Laws affecting Brokered Independent Contractors' tax status
The Good Old Days
Prior to 1987, any US worker who preferred to be engaged as an independent contractor needed only to request this status from his or her client, conduct him- or herself as an independent, and receive a Form 1099 rather than a Form W2 at year's end to qualify as an independent contractor for tax purposes.
Regardless of whether the contractor worked in direct (two-party) or brokered (three-party) relationships relative to the client, both the worker and client company enjoyed protection under the Safe Harbor provision of Section 530 of the Revenue Act of 1978. Specifically, Section 530 acknowledges the 'long-standing recognized practice' and 'judicial precedent' that the worker is an independent contractor as long as the worker has historically and legitimately operated that way. As a result, under Section 530 both contractor and company received the benefit of the doubt with respect to that worker's classification as an independent contractor.
Fear, Uncertainty, and Doubt
In 1987, a new law (Section 1706 of Ronald Reagan's 1986 Tax Reform Act) muddied the waters by revoking these Safe Harbor provisions exclusively for technology industry workers rendering services through a third party (a recruiter, broker, agency, job shop, or other middleperson). Contractors engaged in three-party relationships were henceforth obligated to comply completely with the 'Common Law Factors' or 20 Questions to determine who could qualify as an independent contractor and who was instead an employee.
Shortly after Section 1706 passed, the IRS and California's EDD began reclassifying — from 1099-based independent contractor to W2-based employee — any "engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work" when a third party was involved in the relationship between worker and company. Well-publicized 'show trials' of companies whose contractors flunked the 20 Questions test helped spread the perception that it is dangerous to hire independents.
In the resulting confusion, workers and their clients forgot that contractors participating in two-party relationships retain the benefit of the doubt about their independent contractor status. Athough they too must comply with the 20 Questions, in practice contractors working in two-party relationships with their clients come under scrutiny far less often due to the Safe Harbor provision of Section 530. Even when audited, it is much easier for a worker in a 'direct' relationship to prove such compliance and thus preserve the advantages for both parties.
Despite the joint agendas of IRS (which prefers predictable payroll-related payments over inconsistent and hard-to-verify quarterly estimated tax payments), EDD (which prefers being paid its share of employee payroll taxes to being bypassed entirely), and the technical services companies (which prefer not to compete with independent contractors), the truth remains that contractors working directly with a client company, and conducting themselves as independents, are still eligible to claim 1099 status under the Safe Harbor provision of Section 530.
Specifics of the Brokered Independent Contractor Problem
Under United States common law, a worker is an employee if the person for whom he or she works has the right to direct and control the way he or she works, both as to the final result and the details of when, where, how, and in which sequence the work is to be done. It is the IRS' view that the employer need not actually exercise control. It is sufficient that it has the right to do so.
Section 1706 states that technical services workers in a three-party relationship forfeit their right to the benefit of the doubt regarding their independent contractor status, and must fully satisfy the 20 Questions. And those 20 Questions, which get specific about ways one party might have control over the work of another, almost always cause the worker to be judged an employee. That is because, in practice, the third party controls payment terms to the worker (how much, when, and whether they get paid at all), the location of the work, and who must actually render the contracted services, in addition to having the right to dismiss the worker.
Essentially, most brokered workers fail the 20 Questions test because the third parties control when and whether the worker gets paid and can terminate them without cause. Most third parties only pay the worker after receiving payment from the client company, but some hide the fact that they control payment to the worker by slyly advancing the funds (but retaining the right to demand reimbursement).
When IRS and EDD auditors reclassify brokered independent contractors as employees, the third party and client typically share the resulting liability for back employment and income taxes, unpaid benefits, and other penalties and interest. These can total 50 percent of the amount paid for the worker's services. Even worse, such reclassification audits seldom involve just a single worker, but instead branch throughout the companies involved and extend back multiple fiscal years. The results can be truly intimidating, and are cited by many cautious CFOs as justification for never using brokered independent contractors (or even any 1099ers at all).
How Synergistech Saves Companies 20+ Percent and Solves the Brokered IC Problem
Despite the publicity given companies whose independent contractors were reclassified as employees, it is still possible — and advisable — for companies willing to create 20 Questions-compliant relationships to engage independent contractors. The immediate ROI is a minimum of 20 percent savings in employment-related costs. However, in our experience, being willing to work with 1099ers gives companies another dramatic advantage — access to a much higher quality of talent than is available in the W2 world.
The key to avoiding contractor reclassification audits is to set up two-party relationships and for the company to treat the worker as much as possible as a true independent contractor. Synergistech can help you with both of these requirements.
Synergistech is unique because it lets companies and workers comply completely with the 20 Questions. It sets up two-party, Section 1706-compliant independent contractor relationships for the candidates it introduces. Here are all the details.
Synergistech's competitors — all the other middlepeople — insist on controlling payment to the worker and the right to terminate without cause, thus compromising companies' ability to survive a contractor-reclassification audit and exposing them to the very real risk of overpaying for their workers' services by (another) 50 percent.