The IRS vs. Independent Contractors

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Andrew E. Schultz

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Many pharmaceutical companies are now using independent contractors in increasing numbers; in many cases, these contractors are former employees. What started off as a trickle a few years ago has become a torrent. Quite often, former employees — whether they left voluntarily or not — end up back at their old companies, sitting at their old desks, doing their old tasks. The difference is their old employer is their new client. And they’re get ting paid as a 1099 independent contractor, instead of as a W2 employee. “Contingent” workers such as these — independent contractors, returning retirees, consultants, freelancers, etc. — have become an everincreasing segment of the workforce. And in many companies they’re actually changing the face of the workforce. The contingent workforce already numbers about one in every three American workers, and is the fastestgrowing segment of the workforce. In some biotech and hightech firms, the percentage of contingent workers will grow to 50% within the next year or two. According to Andrew E. Schultz, presi dent of PrO Unlimited, a Boca Raton, Fla. based consulting and outsourcing company specializing in helping companies address compliance and management issues associat ed with the use of contingent workers, this trend isn’t anywhere near peaking. According to recent Department of Labor statistics, by The stakes are high … and companies better know the rules. IRS versus INDEPENDENT CONTRACTOR In an exclusive to PharmaVOICE, Andrew E. Schultz,president of PrO Unlimited, discusses the impact of an emerging workforce — independent contractors. PharmaVOICE VIEW on contractors more per hour. Furthermore, they realize they can avail themselves of this talent without having to pay employment taxes or provide benefits. In turn, many of the pharmaceutical indus try’s most talented people are coming to a real ization of their own — that they can earn more as independent contractors than as employees. “It sounds like a great solution … a win win situation for both the workers, particular ly if they already have benefits from another source, and the company,” Mr. Schultz says. “But recent events are proving that the reality can be somewhat different than the theory.” The reality, according to Mr. Schultz, is in fact often very painful. Pharmaceutical execu tives employing independent contractors should know what the consequences might be. “If you have people who are being paid on a 1099 basis, look out,” he says. “The IRS has its sights set on you…and them.” THE IRS PERSPECTIVE According to Mr. Schultz, 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 now are taking a very aggressive stand in ensuring compliance with regulations. “And with good reason,” he says. “The General Accounting Office has estimated that unpaid taxes by the selfemployed account for a $20 billion annual tax loss to the govern ment. Both the federal government and state taxing agencies now are allocating significant resources in an attempt to recover this money.” According to Mr. Schultz, independent contractors raise a red flag with the govern ment, because they may be functioning more as employees than as “independents.” Recent studies indicate that close to half of the 9 mil lion individuals currently working as inde pendent contractors are misclassified; in the eyes of the law, they’re actually employees. Mr. Schultz says the criteria used by the IRS and many states has traditionally been a series of common law questions, known in tax circles as “The Famous Twenty Questions.” These questions generally point to how much control a company has over a worker’s perfor mance. The more control, the more likely an independent contractor will be classified as an employee. If the company is the worker’s pri mary source of income, for example, and/or the worker is a former employee of the firm, it will be extremely difficult to prove that a legiti mate independent contractor relationship truly exists. The IRS says to be considered an indepen dent contractor, a person must be paid by the project rather than the hour. Additionally, that person should have articles of incorporation, business insurance, and other clients besides your company. The person should have a stan dard business risk of profit or loss. And, according to Mr. Schultz, that’s just the begin ning. Unfortunately, each question can be — and often is — open to interpretation. Complicat ing matters further, the Department of Labor and the states each have separate guidelines of their own. Recent studies indicate that close to half of the 9 million individuals currently working as independent contractors are misclassified. INSTALLING A COMPLIANCE SYSTEM For companies currently classifying some professionals as 1099/independent con tractors, it’s important to come up with a plan — before the IRS does it for them.A good compliance system should include the following: . AMETHODOFANALYZING the prop er classification of all potential inde pendent contractors. . A FILE DOCUMENTATION SYSTEM for all independent contractors who are determined to be truly “indepen dent.”It is imperative that the arrange ments with these workers be set up properly, or the company is at risk. There must be very strong contracts with each worker, setting out clearly that they meet the IRS guidelines. Remember,too,that the company also must arrange for the protection of the company’s intellectual property. . A properly setup THIRDPARTY PAY ROLLARRANGEMENT for those inde pendent contractors and/or returning retirees who probably would not pass the test of the tax authorities. 2005, the biggest employer in the United States may be “self.” “The implications for American business — especially for sectors such as biotech or pharmaceutical — are nothing short of pro found,” Mr. Schultz says. “An increasing num ber of companies are identifying a more flexi ble workforce as a way to operate more efficiently, to protect themselves against lay offs in an economic recession, and to respond more effectively to moves by the competition. In public companies, lower employee head count is generally seen in a more favorable light on Wall Street, so there’s everincreasing pressure on senior management to limit the number of fulltime employees.” To stay with the known competition, and to anticipate and meet the threat from new emerging firms, companies want any advan tage they can get. They realize that contingent workers are often among the most talented in their fields and are willing to pay topdollar for this talent — often as much as $150 or VIEW on contractors Just for the record, a company would be best off avoiding getting into a legal arena with the IRS. In 90% of the companies the IRS investigates, the agency finds some mis classified contractors. In that case, the compa ny could be feeling the consequences for a long time. RECENTRULINGS HAVE RAISEDTHE STAKES Fines, penalties, and interest charges from both the IRS and state tax authorities have been staggering, including a number of assess ments of more than $10 million from a single firm. In addition to the penalties, is the potential disqualification of retirement and benefit plans that can result from an unfavorable inde pendent contractor audit. If the IRS concludes that a company’s “consultants” were employ ees — and should have been counted in the qualified benefit plan calculations — the entire plan could be disqualified. Mr. Schultz says most companies are not aware of how bad the conse quences can be. To illustrate his point, he suggests examining a cou ple of recent cases where companies were caught off guard. Microsoft recently paid $97 million to settle a suit that began as the result of an IRS audit of its independent con tractors. Or the Time Warner case, in which the company recently set tled a suit with the Department of Labor. Or IBM. Or Roadway Ser vices. Or any one of numerous other companies that — too late — real ized the problems in managing a contingent workforce, and in remaining compliant with govern ment regulations. Now, a new area of concern is emerging, with individual states often acting more aggressively than the IRS. CONTRACTS ARE NOTALWAYSTHE ANSWER Some companies try to protect themselves with written contracts claiming the contrac tor’s independence from the company. But, according to Mr. Schultz, companies should n’t make the mistake of relying on this. Regardless of what is written in the contract, the IRS and state tax authorities will make a company prove that its 1099 wage earners are really independent. For legitimate indepen dent contractors, a written contract is indeed essential. However, if the actual relationship is that of an employer and an employee, the contract is most likely not worth the paper it’s written on. If a company does decide to work with a consulting firm on these issues, it’s important to engage a firm that is experienced at navi gating the maze of federal and state regula tions. Mr. Schultz says it’s important to truly understand just who is and who is not an inde pendent contractor. If it is necessary to use a thirdparty payroll, make sure it is set up properly, with contracts that protect intellec tual property and with nondisclosure agree ments. And always, always, insist on strong documentation from an independent contrac tor proving that he or she truly is an indepen dent contractor. THE BOTTOM LINE In our increasingly downsizing world — and especially in areas like pharmaceuticals — contingent workers and independent contrac tors are here to stay. Used wisely, these work ers can be an integral part of the business plan. But it can prove a nightmare to those compa nies that are not adequately prepared. “Thankfully, however, there is one simple thing a company can do to ensure that it is among those that are prepared: install a com pliance system that works, and stick with it,” Mr. Schultz says. “If your company uses inde pendent contractors, make sure they really are independent contractors…before the govern ment does it for you.” F PharmaVoice welcomes comments about this article. Email us at feedback@pharmalinx.com. It sounds like a great solution … but recent events are proving that the reality can be somewhat different than the theory. Install a compliance system that works.And stick to it. PharmaVOICE

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