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It's Monday morning at the office. A new independent contractor has arrived to help out in the IT department, which has been running very lean because of the latest round of "rightsizings" and early retirements. Word is out that management is very high on this new person because she's already familiar with the company's proprietary systems. The company, in turn, is quite familiar with her. And well they should be: She was an employee of the company only a week earlier- until she became the newest victim of the "rightsizings."
The scenario is familiar in today's business world. No company is immune from layoffs and "early retirements." For many companies, lopping off salaries is an answer to the economic slowdown, at least for the short term. In addition, an increasing number of top professionals have decided they've had enough of working for somebody else and that it's time to go out on their own.
But all those newly empty offices and parking lots are presenting corporate America with a rather serious problem: The work still needs to get done.
In attempting to face up to those problems, corporations have learned a big lesson over the past few years: The people who can do the job best are often the ones who, until recently, occupied those now empty offices and parking lots. And many exemployees have found that "going out on your own" doesn't necessarily mean going very far.
Bringing Them Back
Many companies are now bringing back former employees as independent contractors. What started off as a trickle a few years back is now, in many industries (including biopharm), a torrent. Former employees - whether they left voluntarily or not - quite often end up back at their old companies, sitting at their old desks, and doing their old tasks. But now their former employers are their new clients, and they're getting paid as 1099 independent contractors instead of as W-2 employees.
Contingent workers such as these (independent contractors, returning retirees, consultants, and freelancers) are an increasing segment of the work force. In many industries, they're actually changing the face of the work force. The contingent work force already numbers about one in every three U.S. workers, and it's now the fastest growing segment of the work force. In some biotech and high-tech companies, the percentage of contingent workers will grow to 50% within the couple of years. Some experts are predicting that within four years, in corporations with revenues exceeding $1 billion, more than half of all IT activities will be carried out by contingent workers.
The trend isn't anywhere near peaking. The Department of Labor (DOL) states that within four years, the biggest U.S. employer will be "Self."
The implications for American business, especially for sectors such as biotech and biopharmaceuticals, are nothing short of profound. Companies are seeing a more flexible work force as a way to operate more efficiently, to protect themselves against layoffs in an economic recession, and to respond more effectively to moves by the competition. In public companies, a lower employee head count is generally seen in a more favorable light on Wall Street, so pressure on senior management is to limit the number of full-time employees.
To stay abreast of the known competition and to anticipate and meet the threat from new, emerging companies, many companies are looking for any advantage they can get. They realize that contingent workers are often among the most talented in their fields. Accordingly, companies are willing to pay top dollar for that talent - often as much as $150 or more per hour. They realize, as well, that they can avail themselves of that talent without having to pay employment taxes or provide benefits. In turn, many of the biopharmaceutical sector's most talented people are coming to a realization of their own: that they can earn more as independent contractors than as employees.
In our research, we see that most technology-oriented companies that use a high percentage of independent contractors are very successful, in part, because they're benefiting from the knowledge brought in by professionals who have worked for a number of companies.
It sounds like a great solution for both the workers (particularly if they already have benefits from another source) and the company. But recent events are proving that the reality can be somewhat different from the theory. The reality can be painful. If you're an executive in biotech or pharmaceuticals, and you're using independent contractors, you should know what you might be in for. If you have people who are being paid as 1099 contractors, look out! The IRS has its sights set on you and them.
The IRS Perspective
The IRS is not convinced that independent contractors are paying their fair share of taxes. As a result, and because of the rapid growth of this work force, tax authorities are now taking an aggressive stand in ensuring compliance with regulations regarding independent contractors. The General Accounting Office has estimated that unpaid taxes by the self-employed amount to a $20 billion annual tax loss. Both the federal government and state taxing agencies are now allocating significant resources to recover that money.
Independent contractors raise a red flag with the government because they actually may be functioning more as employees than as independents. Recent studies indicate that close to half of the nine million individuals currently working as independent contractors are misclassified; in the eyes of the law, they're actually employees.
Independent criteria.
The criteria used by the IRS and many states have traditionally been a series of common law questions, known in tax circles as "the famous 20 questions" (see "The IRS Test" below). These questions generally point to how much control a company has over a worker's performance. The more control, the more likely it is that your independent contractor will be classified as an employee. If your company is the worker's primary source of income, for example, and the worker is a former employee of your company, it will be extremely difficult to prove that a legitimate independent contractor relationship truly exists.
The IRS says that to be considered an independent contractor, a person must be paid by the project rather than the hour. He or she should have articles of incorporation, business insurance, and clients other than you. He or she should have a standard business risk of profit or loss. And that's just the beginning. Unfortunately, each question can be - and often is - open to interpretation. In addition, the DOL and the states each have separate guidelines.
Both the federal and state governments are looking closely at business segments that use a lot of contractors. For the record, you are best off if you avoid getting into a legal arena with the IRS. In 90% of the companies it investigates, the agency finds some misclassified contractors. If that happens in your company, you could be feeling the consequences for a long time to come.
Recent Rulings Raising the Stakes
Fines, penalties, and interest charges from both the IRS and state tax authorities have been staggering, including a number of assessments of greater than $10 million for a single company. In addition to the penalties, retirement and benefit plans can be disqualified as a result of an unfavorable independent contractor audit. If the IRS concludes that a company's "consultants" were actually employees and should have been counted in the qualified benefit plan calculations, the entire plan can be disqualified.
Lawsuits. How bad can the consequences possibly be? Just ask Microsoft, which recently paid $97 million to settle a suit that began as the result of an IRS audit of its independent contractors; or Time Warner, which recently settled a suit with DOL; or IBM, or Roadway Services, or any of numerous other companies that - too late -realized the problems in managing a contingent work force and in remaining compliant with government regulations.
The DOL suit against Time Warner, in particular, is a new, and very ominous, warning sign. The agency believed that many of the company's workers were misclassified as independent contractors. It was the very first time that DOL weighed in on this issue, and after Time Warner's $6 million settlement, you can be sure that it will not be the last. As you might imagine, the impact of those decisions on companies that use independent contractors is potentially enourmous.
New regulations. Now new concern is emerging. Five states (California, Massachusetts, Minnesota, Iowa, and New Hampshire) have enacted legislation that requires companies to report the names, addresses, and earnings of all sole proprietors within a few weeks of the performance of their work. Our research department believes that most other states will enact similar legislation within the next few years.
The intent of that legislation is good: to catch independent contractors who may be "deadbeat dads" (or moms). But the effect on companies will be to add the long line of regulatory hoops through which they must already jump, not to mention to increase the cost of doing business.
Contracts Not Always the Answer
Some companies try to protect themselves with written contracts claiming the contractor's independence from the company. But don't make the mistake of relying on this. Regardless of what's written in the contract, the IRS and state tax authorities will make you prove that your 1099 wage earners are really independent. For your legitimate independent contractors, a written contract is indeed essential. However, if the actual relationship is that of employer and employee, your contract is most likely not worth the paper it's written on.
Biopharmaceutical Implications
Keep in mind, again, that companies involved in growing sectors such as biotech or pharmaceuticals are prime targets for government audit because of the rapid growth of the contingent work force serving them. In addition, it's wise to remember that the implications of using independent contractors extend far beyond compliance issues. More and more, companies are coming face-to-face with some very difficult management issues. For one thing, it's tougher to control intellectual property when using contractors in critical roles.
A job for human resources. For another, the job of developing and implementing corporate culture programs is obviously trickier when a significant number of the workers are not employees of the corporation. Distinguishing the roles of the on-site independent contractors from those of the employees is often ambiguous for both contractors and employees. Some independent contractors (for example, those previously downsized from salaried positions) might really prefer to be employees. And some employees might prefer the flexibility of being a contractor. HR managers can explain to those employees exactly what they need to do to qualify as a legitimate independent contractor and remind them of the lack of company benefits, let alone weekly paychecks.
HR needs to communicate clearly to those employees. "Outsourcing" has often been a dirty word to many employees, with the connotation of lost jobs. But most executives now understand the need for independent contractors. In addition, most executives understand that some people are better cut out to be employees and others to be independent contractors. Employees need to understand that no one is suggesting the company run out and hire independent contractors to replace all of them; the core competencies of the permanent staff are essential. A good mix of workers, however, is also essential to the success of the company, and by extension, to the success of the employees. Communication is the key, along with the ability to clearly outline to the employees the benefits they receive.
Incidentally, these can all be touchy areas for HR, which in many cases may be uninvolved in the actual hiring of the independent contractors, but which will often get blamed when something goes wrong.
Installing a Compliance System
If your company is currently classifying some professionals as 1099 independent contractors, it's important to come up with a plan - before the IRS does it for you. A good compliance system should include a method of analyzing the proper classification of all potential independent contractors and a file documentation system for all independent contractors whom you determine to be truly "independent." It is imperative that the arrangements with those workers be set up properly, or your company will be at risk. You must have strong contracts with all workers, setting out clearly how they meet the IRS guidelines, and you must also arrange for the protection of the company's intellectual property.
You need a third-party payroll for independent contractors or returning retirees who probably would not pass the test of the tax authorities. If you do decide to work with a consulting company with such people, make sure you get one that is experienced at navigating the maze of federal and state regulations. Make sure that the company truly understands just who is and who is not an independent contractor. If you find it necessary to use a third-party payroll, make sure it is set up properly, with contracts that protect intellectual property and with nondisclosure agreements. And always, always insist on strong documentation from an independent contractor that he or she truly is an independent contractor.
The Bottom Line
In our increasingly downsizing world, contingent workers and independent contractors are here to stay. It's an axiom of the new economy that when the head count goes down, the contingent worker count goes up. Used wisely, those workers can be an integral part of your business plan. But hiring them can prove a nightmare to those companies that are inadequately prepared.
A recent DOL report notes that misclassification of nontraditional workers "is not an easy problem to solve, and will only get worse as more nontraditional workers join the labor force." Thankfully, however, one simple thing will ensure that your company is among those that are prepared. If you use independent contractors, make sure they really are independent contractors - before the government does it for you. Install a compliance system that works, and stick with it.
THE IRS TEST
To determine whether a worker is an independent contractor or an employee, you need to read IRS publication 15-A, Employer's Supplemental Tax Guide. If you want the IRS to determine whether a specific individual is an independent contractor or an employee, you can file Form SS-8.
You must examine the relationship between the worker and the business. All evidence of control and independence in this relationship should be considered. The facts that provide this evidence fall into three categories: behavioral control, financial control, and the type of relationship itself.
Behavioral control covers facts that show whether or not the business has a right to direct and control how the work is done, through instructions, training, or other means. IRS questions that help determine behavioral control include who decides when and where to do the work, what tools or equipment to use, what workers to hire or to help with the work, where to purchase supplies and services, what work must be performed by a specified individual, and what order to sequence to follow.
Financial control covers facts that show whether the employer or business has a right to control the business aspects of the worker's job, including the extent ot which the worker has unreimbursed business expenses, the extent of the worker's investment in the business, the extent to which the worker makes services available to the relevant market, how the business pays the worker, and the extent to which the worker can realize a profit or incur a loss.
Type of relationship facts include written contracts describing the relationship the parties intended to create, the extent to which the worker is available to perform services for other similar businesses, whether the business provides the worker with employee-type benefits (such as insurance, a pension plan, vacation pay, or sick pay), and the permanency of the relationship.
The Famous 20 Questions
In a revenue ruling (87-41, 1987-1CB 296), the IRS developed 20 factors used to determine whether a worker is an independent contractor. The burden of proof is on the company, so at least 11 of these factors should show that a worker has independent contractor status to feel confident of your determination.
For the following questions, a "yes" answer means the worker is an employee.
- Does the principal provide instructions to the worker about when, where, and how he or she is to perform the work?
- Does the principal provide training to the worker?
- Are the services provided by the worker integrated into the principal's business operations?
- Must the services be rendered personally by the worker?
- Does the principal hire, supervise, and pay assistants to the worker?
- Is there a continuing relationship between the principal and the worker?
- Does the principal set the work hours and schedule?
- Does the worker devote substantially full time to the business of the principal?
- Is the work performed on the principal's premises?
- Is the worker required to perform the services in an order or sequence set by the principal?
- Is the worker required to submit oral or written reports to the principal?
- Is the worker paid by the hour, week, or month?
- Does the principal have the right to discharge the worker at will?
- Can the worker terminate his or her relationship with the principal any time he or she wishes without incurring liability to the principal?
- Does the principal pay the business or traveling expenses of the worker?
For the following questions, a "yes" answer means the worker is an independent contractor.
- Does the worker furnish significant tools, materials, and equipment?
- Does the worker have a significant investment in facilities?
- Can the worker realize a profit or loss as a result of his or her services?
- Does the worker provide services for more than one company at a time?
- Does the worker make his or her services available to the general public?
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