On December 15, 2009, Sen. John Kerry (D-Mass.) introduced the Taxpayer Responsibility, Accountability and Consistency Act of 2009 (S. 2882). The proposed legislation is quite similar to a bill (H.R. 3408) introduced in the House of Representatives by Rep. Jim McDermott (D-Wash), and is intended to constrict the current “safe harbor” provisions that allow employers to classify some workers as independent contractors. The bill, which was referred to the Senate Finance Committee, is co-sponsored by Senators Richard Durbin (D-Ill.), Tom Harkin (D-Iowa), Chuck Schumer (D-N.Y.), Sherrod Brown (D-Ohio), Bob Menendez (D-N.J.), and Paul Kirk (D-Mass.).
One of the most difficult issues for employers is the classification of workers as either employees or contractors. In general, employers assume fewer duties with respect to independent contractors than employees, and independent contractors are generally outside the scope of many laws and regulations governing the employer-employee relationship. For example, employers must withhold federal state and local taxes from wages paid to employees, but are not required to do so for contractors. Contractors can also be excluded from company benefits programs intended for employees. Also, in many states contractors are outside the scope of employment discrimination laws. Significantly, Washington is not one of those states. Since the 1995 Washington Supreme Court decision in Marquis v. City of Spokane, contractors have been permitted to assert discrimination claims under RCW 49.60.030, the Washington statute that prohibits discrimination in the employer-employee context. Nevertheless, on balance, there are many reasons why employers, including Washington-based employers, seek the services of independent contractors rather than hiring employees.
To determine whether a worker is an employee or contactor, the IRS uses a common law test known as the 20-Factor Test where the employer answers questions with a “yes” or “no.” IRS guidance has generally provided that a high number of “yes” answers most likely indicates the presence of an employment relationship, a high number of “no” answers may or may not indicate a contractor relationship.
The current “safe harbor” provisions of Section 530 of the Revenue Act of 1978 allow employers to designate employees as independent contractors for employment tax purposes, regardless of a worker’s status as an independent contract under the common law test, unless the employer has no “reasonable basis” for such treatment. If the conditions of the “safe harbor” are satisfied, the IRS is barred from challenging the status of workers as contractors and cannot penalize the employer for misclassifying a worker: Those conditions are:
- The employer has always treated the worker as an independent contractor
- The employer has filed all returns for the worker for all periods after 1978 and the returns were consistent with independent contractor status
- The employer had a reasonable basis for treating workers as an independent contractor by either relying on judicial precedent, published rulings or technical advice, a prior IRS audit showing no penalties assessed for similarly situated workers, or a longstanding recognized practice of a significant segment of the industry in which the individual worked.
In practice, the 20-Factor Test and the “safe harbor” do not really provide the sort of certainty that employers really need, and often lead to inconsistent results and penalties for misclassifications. The danger of misclassifying employees as contractors was amply illustrated in Washington in the 1996 class action lawsuit, Vizcaino v. Microsoft. In that case, the plaintiffs were temporary employees (later referred to as “permatemps”) furnished to Microsoft by staffing services companies. The plaintiffs argued that if they had been correctly classified, they would have been eligible to participate in Microsoft’s Employee Stock Purchase Plan. The Vizcaino case was ultimately appealed to the Ninth Circuit, but Microsoft settled the case for $97 million before that court could issue a ruling.
The proposed legislation would make the current “safe harbor” even more treacherous for employers. In addition to significantly increasing the penalties associated with misclassification, the amended safe harbor provision would only permit a business to have a reasonable basis for classifying a worker as an independent contractor if it satisfies a two-factor test. First, neither the employer nor its predecessor has treated any other individual holding a substantially similar position as an employee since December 31, 1977. Second, the employer’s treatment of the worker as an independent contractor must be in reasonable reliance on “a written determination … addressing the employment status of the individual or an individual holding a substantially similar position” with the employer; or ” a concluded examination (by the IRS for employment tax purposes) of whether the individual (or an individual holding a substantially similar position) should be treated as an employee…” If passed into law, the bill would also grant individuals classified as independent contractors the right to petition the Secretary of the Treasury for a determination of their status for employment tax purposes.
At this point, we assume Congress will craft a compromise bill based on the Senate Bill introduced by Sen. Kerry and the House bill introduced by Rep. McDermott. In crafting the final bill, Congress may also look to bills introduced in prior sessions, including the Independent Contractor Proper Classification Act of 2007 (S.2044), introduced by then-Senator Obama. We will provide updates as the legislation progresses through the Congress. Given the current Democrat majorities in the House and Senate, it is reasonable for employers to assume that the “safe harbor” provisions of Section 530 will soon be severely constricted or possibly eliminated.