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Federal Withholding Taxes Table


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                                             TABLE OF CONTENTS

TABLE OF CONTENTS .................................................................................................i

I.         INTRODUCTION................................................................................................1


           A.          Common Law Factors. .............................................................................1

           B.          Section 530 of the Revenue Act of 1978. ................................................2

           C.          IRS Application Of § 530. .......................................................................3

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                       1.          Common Law Factors First..........................................................3

                       2.          Legal Precedent Safe Harbor. ......................................................3

                       3.          Prior Audit Safe Harbor. ..............................................................3

                       4.          Industry Practice Safe Harbor. .....................................................4

                       5.          Other Reasonable Grounds. .........................................................4

III.       MISCLASSIFICATION TAXES AND PENALTIES .........................................4

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                                             I.   INTRODUCTION

       The distinction between "employee" and "independent contractor" is significant
for both federal tax and non-tax purposes. Employees are subject to the withholding of
income and FICA taxes, and employers must pay federal unemployment tax on
employees as well. Beyond these federal tax ramifications, however, employees are
covered by a variety of labor and social legislation, including health care under the
Consolidated Omnibus Reconciliation Act (COBRA); the National Labor Relations Act;
the Occupational Health and Safety Act (OSHA); the Civil Rights Act of 1964; the Fair
Labor Standards Act; the Employment Retirement Income Security Act of 1974 (ERISA);
the Family and Medical Leave Act of 1993; not to mention state unemployment coverage.

        Whether an individual qualifies as an employee or independent contractor is
equally important from a state law standpoint. For example, in the State of Washington,
an employee classification will require in most instances that the employer not only pay
for unemployment compensation and workman’s compensation, but also file many more

        Employee maintenance is expensive and employers have historically preferred to
treat persons as independent contractors rather than employees.


A.         Common Law Factors.

       The basic definition of "employee" for tax purposes is set forth in Treas. Regs.
§ 31.3401(c)-1, reading, in part:

                       Generally, the relationship of employer and employee exists
                       when the person for whom services are performed has the
                       right to control and direct the individual who performs the
                       services, not only as to the result to be accomplished by the
                       work but also as to the details and means by which that
                       result is accomplished. That is, an employee is subject to
                       the will and control of the employer not only as to what
                       shall be done but how it shall be done.

        Case law developed a number of so-called "common law" factors regarding who
does and does not qualify as an employee. The IRS eventually memorialized twenty of
these factors. Rev. Rul. 87-41, 1987-1 C.B. 296. A list, most representing variations on
the control theme, is in the Appendix.

       The IRS employment tax audit training manual, issued in 1996 and discussed
below, states that the twenty factor list does not necessarily include all relevant factors.

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The manual nevertheless provides extensive guidance regarding how the twenty factors
should be applied.

       Code §§ 3121(d) and 3508 describe certain individuals whose status as employees
or non-employees is determined by statute rather than common law. Statutory employees
include corporate officers; certain agents; full-time life insurance salespersons; traveling
salesmen; and persons who work at home at the direction of a party that supplies their
materials and supplies. Pertinent Treasury Regulations add several additional conditions
that must be satisfied if these individuals are to be classified as employees.

       Statutory "non-employees" include "direct sellers" and qualified real estate agents.
While § 3508 defines a "direct seller" as one engaged in the business of selling "consumer
products", case law has clarified that "consumer product" may include both tangible
products and intangible services. E.g., Cleveland Institute of Electronics, Inc., v. U.S.
787 Fed. Supp. 741 (N.D. Ohio 1992). Direct sellers and real estate agents will be treated
as independent contractors only if they perform services under written contracts that
provide that they will not be treated as employees "for federal tax purposes."

B.         Section 530 of the Revenue Act of 1978.

       The Service's reliance on common law considerations perhaps unavoidably proved
inconsistent. Employers resented the subjectivity of IRS personnel, not to mention
defense costs and penalties in event of reclassification. Congress responded with Section
530 of the Revenue Act of 1978. A copy of § 530 is in the Appendix. Congress intended
to buy time with § 530 while it developed more comprehensive employment legislation
before § 530 was to expire on December 31, 1979. However, § 530 was extended twice
and finally was adopted permanently by the Tax Equity and Fiscal Responsibility Act of
1982 (TEFRA).

       The essential thesis of § 530 is that as long as an employer has timely filed all
federal tax returns and has consistently treated an individual and similarly situated
individuals as independent contractors, the individual cannot be treated as an employee
unless the taxpayer had no "reasonable basis" for not treating the individual as an
employee. A "reasonable basis" can be found in:

                       a.          Judicial precedent or certain IRS pronouncements;

                       b.          A prior IRS audit that failed to reclassify similarly situated

                       c.          A long-standing practice of a "significant segment of the industry"
                                   to treat such an individual as a non employee; or

                       d.          Other reasonable grounds.

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       The first three items are "safe harbors." The conference agreement accompanying
the Revenue Act of 1978 adopted a provision of House Report No. 1748 to the effect that
§ 530 was to be "construed liberally in favor of taxpayers."

       If successfully applied, § 530 will relieve an employer of liability for past
employment taxes, interest and penalties. It will not, however, change the status of an
employee for tax purposes. Also, § 530 will not avoid pension plan disqualifications.
See generally Rev. Proc. 85-18, 1985-1 C.B. 518.

C.         IRS Application Of § 530.

           1.          Common Law Factors First.

        While IRS employment tax audit procedures have been inconsistent, as might be
expected from collection personnel, the IRS followed a policy, until recent changes, that
it should not apply § 530 before it completes a common law determination. The IRS
would first classify an individual as an employee or independent contractor pursuant to
the common law tests. Thereafter, the taxpayer could rebut the Service's common law
determination or seek alternative relief under § 530. Many taxpayers complained that
the IRS resists application of § 530. Several courts criticized or rejected the Services'
approach. E.g., J&J Cab Service, Inc., v. U.S., 75 AFTR.2d 95-618 (W.D.N.C. 1995);
McClellan v. U.S., 76 AFTR.2d 95-5515 (E.D. Mich. 1995).

        Both § 530 and the IRS have required that if a taxpayer intends to cite § 530, he
must show that he actually relied on one safe harbor or the other in the process of making
the classification. That means that simply citing § 530 today to justify a classification
made previously was, at least technically, not sufficient.

           2.          Legal Precedent Safe Harbor.

        This safe harbor includes not only cited case law, but also revenue rulings and a
private letter ruling or determination letter issued with respect to the employer. How safe
the harbor is depends on the similarity of underlying facts.

       Because § 530 requires a taxpayer's "reasonable reliance" on any of the safe
harbors, IRS has argued that a taxpayer cannot rely on precedent arising after the tax
periods in question. However, subsequent authority should satisfy the "other reasonable
grounds" requirement.

           3.          Prior Audit Safe Harbor.

        The IRS was particularly taxpayer-friendly in applying the prior audit safe harbor
rule. It normally found reasonable reliance on a prior audit even if that audit failed to
address employment tax issues. However, the IRS does require that an "audit" must be an
audit, involving an examination of books and records. Compliance checks to determine
whether a taxpayer has filed returns, or other inquiry short of an exam, does not qualify.

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           4.          Industry Practice Safe Harbor.

        Under the industry practice provisions of § 530, questions normally address what
industry the taxpayer is in; how long the industry practice has existed; and whether the
practice is observed by a significant segment of the industry. The various standards
imposed by the IRS and the case law have been all over the block. Suffice it to say that
the taxpayer has been on firm ground if he could identify actual competitors as
representing his industry, e.g., Sanderson III v. U.S., 862 F. Supp. 196 (N.D. Ohio 1994);
if at least half of the industry treats similarly situated individuals as independent
contractors, In Re: Bentley, 73 AFTR.2d 94-667 (E.D. Tenn. 1994); and if the
classification practice has existed for at least seven years. REAG, Inc., v. U.S., 801 F.
Supp. 494 (W.D. Okla. 1992). These examples are conservative, and taxpayers have
prevailed under more relaxed standards.

           5.          Other Reasonable Grounds.

        A federal court has, for example, upheld an independent contractor classification
under circumstances in which the taxpayer relied upon the advice of two CPAs who had
diligently reviewed facts pertinent to the taxpayer's business, who had previously worked
successfully on related matters and who appeared to the taxpayer to be knowledgeable
and experienced. Smokey Mountain Secrets, Inc. v. U.S., 910 F. Supp. 1316 (E.D. Tenn.
1995). Other reasonable bases have included reliance on the advice of counsel, state
agency determinations, the audit of another similarly situated taxpayer and IRS rulings
issued to other taxpayers.

        Some taxpayers have succeeded in arguing that if they are successful in
identifying common law as the source for other reasonable grounds, their burden of proof
should be relaxed. A taxpayer's normal burden of proof is to establish his position by "a
preponderance of the evidence." The legislative history underlying § 530, however,
requires that it be interpreted liberally in favor of taxpayers. Id.; REAG, Inc., supra;
Contra, Bowles Trucking, Inc. v. U.S., 77 F.3d 236 (8th Cir. 1996).


        Unless other provisions apply, if independent contractors are reclassified as
employees, the IRS may collect the unpaid payroll taxes as far back as permitted by the
applicable statute of limitations. The two limitations rules generally applicable to payroll
taxes are that (1) the IRS may go back three years; and (2) the limitations period for each
quarter begins to run on April 15 of the following year.

        Section 3509 of the Internal Revenue Code deserves special mention because
under certain circumstances, it relieves taxpayers of what otherwise would be a much
more costly settlement. Section 3509 applies only to the "trust fund" taxes, i.e. the
withholding and the employee's portion of FICA. If a taxpayer can show that he did not
intentionally disregard withholding requirements and that he met reporting requirements
such as timely filing Forms 1099, his employment tax liability will be limited to 1.5% of

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wages and 20% of the employee's share of FICA. If the taxpayer failed to meet the
reporting requirements only, § 3509 will limit liability to 3% of wages paid and 40% of
the employee's portion of FICA. The statute will not relieve a taxpayer who has
intentionally disregarded withholding requirements.

       A taxpayer will still be liable under § 3509 for penalties and interest, but those
items will be computed against the reduced tax liabilities.

         If a newly-classified employee has paid income tax, § 3402(d) commensurately
reduces the employer's liability for withheld income tax. If certain conditions are met, §
6521 provides similar relief with respect to FICA self-employment taxes. The taxpayer
will still be liable for penalties and interest.

       Unless a relief provision applies, misclassification can lead to the following
additions to tax:

                       a.          Failure to deposit penalty: In misclassification cases, applies only
                                   to employer's share of FICA, not to other taxes which were not
                                   actually withheld.

                       b.          Failure to file or delinquency penalty: 5% per month to a maxi-
                                   mum of 25%. Penalty will not apply simply because employees
                                   were omitted from Forms 940 or 941 that were actually filed.

                       c.          Interest: At varying rates determined quarterly. Under § 6205(a),
                                   only FUTA interest will be paid if the taxpayer pays the
                                   employment tax deficiency before receipt of a notice and demand,
                                   unless the underpayment was intentional. See also Rev. Rul. 75-
                                   464, 1975-2 C.B. 474.

       The potential cost of a reclassification of independent contractors as employees
may go beyond employment taxes. Newly denominated employees may result in a
termination of an employer's qualified retirement plan on grounds that it is
discriminatory. As a result, prior contributions on behalf of vested individuals could be
imputed as income to them. Key employees and highly compensated individuals might
have to recognize as income the cost of group term life insurance; amounts received
under accident and health plans; and certain fringe benefits and employee discounts.

       Finally, as reflected so emphatically by Vizcaino v. Microsoft Corporation, 80
AFTR.2d ¶¶ 97-5143 (9th Cir. 1997), newly classified employees may very well seek
stock purchase and various other employee benefits.

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                                             COMMON LAW FACTORS

1.         Whether a worker is required to comply with other persons' instructions about
           when, where, and how he is to work.

2.         Whether a worker is trained by employer.

3.         Whether a worker's services are integrated into business operations so that the
           success or continuation of the business depends to an appreciable degree on the
           performance of such services.

4.         Whether the services must be rendered personally.

5.         Whether the persons for whom the services are performed hire, supervise, and pay

6.         Whether the services are performed as part of a continuing relationship between
           the worker and the person for whom the services are performed.

7.         Whether the worker has set hours during which he must work.

8.         Whether the worker is required to work substantially full time.

9.         Whether the work must be performed on the employer's premises.

10.        Whether the order or sequence of the services the worker is to perform are set by
           the person for whom the services are performed.

11.        Whether the worker is required to submit regular oral or written reports.

12.        Whether the worker is paid by the hour, week or month, or whether he is paid by
           the job or on a straight commission basis.

13.        Whether the worker's business expenses are paid by the person for whom he
           performs the services.

14.        Whether the worker is furnished with tools and materials.

15.        Whether the worker has a significant investment in facilities used in the
           performance of his services.

16.        Whether the worker can realize a profit or suffer a loss from his services that is
           greater than the profit or loss ordinarily realized by employees.

17.        Whether the worker performs services for multiple unrelated parties at the same

18.        Whether the worker makes his services available to the general public.

19.        Whether the person for whom the services are performed has the right to
           discharge the worker.

20.        Whether the worker has the right to terminate his relationship with the person for
           whom the services are performed at any time without incurring liability.

rminate his relationship with the person for whom
             the services are performed at any time without incurring liability.


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