Tax Reform Act of 2014 Not Helpful for Independent Contractors or their Clients

The worker-classification proposals contained in House Ways and Means Committee Chairman Dave Camp (R-Mich) proposal for fundamental tax reform, the Tax Reform Act of 2014, would for the first time require federal income-tax withholding on payments to independent contractors and marginally increase the risk for a potential repeal of Section 530 of the Revenue Act of 1978 (Section 530).

The principal feature of the proposal is a new safe harbor for creating an independent-contractor relationship, which would be recognized for all purposes of the Internal Revenue Code (the Code), including both employment taxes and income taxes.

The bill also would provide taxpayers that meet specified criteria with protection against workers being reclassified as employees on a retroactive basis.

I. The Safe Harbor

The proposed new safe harbor would be satisfied by a work relationship meeting six requirements, namely, (i) a substantive requirement, (ii) a facilities requirement, (iii) a contract requirement, (iv) a federal income-tax withholding requirement, (v) an information-reporting requirement, and (vi) a course of business requirement.  The safe harbor would not be available with respect to an individual who performs services (a) for an entity, or (b) that are paid for by an entity, if individual is an owner of the entity, unless the entity is publicly traded.
Three critical terms are used in the new safe harbor. A service provider is (i) a natural person who performs services for a service recipient; or (ii) an entity, if any of the services the entity provides for a service recipient are performed by one or more natural persons who directly own interests in the entity. A “service recipient” is the person for whom the service provider performs services. A “payor” is any person who pays the service provider for performing such services for the service recipient.

      1. Substantive Requirement

The substantive requirement divides workers into two categories, namely, (i) those engaged in the trade or business of selling or soliciting the sale of goods or services, and (ii) all others.

      • The sales safe harbor is satisfied if:
      • the service provider is compensated primarily on a commission basis; and
      • substantially all the compensation for the service is directly related to sales of goods or services rather than to the number of hours worked.
      • The safe harbor applicable to all others is satisfied if the service provider:
      • incurs significant unreimbursed expenses;
      • agrees to perform the service for a particular amount of time, to achieve a specific result, or to complete a specific task;
      • is primarily compensated on a basis not tied to the number of hours worked; and
      • satisfies any one of the following:
        • has a significant investment in assets or training;
        • is not required to perform services exclusively for the service recipient; or
        • has not performed services for the service recipient as an employee during the one-year period ending with the date of commencement of services under a contract meeting the safe-harbor requirements (see below, Section I.3).
      1. Facilities Requirement

The facilities requirement is satisfied if the service provider:

      • has a principal place of business;
      • does not primarily provide the service in the service recipient’s place of business;
      • pays a fair market rent for use of the service recipient’s place of business; or
      • provides the service primarily using equipment supplied by the service provider.
      1. Contract Requirement

The service provider must enter into a written contract with the service recipient (or the payor) that contains specified provisions. The term of the contract cannot exceed one year, but the contract can be renewed for additional one-year terms, provided that both parties sign the contract to effect each renewal and any information concerning the service provider that the contract is required to contain is updated as necessary. The contract, and any renewal thereof, must be signed by both parties no later than the date on which aggregate payments made by the service recipient to the service provider exceed $600.

The contract must include:

      • the service provider’s name, taxpayer identification number, and address;
      • a statement that the service provider will not be treated as an employee with respect to the services provided pursuant to the contract for purposes of the Code;
      • a statement that the service recipient (or the payor) will withhold upon and report to the IRS the compensation payable pursuant to the contract, in accordance with the Code requirements;
      • a statement that the service provider is responsible for the payment of Federal, State, and local taxes, including self-employment taxes, on compensation payable pursuant to the contract; and
      • a statement that the contract is intended to be a contract described in Code section 7707(d).

While the bill’s language fastidiously includes (or payor) when referring to the service recipient, this provision imposes a date by when the contract must be signed based on payments made only by the service recipient; no reference is made to (or payor). It is not clear whether this was a typographical error, or whether payments by  payor were intended to be disregarded for this purpose.

      1. Federal Income-Tax Withholding Requirement

Any compensation paid pursuant to a contract that meets the safe-harbor’s contract requirements (see above, Section I.3) will be treated as a payment of wages by an employer to an employee, for purposes of the Code’s provisions governing federal income-tax withholding and tax procedure and administration (which includes applicable penalties and additions to tax), and subject to federal income-tax withholding at the flat rate of 5% on the first $10,000.

      1. Information-Reporting Requirement

A service recipient or payor must comply with Form 1099 reporting requirements with respect to a service provider, unless a failure was due to reasonable cause and not willful neglect. This requirement appears to apply separately on a service recipient-by-service recipient basis, and on a year-by-year basis.  The Form 1099 must (i) show the amount of income tax withheld pursuant to the safe-harbor requirement (see above Section I.4), and (ii) indicate whether the service recipient or payor has on file a copy of the safe-harbor contract (see above, Section I.3) with the service provider.

      1. Course of Business Requirement

The services performed by the service provider must be performed in the ordinary course of a trade or business of the service recipient.

II. Prospective Worker Reclassification

A reclassification for federal tax purposes of individuals from independent contractors to employees would be prospective only with respect to a service recipient or a payor, provided that:

      • the service recipient or payor has entered into a written contract with the service provider that meets the safe-harbor requirements (see above section I.3),
      • the service recipient or the payor satisfied the applicable reporting requirements (see above Section I.5), unless the failure is due to reasonable cause and not willful neglect, and federal income-tax withholding requirements (see above section I.4), for all relevant taxable years with respect to the service provider;
      • the service recipient or the payor demonstrates a reasonable basis for determining that the service provider is not an employee under the safe harbor and that the determination was made in good faith.

A reclassification for federal tax purposes of individuals from independent contractors to employees would be prospective only with respect to a service provider, provided that:

      • the service provider has entered into a written contract with the service recipient or payor that meets the safe-harbor requirements (see above section I.3);
      • the service provider satisfied applicable income tax and self-employment tax return filing requirements for all relevant taxable years with respect to the service recipient or payor, unless the failure is due to reasonable cause and not willful neglect;
      • the service provider demonstrates a reasonable basis for determining that the service provider is not an employee under the safe harbor and that the determination was made in good faith.

III. Miscellaneous

The proposal would make clear that its provisions do not in any way limit any opportunity for administrative or judicial review of a determination by the Internal Revenue Service.

The new safe harbor would be effective with respect to services performed after December 31, 2014.

IV. Comments

      • The bill misses an opportunity to address the modern service-based economy, in which individuals pursue self-employment from their own homes, while incurring little if any expenses. The first component of the substantive safe-harbor requirement, which requires that an individual incur significant unreimbursed expenses, would disqualify these service-based new-economy entrepreneurs.
      • The proposed requirement of federal income-tax withholding, as a condition to qualifying for the new safe harbor, undermines a fundamental tax distinction between employees and independent contractors, inasmuch as traditionally an employer withholds taxes from employees, but not from nonemployees  or other business vendors.
        • Subjecting independent contractors to federal-tax withholding is arguably the beginning of the end to this bedrock tax distinction between employees and nonemployees. Once such a tax-withholding regime is in place, it likely would only be a matter of time until tax withholding is expanded to other federal payroll taxes and is adopted by states.
        • Requiring clients to withhold taxes from payments to independent contractors would make sole proprietors less attractive to potential clients, inasmuch as a potential client could avoid these additional tax-compliance duties by doing business instead with larger competitors.
        • The tax-withholding duty would expose clients to potential penalties and additions to tax for failures to fastidiously comply with the new duties.
        • For independent contractors that operate on a narrow gross margin, the 5% withheld from their fees could make some work unprofitable, create new pressure on cash management and result in over-withholding.
        • The new withholding requirement would create a new artificial incentive for independent contractors to pursue substantial work from fewer clients, rather than smaller projects from many clients, because the effective rate of income-tax withholding would diminish as an independent contractor’s revenues from one client exceed the $10,000 maximum. In this same regard, those independent contractors who operate in an industry where they have no choice but to perform small projects for many clients would be subjected to a higher effective tax-withholding rate than those who operate in industries conducive to performing substantial work for few clients.
      • While the proposal would retain Section 530, which is positive, the proposed new safe harbor could make the current-law safe-harbors appear redundant and arguably make them more vulnerable to repeal.
      • Condition 6 of the proposed new safe harbor (see above section I.6), which would limit the new safe harbor to only those services that are performed in the ordinary course of a trade or business of the service recipient could make a service recipient who qualifies for this new safe harbor unable to satisfy the ABC test in many states, e.g., in Massachusetts, which requires that services provided by an independent contractor be outside the usual course of the business of the employer.
      • The proposed new safe harbor would not be available to any hourly based work (see above, section I.1), even if an hourly based payment method is an industry practice, e.g., for many service-based industries.
      • The qualification conditions for the proposed new safe harbor are too numerous and prescriptive, creating a high probability that companies seeking to qualify could fall short, e.g., requiring that the contract, and any renewal thereof, be signed by a specified date, and that specified information contained in the contract be updated each time the contract is renewed.
      • The prospective reclassification provisions create a high likelihood of inconsistent treatment of a company and an individual, as a company would have an incentive to establish the facts necessary to qualify for prospective reclassification, while an individual might prefer a retroactive reclassification, and could achieve it merely by failing to meet any of the conditions for prospective treatment.
      • The proposed modification of Section 530 to permit the Treasury Department to issue such regulations as the Secretary determines are necessary to carry out the purposes of this section is ambiguous and could be vulnerable to a broad interpretation.
      • The proposed new safe harbor, as noted, would apply to employment taxes and income taxes, which means that it also would apply for purposes of determining an individual’s status for federal tax purposes relative to employee benefit plans and arguably for purposes of the Affordable Care Act.
      • The safe-harbor proposal appears to be premised in part on a prior bill, namely, the Independent Contractor Tax Simplification Act of 1998,(http://www.gpo.gov/fdsys/pkg/BILLS-105hr3722ih/pdf/BILLS-105hr3722ih.pdf)

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