employer not only as to what shall be done but [also] 

how it shall be done. 118 

Over the years, the IRS has identified 20 important factors for determining when the common 

law tests are satisfied. 119 These factors, which are listed in Appendix B, are used in resolving 

issues raised in rulings and other guidance, including guidance on the status of technical services 

m Bartles v. Binningham, 332 U.S. 126 (1947), and United States v. Silk, 331 U.S. 704 

(1947). See also Harrison v. Greyvan Lines, 331 U.S. 126 (1947). 

116 Bartles, 332 U.S. at 130. 

117 H.R.J. Res. 296, Pub. L. No. 642, 62 Stat. 438 (1948). 

118 Treas. Reg. §§ 31.312l(d)-1(a)(2), 31.3306(i)-1(b) and 31.3401(c)-l(b). 

119 Internal Revenue Manual4600 (Employment Tax Procedures), Exhibit 4640-1; see also 

Rev. Rul. 87-41, 1987-1 C.B. 296. These factors were originally compiled by the Social 

Security Administration in determining entitlement to benefits. 
77 

workers issued after the enactment of section 1706. 120 No one factor on this list is determinative, though some are more important than others. 

Congress and the courts have overridden the common law tests in some situations. For 

example, certain occupations generally performed by employees are nevertheless treated as 

performed by independent contractors under the Code; these include certain door-to-door 

salesmen and real estate agents. 121 Conversely, certain occupations generally performed by 

independent contractors are nevertheless treated as performed by employees for employment tax 

purposes. These "statutory employees" include certain full-time life insurance salesmen, agentdrivers and commission-drivers engaged in the distribution of specific kinds of products, 

homeworkers and traveling or city salesmen. 122 

Relevance of Incorporation. An employee generally cannot change her status for Federal 

tax purposes to that of an independent contractor via incorporation. The common law tests focus 

on the relationship between the individual performing the services and the service-recipient; if 

an employment relationship exists, it is generally irrelevant whether payments are made directly 

or through a corporation controlled by the individual. 123 The legislative history of section 

1706 reiterates this point. 124 

120 See Rev. Rul. 87-41, 1987-1 C.B. 296. See also Moore, Defining the Employee: 

Common-Law Rules, Direction, February, 1988, at 13. Mr. Moore is the technical assistant for 

Federal employment tax in the Office of the Assistant Chief Counsel (Employee Benefits and 

Exempt Organizations) of the IRS. See generally Annotation, DeterminaJion of EmployerEmployee Relationship for Social Security Contribution and Unemployment Tax Purposes, 37 

A.L.R. Fed. 95 (1978), and Annotation, What Constitutes Employer-Employee Relationship for 

Purposes of Federal Income Tax Withholding, 51 A.L.R. Fed. 59 (1981). 

121 See Code § 3508; see also Code § 1372. 

122 See Code § 3121(d); Treas. Reg. § 31.312l(d)-1(d); Rev. Rul. 90-93, 1990-45 I.R.B. 

4. Full-time life insurance salesmen may also be treated as employees for certain fringe benefit 

purposes. Code § 7701(a)(20). 

123 E.g., Sargent v. Commissioner, 93 T.C. 572 (1989); Rev. Rul. 87-41, 1987-1 C.B. 296; 

and Rev. Rul. 74-330, 1974-2 C.B. 278 (examples (1) and (2)). 

124 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. ll-835 (1986); 132 Cong. Rec. 58088-

89 (June 20, 1986); see Rev. Rul. 87-41, 1987-1 C.B. 296; and Private Letter Ruling 9002017 

(October 12, 1989). 
78 

An independent contractor also generally cannot change her status for Federal tax 

purposes to that of an employee of her client via incorporation; she may, however, be treated 

as an employee of her own personal service corporation for certain purposes, and derive certain 

tax benefits as a result. The effect depends on whether the personal service corporation elects 

to be taxed as a Subchapter S corporation under section 1362 of the Code. If it does not, the 

individual will generally be treated as an employee of the corporation for tax purposes, and can 

thus take advantage, inter alia, of various employee benefit provisions of the Code. She will, 

moreover, not be subject to the two-percent floor on itemized deductions or other limits on 

employee trade or business expense deductions to the extent she causes such expenses to be 

deducted at the corporate level. Although any income received and retained by the corporation 

will be taxed at (usually higher) corporate rates, in practice this problem can be minimized by 

distributing as much income as possible in the form of compensation. 

If the personal service corporation does elect to be taxed as an S corporation, the 

individual will also generally be treated as an employee of the corporation for tax purposes, 125 

but with one important exception: assuming her ownership interest exceeds two percent, she 

will not be treated as a employee for purposes of the employee benefit provisions of the 

Code. 126 The treatment of trade or business expenses is roughly the same as for a C 

corporation. 

177 

m. OTHER LAWS 

A. Federal Labor Laws 

Most Federal labor laws apply only to employees and do not protect independent 

contractors. This is generally beneficial to the independent contractors' clients, who may save 

the direct costs of providing additional benefits to the individuals plus any associated 

administrative costs, but may not be beneficial to the independent contractors unless they do not 

need the protection and can share in their clients' cost savings. 

125 See Spicer Accounting, Inc. v. United Stales, 918 F.2d 90 (9th Cir. 1990). 

126 Code § 1372. 

177 Code § 67(c); Temp. Treas. Reg. § 1.67-2T{b). 
79 

COBRA. Employers must generally give their employees and the employees' 

beneficiaries the right to continue coverage under an employer-sponsored health plan after their 

coverage has ceased, if coverage ceases on account of certain qualifying events. 128 This 

requirement applies to employees and independent contractors (provided the plan covers at least 

some common law employees).

129 

ERJSA. Pension and welfare benefit plans are subject to various coverage, funding , 

fiduciary, reporting, and other requirements under the Employee Retirement Income Security 

Act of 1974. 130 These labor provisions of ERISA do not apply to plans benefiting selfemployed individuals (including independent contractors) unless they also cover employees, and 

many of the specific protections provided under ERISA extend only to employee-participants. 131 The tax provisions of ERISA are included in the Code. 

Other Labor I..aws. Independent contractors are generally not covered by the National 

Labor Relations Act, and therefore generally may not engage in collective bargaining or similar 

protected activities. 132 They also receive no protection under the nondiscrimination requirements of the Age Discrimination in Employment Act133 or Title Vll of the Civil Rights Act 

128 Code § 4980B, as added by the Consolidated Omnibus Budget Reconciliation Act of 

1985 (COBRA), Pub. L. No. 99-272, Title X, 100 Stat. 222 (1986), and amended by TAMRA 

§ 3011. 

129 Code§ 4980B(t)(7); Prop. Treas. Reg. § 1.162-26, Q&A-16(b). 

130 Pub. L. No. 93-406, 88 Stat. 829 (1974), codified al 29 U.S.C. §§ 1001 et seq. 

131 ERISA §§ 3(3) and (6), 4(a) and 4021(a), 29 U.S.C. §§ 1002(3) and (6), 1003(a) and 

132l(a); 29 C.F.R. § 2510.3-3. 

132 NLRA § 7, 29 U.S.C. § 157. See Nonh American Van Lines, Inc. v. NLRB, 869 F.2d 

596 (2d Cir. 1989). 

133 ADEA §§ 4(a) and (11), 29 U.S.C. §§ 623(a) and 630(t). See Hyland v. New Haven 

Radiology Assocs. , P.C., 794 F.2d 793 (2d Cir. 1986). 
80 

of 1964, •:w the safety requirements of the Occupational Safety and Health Act, 135 or the 

minimum wage and overtime requirements of the Fair Labor Standards Act, 136 among others. 

B. Patent and Copyright Laws 

An employer is generally considered the author of any work prepared during the course 

of an employee's employment for purposes of the Federal copyright laws; no such presumption 

exists with respect to work prepared by independent contractors.137 By contrast, generally no 

legal distinction is drawn between employees and independent contractors under the Federal 

pa~t laws. 131 In practice, however, independent contractors may find it somewhat easier to 

secure patent protection for on-the-job creations than employees, since this issue often turns on 

a court's analysis of the implicit bargain struck between the parties. 139 

C. State Laws 

Many State laws also impose different requirements on employers and employees on the 

one hand and independent contractors and their clients on the other. In particular, employers 

are generally required to contribute a portion of the wages paid to each of their employees to 

t:w Civil Rights Act (1964) § 70l(f), 42 U.S.C. §§ 2000e(f). See Wheeler v. Hurdman, 825 

F.2d 257 (lOth Cir.), cert. denied, 484 U.S. 986 (1987). 

135 OSHA §§ 3(6) and 5(a)(1), 29 U.S.C. §§ 652(6) and 654(a)(l). 

136 FLSA §§ 3(e)(l), 6 and 7, 29 U.S.C. §§ 203(e)(1), 206 and 207. See Walling v. 

Portland Termirull Co., 330 U.S. 148 (1947). Recent legislation has created an exemption from 

FlSA for technical services workers who are employees. Pub. L. No. 101-583, 1()4 Stat. 2781 

(1990). 

137 Copyright Act §§ 101 and 20l(b), 17 U.S.C. §§ 101 and 20l(b) (work-for-hire). See, 

e.g., CCNV v. Reid, 104 L.Ed.2d 831 (1989); and A/don Accessories Ltd. v. Speigel, Inc., 738 

F.2d 548, 552 (2d Cir.), cen. denied, 469 U.S. 982 (1984). 

138 See, e.g., Francklyn v. Guilford Packing Co., 695 F.2d 1158, 1160-61 (9th Cir. 1983); 

and B. F. Gladding &: Co. v. Scientific Anglers, Inc., 248 F.2d 483 (6th Cir. 1957). 

139 This is especially true of the so-called "shop right" doctrine, under which an employer 

or client may claim royalty-free use of an invention. See, e.g., Hobbs v. United States, 376 

F.2d 488, 495 (5th Cir. 1967), and Crom v. Cement Gun Co., 46 F. Supp. 403, 404 (D. Del. 

1942). 
81 

State workers' compensation and unemployment funds.

140 Clients of independent contractors 

generally are not required to do so, and, as a consequence, independent contractors generally 

are not eligible for benefits under these systems. Employee wages may also be protected under 

State wage payment laws, while payments to independent contractors are not. 141 As with 

Federal labor laws, this exclusion is generally beneficial to the clients of independent 

contractors, but may not be beneficial to the independent contractors themselves unless they do 

not need the protection and can share in their clients' cost savings. 

D. Determination of Employee Status 

The status of an individual as an employee or independent contractor for purposes of 

Federal and State labor and other laws is generally determined under standards that resemble the 

control-based common law standards applied under the Code. 142 Depending on the purpose 

of the law involved, however, different factors are often emphasized in making this determination. 143 Thus, IRS determinations of employee status are generally persuasive but not 

140 See, e.g., N.Y. Workmen's Compensation Law § 210 (McKinney 1965), and N.Y. 

Labor Law §§ 560 and 570 (McKinney 1988) (unemployment insurance). See also text 

accompanying footnote 80 above. 

141 See, e.g., N.Y. Workmen's Compensation Law§ 50 (McKinney 1965) (requirement that 

employer provide security for payment of wage compensation). 

142 See .generally Annotation, Trucker as Independent Contractor or Employee Under § 2(3) 

of the National Labor Relations Act (29 U.S. C.S. § 152(3)), 55 A.L.R. Fed. 20 (1990); 

Annotation, Detennination of "Independent Contractor" and "Employee" Status for Purposes of 

§ 3(e)(l) of the Fair Labor Standards Act (29 U.S.C.S. § 203(e)(l)), 51 A.L.R. Fed. 702 

(1990); Annotation, Who is "Employee" Within the Meaning of Age Discrimination in 

Employment Acl (29 U.S.C.S. §§ 621-634), 69 A.L.R. Fed. 700 (1990); Annotation, Who is 

"Employee• as Defined in§ 701(/) ofrhe Civil Rights Act of 1964, 42 U.S.C.S. § 2000e(/), 72 

A.L.R. Fed. 522 (1990); and Annotation, Right to unemployment compensation or social security 

of one working on his own projects or activities, 65 A.L.R.2d 1182 (1990). 

1

° Federal Jaw: see, e.g., Darden v. Nationwide MUiual Ins. Co., 796 F.2d 701 (4th Cir. 

1986) (ERISA); Weisel v. Singapore Joint Venture, Inc., 602 F.2d 1185 (5th Cir. 1979); Dunlop 

v. Dr. Pepper-Pepsi Cola Bottling Co., 529 F.2d 298 (6th Cir. 1976) (NLRA); Brennan v. 

Gilles & Cotting, Inc., 504 F.2d 1255 (4th Cir. 1974) (OSHA); Spirides v. Reinhardt, 613 F.2d 

826 (D.C. Cir. 1979) (Title VII); and EEOC v. Zippo Mfg. Co., 713 F.2d 32 (3d Cir. 1983) 

(ADEA). 

State Jaw: see, e.g., Taylor v. Employment Division, 597 P.2d 780 (Or. 1978); 

Slarinieri, v. Unemployment Compensation Board of Review, 289 A.2d 726 (Pa. 1972); and 
82 

determinative, and, in some cases, a worker can simultaneously be an employee for some 

purposes and an independent contractor for others. 

IV. SUMMARY 

Current law does not consistently favor employee or independent contractor status. 

Independent contractors and their clients are treated somewhat more favorably with respect to 

employment taxes, and significantly more favorably with respect to their trade or business 

expense deductions. On the other hand, employees and employers are treated more favorably 

with respect to the taxation of some fringe benefits. Similarly, clients of independent contractors 

do not bear as great a burden as employers under Federal and State labor laws, but independent 

contractors also do not enjoy the same benefits or protections under those laws as do employees. 

Laeng v. Workmen's Compensalion Appeals Board, 494 P.2d 1100 (Cal. 1972); cf. Cumming 

v. District Unemployment Compensation Board, 382 A.2d 1010 (D.C. 1977) (self-employed 

status does not per se disqualify claimant). 
APPENDIX B 

COMMON LAW FACTORS USED TO DETERMINE EMPLOYEE STATUS 

Workers are generally considered employees for Federal tax purposes if they: 

1. Must comply with employer's instructions about the work. 

2. Receive training from or at the direction of the employer. 

3. Provide services that are integrated into the business. 

4. Provide services that must be rendered personally. 

5. Hire, supervise, and pay assistants for the employer. 

6. Have a continuing working relationship with the employer. 

7. Must follow set hours of work. 

8. Work full-time for an employer. 

9. Do their work on the employer's premises. 

10. Must do their work in a sequence set by the employer. 

11. Must submit regular reports to the employer. 

12. Receive payments of regular amounts at set intervals. 

13. Receive payments for business and/or travelling expenses. 

14. Rely on the employer to furnish tools and materials. 

15. Lack a major investment in facilities used to perform the service. 

16. Cannot make a profit or suffer a loss from their services. 

17. Work for one employer at a time. 

18. Do ·not offer their services to the general public. 

19. Can be fired by the employer. 

20. May quit work at any time without incurring liability. 

Source: Exhibit 4640-1, Internal Revenue Manual 4600 (Employment Tax Procedures), and 

Rev. Rul. 87-41, 1987-1 C.B. 296. 

83 
APPENDIX C 

ADDIDONAL BACKGROUND TO TCMP AND SVC-1 

I. TCMP 

The definition of "technical services worker" for purposes of Table 5-2 is based on the 

occupation of the primary taxpayer determined in the course of the TCMP audit. Unweighted 

frequencies for the occupations included in the analysis are as follows: 

Frequency 

102 

1,327 

27 

79 

204 

8 

182 

27 

176 

94 

11 

8 

39 

4 

47 

12 

13 

6 

98 

4 

216 

2,684 

Occupation 

Architects 

Engineers 

Surveyors and Mapping Scientists 

Computer Scientists 

Operations and Systems Researchers and Analysts 

Mathematical Scientists 

Physical Scientists 

Life Scientists 

Engineering Technologists and Technicians 

Drafting Occupations 

Survey and Mapping Technicians 

Biological Technologists and Technicians (Except Heatth) 

Chemical and Nuclear Technologists and Technicians 

Mathematical Technicians 

Science Technologists and Technicians, Not Elsewhere Classified 

Air Traffic Controllers 

Radio and Related Operators 

Legal Technicians 

Programmers 

Technical Writers 

Technicians, Not Elsewhere Classified 

Total 

85 
86 

U. SVC-1 

Unweighted frequencies for the "technical services" occupations included in the SVC-1 

survey are as follows: 

Frequency 

1 

8 

4 

10 

5 

15 

43 

Occupation 

Architects 

Engineers 

Physical Scientists 

Engineering Technologists and Technicians 

Air and Ship Officers and Technicians 

Technicians, e.g., Embalmer/Morticians, Radio Operator, 

Computer Programmer 

Total 

The following occupations were included in the TCMP analysis, but did not appear in the SVC-1 

sample of misclassified employees: 

Computer Scientists and Specialists; 

Operations and System Researchers and Analysts; 

Mathematical Scientists including Mathematicians, Actuaries and Statisticians, 

Life Scientis!5; 

Science Technologists and Mathematical Technicians. 
Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300