How a Tax Law Helps Insure a Scarcity of Programmers (1998)
nytimes.com
nytimes.com
1. The technical issue concerns the tax risk to an employer whether someone functioning as an independent contractor might be reclassified as an employee via an IRS audit that finds that the person is in fact functioning as an employee and not as someone who runs his own business. This risk exists for every business, large or small, that hires contractors. And the rules by which the outcome is determined are positively byzantine and pretty hostile to employers (and to contractors). They are set forth in IRS Revenue Ruling 87-41 and are summarized here (http://www.morebusiness.com/running_your_business/taxtalk/in...). In general, they state that if an employer has the right to control the means and manner by which someone performs his duties, as opposed to being concerned strictly with the result, then the person is functioning as an employee. They also set forth a list of 20 factors that auditors are to use to help to decide the issue, making this legal determination a very detailed facts-and-circumstances determination that can easily turn one way or the other depending on how an auditor chooses to apply a range of detailed factors. In the background, the law also has cases, precedents, administrative decisions and rulings, etc. that boggle the mind in their complexity concerning how the "rules" work. Moreover, the penalties associated with having a group of contractors reclassified as employees can be extreme. The employer must not only pay employment taxes (Social Security, etc.) for all such persons but also associated penalties and interest. The kicker in the case of a major audit covering several years is even worse because, if the employer can no longer locate the persons involved to get them to sign affidavits attesting that they in fact paid income tax on the income received, the employer also gets stuck having to pay the estimated income taxes for each such reclassified person. In practice, this can amount to a penalty that amounts to nearly half of the wage base involved in the dispute.
2. As one might imagine, this is a horrible landscape for companies to try to traverse without something that eliminates or sharply limits the above risks when they deal with contractors. And, to what should be nobody's surprise, such limits have historically existed to enable companies to have some rational means of dealing with the contractor issue. The limits appear in what are called "safe harbor" classifications. This means that a company hiring contractors can know with reasonable certainty that there will be no reclassification of the contractors as employees as long as the company complies with the safe harbor rules. These rules in turn vary from industry to industry but every industry has them. This is how companies hire sales people as contractors, for example, without incurring major risks of tax liabilities.
3. The 1986 law referred to in this article repealed the "safe harbor" provisions for providers of high-tech services. Thus, there was no law passed that said, "You are barred from hiring tech service providers as contractors." Companies can hire such contractors as much as they like. The repeal of the safe harbor for this type of service provider (and for no other) had the practical effect of making such service providers unmarketable to companies that had no interest whatever in taking on major tax risks just to be dealing with contractors as opposed to employees.
4. Just a background note on this repeal. Before the 1986 repeal, it was true that companies throughout Silicon Valley would hire "contractors" who would literally do, e.g., a 3-year stint working full-time at one desk for one supervisor on one project. Whatever else these persons were, they were clearly functioning as employees. They had to report for work at designated times and in a designated place. They took direct orders from supervisors on when, how, and where to perform specific duties throughout the course of a project or series of projects. There was nothing in such relationships remotely resembling a situation of a company dealing with a person who was in his "own business." In essence, what the companies were doing was hiring employees, calling them contractors, and saving the trouble of having to pay them employee benefits and employment taxes for their services. These were clearly abuses, and they prevailed at all sorts of Valley companies (Intel, HP, all the biggies). Thus, by 1986, this was an area ripe for attack. How did this happen in Congress? Well, 1986 was the great bipartisan coming-together for the lowering of individual tax rates in exchange for closing a variety of tax loopholes and tightening of tax requirements. In the midst of this bipartisan compromise, Congress took note of the abuses happening in Silicon Valley and repealed the safe-harbor classifications for high-tech service providers as a means of eliminating what was perceived as an abusive loophole.
5. While the above explains why the tech industry happened to get singled out as it did in 1986, it does not eliminate the fact that this safe-harbor repeal was in fact a highly discriminatory act in that every industry in American had safe-harbor rules available to it so that it could reasonably hire contractors while the tech industry was suddenly left without any such rules at all. Thus, from 1986 forward, tech companies became terrorized at the thought of hiring contractors under any circumstances (by the way, one of the last holdouts, Microsoft, continued to use large numbers of contractors and got slammed for this in major rulings that came out by the early 1990s, if I recall, though that case involved much more than tax issues).
6. Almost instantly from 1986 and on, a cottage industry sprang up of "placement agents" who would, in effect, assume the employee risk by hiring the tech-service providers directly and, in turn, contracting with companies to place them there as contractors. This worked for the tech companies because, from their perspective, they simply signed a contractor agreement with the placement firm and paid for the work as contract work. The placement firm, for its part, would then hire the tech-service providers mostly as W-2 employees and occasionally (if they were adventuresome) as contractors. If they retained individuals as contractors, though, they ran the risk of having those persons reclassified as employees and so faced the risk at their level that the tech companies once had directly. Because of this risk, most placement firms would not take on tech people as contractors unless they could have what they perceived as a strong case of calling them true contractors. The practical result of this was that, if a tech-service provider wanted to hire on to a placement firm as a contractor, he would first have to incorporate himself and then the placement firm would take on his company. The irony here is that the tax regulations behind the 1986 repeal specifically provided that it was irrelevant whether or not a sole contractor had incorporated himself and that this fact was to be disregarded in making the tax determination. Thus, though the fact of incorporation was technically irrelevant, most placement firms were happy to take people on as contractors once they had become incorporated. Go figure. (This article, by the way, discusses how the IRS would target such incorporated individuals in search of audit opportunities).
7. After 1986, it became virtually impossible for a tech service provider to hire himself out directly to a company as a contractor. Every one of the large Valley companies adopted strict rules forbidding this. In rare cases, someone might get through the rules if the person was incorporated but even then most times the answer from the company was no. Companies simply re-did their hiring practices and thereafter took on contractors pretty much strictly through placement firms and no longer directly.
8. For a tech service provider looking to go into business, this essentially put up an impregnable practical wall to finding reasonable opportunities to work independently in the tech world, at least in terms of providing services to the larger companies. This remains the case today as well, since the law has not changed in the decade following publication of this article.
9. By the way, this is not just a "big company" issue. Even little businesses can get into trouble without the benefit of safe-harbor protections. If you as a founder hire an early-stage contractor (which is often done) and later terminate the relationship, that person can go file for unemployment on the theory that he was in fact an employee of your company and had functioned as such. This in turn can easily trigger an audit of your entire company's history in this area (1099s you have issued are an easy way for the auditors to focus on key areas). Should this happen to you, you find yourself going down a rabbit hole that is likely to be unpleasant. (An aside: one reason to incorporate as a startup is that reclassification penalties/taxes apply only to the entity and not to the founders directly).
10. To sum up, then: there is no law forbidding tech people from offering their services as independent contractors but such persons face serious practical barriers in building a service business because employers will not hire them as contractors for fear of having their status reclassified in a later audit. This is pure discrimination against tech people. No one else is burdened in this particular way in wanting to set up a service business. The fix is an easy one for Congress to make but I have seen no movement on this whatever. For the near future, I am afraid tech service providers are stuck and have no real remedy for this problem.
Well...there is one remedy.
Let's say you can contract yourself out directly to a company at $200/hour in 1985.
After 1986 if, for all practical purposes, you have to go through an agency for the same work, that agency now wants their cut.
This cut could be 50% or more of the actual rate to account for expenses and profit.
So you end up going from an effective contract rate of $200/hour to a rate closer to $100/hour.
1. As you note, they take a percentage of your billable rate, sometimes as high as 50%.
2. In most cases, you need to be a W-2 employee in relation to them and this means you get all of the drawbacks of being an employee without any of the benefits (agencies normally do not offer vacation time, health insurance, profit sharing, stock options, or other perks of employment).
3. You are regarded, in a sense, as an "asset" of the agency. In other words, the agency has a contract with the customer-company and that contract will prevent the company from hiring or contracting with you directly without paying the agency a "non-circumvention" fee. (I know - we have represented many such agencies over the years and protecting this area is always one of their foremost concerns). Thus, your future opportunities with the company you do work for are made dependent on the company's willingness to pay the agency, e.g., a fee equal to six month's of your services before they can do anything with you directly, making you far less marketable.
4. Though they classify you as an employee, some agencies insert a clause in your written contract stating that you get paid only when they get paid. This is plainly illegal if you are their employee but they do will sometimes do it anyway. In that case, or in the case where you are a contractor in relation to them, the effect of such a clause is to put the compensation for your services at collection risk. That is, the agency might decide to string you or stiff you even after they get paid on account of your work for the customer. None of this would happen, of course, if you were allowed to contract directly with the customer.
All this and more is pretty negative for the tech service provider and leaves him vulnerable to getting used and manipulated in various ways. Of course, agencies will vary and some are better than others but inherent problems remain even with the best of them. In a sense, the tax laws have made them a toll gate between you as a service provider and your true customer and there is no way of getting to your customer without paying a price of some kind, one that would not need to be paid but for the arbitrary quirk in tax laws.
So if you start your own "placement agency" and hire yourself as a W-2 employee, and then sell your company's and your services, the IRS will be happy? How is this different from just incorporating yourself?
I work part time at a company and they pay me directly as a contractor. I do all my work there and am subject to their workplace regulations.
Could the company and I potentially be at risk?
The traditional assessment (i.e., one done without regard to any safe harbor protections and also without going mindlessly through the "20 factors," which is usually not helpful) would run roughly as follows: (1) do you have a written agreement specifying that you are an independent contractor and setting forth terms that characterize an independent contractor relationship? (if you don't have such an agreement, the company basically loses out the gate on this issue in almost all cases); (2) are your services of the highly skilled type that people normally would pay an outside contractor to perform? (if so, this tips toward contractor); (3) are you truly in business for yourself and do the various indicia (yes, that is a lawyer word) of your work situation corroborate this (if sole proprietor, do you have a business license, a dba, a policy of liability insurance, etc. relating to your contract work or are you set up as an entity - these factors all tip toward contractor); (4) can you document that you perform services for multiple clients, that you hold yourself as doing so, and that your agreement permits work for others (if you have a website advertising your company, or if you in fact have done contracting work for multiple clients over a sustained period, etc., this tips toward contractor); (5) is what you do for your company a regular and recurring part of its business, for which it would normally hire an employee as opposed to more of a spot project such as helping develop a company's website? ("regular and recurring" tips strongly toward employee; "spot" tips toward contractor); (6) do you have to report to a specific place of work on a specific schedule? (tips strongly toward employee); (7) do you work under the direct supervision of any person at the company, whether a boss or a supervisor? (tips strongly toward employee); (8) are you required to complete a clearly defined "project" or must you show up at work to do whatever you are ordered? (the latter tips strongly toward employee).
All of the above is another way of saying, "is this person really in his own business?" when performing duties for this company. If I am hired as the company's lawyer, my goal is to deliver a result on my own time and in my own way. If what you are doing is analogous to this, then you might truly be a contractor. If not, then you likely are not.
Of course, check with a knowledgeable lawyer about your own specific case and concerning any risk or options should you be mis-classified. Can't give advice here about any specifics.
In practical terms, employees do have input at hearings in which an employer will challenge the results of an audit because it is the employees who are often the key witnesses in such hearings (this usually works to the severe disadvantage of employers though, as a parade of employees is often called in and asked, "did you have to report in for work at a specific time?", "is it true that your duties consisted of making telemarketing cold calls while strapped to a desk?," "are you telling me that making such calls non-stop from 8 to 5 every day signifies that you were 'in your own business' just because your boss made you get a business license?" - this often goes on and on to disastrous effect for the employer and, though I have framed it a bit facetiously here, this is about the spirit in which it occurs).
Therefore, if you try to claim you are a contractor, this will be given only the slightest weight, if any at all - in other words, in your words, they don't have to stick with what you say, and indeed normally won't (they will just apply their multi-part test and come to whatever determination they feel is justified).
On the other hand, if you claim you are an employee, they will give that a lot of weight and will ask you considerable detail about all the factual points that tend to confirm that you are an employee (in order to nail your employer with the taxes/penalties that result from the reclassification).
Everything is basically stacked against the person claiming to be a contractor. You can win on the issue but it is usually a tricky proposition. In most contested situations, you might win in two or three out of ten at most.
1. inherited from european common law.
BUT the above discussion is both correct and incorrect. A trial court can strike down a law that has not previously been ruled on by a higher court. So if the U.S. Supreme Court has ruled on it no other court in the country can do anything about it ever. (more or less. They might rule around it or strike it down on different grounds.) If the U.S. Supreme court hasn't ruled on it then the court is free. It is more complicated than that because the relation between state and federal courts is being ignored here.
For the most part laws are only struck down for being unconstitutional for one reason or another. You are referring to when a law is "unconstitutionally vague."
Finally - The American Common Law tradition specifically comes from English Common Law. Continental Europe used, and still uses, the Civil Code system which is based on Roman and then Napoleonic Codes.
I can't imagine why anyone would believe a contractor is an employee if they apply for unemployment.Such a person has admitted they willfully lied under oath to the IRS when filing their 1099. People with so little integrity should never be hired or contracted with; I hope all such people are indited for fraud.
The company I work for now has me classified as an independent contractor (I do web development work) but you would think that I'm an employee by the way they treat me. My pay is salary based, I have to be available between the times they specify, I speak directly to a "supervisor", I have paid holidays/vacations and sick days, and I'm not allowed to take on other work, even if they're not direct competitors.
Is what they're doing wrong? This seems like a pretty sweet deal for them because they don't have to give me any real benefits or pay any employee taxes. I on the other hand, who really isn't an "Independent Contractor", have a tax-lien against me now because I can't afford the huge amount of taxes the IRS wants at the end of each year and have no idea what I'm going to do about it.
Solution: abolish all the taxation overhead for employees which was the problem in the first place.
Result: Companies will be motivated to hire more people as employees again reducing the number of unemployed, at the same time there will be no worries about having actual contractors, since there will be no more draconian tax laws to begin with.
This is just another example where an originally good idea(all the taxes on the employer which were supposed to help the employee) turned out to have disastrous consequences.
Your congress at work -- raise taxes on the little guy in order to give tax breaks to the wealthiest.
Which is also why we've developed such an imbalance in wealth!
We've got a serious problem with an imbalance in INFLUENCE!!!
Actually that's my own focus for technological innovation...
Realtime Networked Citizen Lobbying and distributed credit creation... (no pitches here, see my blog if interested)
Fortunately I don't fly planes and still have a sense of humor.
[6] Are you jealous?
Extremes in wealth are not compatible with a stable free society. Though I'm open to contrary evidence.
So... try again?
How is that one guy with plane is affected by this law, but nobody I've ever talked to is?
So if you're an independent contractor and you get your own business, you should be fine.
If someone knows this to be incorrect, please let me know.
EDIT: nevermind me, read grellas comment.
I believe I am operating properly here.
The shift meant a reduction in rates and another middleman to carve up the billable amount. It didn't totally eliminate the independent contractor but it certainly put the kibosh on it as most of the corporate world (big employers) funneled those positions to a set of preferred vendors.
And which was exacerbated further with the rise of offshore vendors (who supplanted domestic bodyshops) and NIV workers.
As an ex-college-newspaper editor, this error always stands out to me. And the NYT should know better.... even in 1998. YC's headine is the same as the Times.
They really are two different words.
My understanding is that you can protect yourself from this law by working through employment agencies as a W2 or Corp-Corp contractor?
Is that correct?
Is so, then perhaps the programmers I've met who said they were "independent consultants" were likely working through agencies since the risks of being truly independent are too high?
"For example, an engineer retained by a technical services firm to provide services to a manufacturer cannot avoid the effect of this provision by organizing a corporation that he or she controls and then claiming to provide services as an employee of that corporation."
The bottom line is if you are an independent contractor, you should do all your work through an LLC or S/C-Corp and manage your tax filings well. Some clients may still not accept dealing with your LLC directly and hand you a list of "approved contractors" to bill through. The only way you may get in trouble past this is if all you work is for one client and the IRS feels your really acting as an employee.
LLC and Single person corps were treated badly 10yrs ago. Now pretty much every state recognizes LLCs/S-Corps and yes, one can be owner and single employee.
IANAL, and I could be completely wrong on that; anybody who knows better, please correct me.
EDIT: nevermind me, read grellas comment.
Save up at least a year's living expenses, get rid of everything you own, travel the world for a year. You'll save money over keeping it, see the world, write some code on your laptop at hotels. Get one of those netbooks that will fit in a backpack. Charge it up at the coffee shop. You can get good wireless cheap overseas. Room and board is cheap.
Make arrangements to work with companies while you are away. Start getting paid the next tax year.
''Basically the I.R.S. is saying it would rather collect less revenue with less cheating than collect more revenue with more cheating. Does that make economic sense?''
It is interesting that what is proposed here as more profitable government policy encourages cheating, something we don't appreciate in our species.
You have a guaranteed income when you get back just don't run out of money that's all. If you do run out of money, go back to employment and start over. Find a job while you are away.
The world outside employment is full of green pasture and sun for programmers as individuals and the future of the world alike.
My wife falls into this category. First (years ago), she just worked as a consultant via her sole proprietorship. Then, she had to start getting insurance policies. Then, she incorporated. Now, her corporation does work for another corporation that has a contract with the corporation she actually works for.
It's a bad law and it should be removed.
Our IRS equivalent decides that incorporation was fictional if former employee has 1 person company, has only one client and this client is his former employer. If you have multiple clients and none of them hired you before you started your own company then you are safe.
I mean, if this is really an important law to understand, wouldn't the idea of good journalism be to tell me how to avoid breaking it? I don't see that at all here. It reads like just another "tax is bad" screed.
A pointer to the text of the law, or a less sensationalist presentation would be very appreciated.
the problem is that it's pretty unclear how to avoid violating it.
In fact the only sensible way to work for a Dutch company whilst living in Sweden is to have your own company or be a sole trader, even if you work 100% for the same company in the Netherlands and invoice only them.
To elaborate slightly: The tax system treatment of dividends is set up to make "company produces a profit; company pays corporate income tax; company pays out the rest as dividends; individuals pay personal tax on the dividends" approximately equivalent to "sole proprietorship produces a profit; owner pays personal income tax". Depending on how much other income the owners have, the effective tax rate can be a few % better in either direction -- things don't line up perfectly -- but on average it works out pretty evenly.
There are, however, three common situations where incorporating produces a tax advantage in Canada: 1. If you use the company to "buffer" profits, retaining some of them in good years and paying them out in poor years (either as dividends or salary), in order to keep your personal income in a lower tax bracket (many professional corporations use this approach); 2. If you reinvest profits, since avoiding personal income taxes allows you to compound more effectively; 3. If you sell the company, since capital gains are taxed at a lower rate and in some cases capital gains on the sale of a small business are entirely tax-exempt.
Of course, I am not a Canadian Tax Lawyer, etc.
I've worked with plenty of contractors and few of them were 'independent' by any reasonable definition, but no one seems to care much. Every contractor I've worked with seemed to be in it to shift the risk/reward ratio in their favour, rather than because they couldn't find a full-time job.
Does this mean that my dream of starting a side business of writing kernel code for hire in SV is DoA?
It just means that it will be quite difficult to find people who will hire you without going through a headhunting firm that will take half your pay, and that if you do manage to find a small corp that will hire you directly as an independent contractor, and you write off business expenses against that income, there is a chance the IRS will invalidate those writeoffs, which often results in big debit that can't be discharged by bankruptcy.