Legal business entities authorized to exist by a government agency are “C” and “S” corporations, LLCs, and partnerships. In the United States, individual states are the authorizing agencies. The reasons for setting up a corporation or a LLC vary. The most common reasons are to limit shareholder liability and make it easier for owners to sell pieces of the corporation to investors. Partnerships do not limit owner liability but are advantageous in some situations. Independent Contractors usually set up corporations since they tend to be more “arms length” than partnerships.
If an Independent Contractor follows his state’s filing requirements, technically, he has a legal corporation. Filing for corporate status is the easy part. Unfortunately, simply creating a legal corporation is not sufficient to satisfy other government requirements to meet the legal definition of IC status.
The real concern is a legal concept known as “piercing the corporate veil,” or in IRS terminology: “substance over form.” In other words, for purposes of IC compliance, the federal government can legally pretend the corporation does not exist, regardless of corporate filing status. This enables the federal government to apply the same Twenty Common Law Factors the IC’s client and the IC were hoping to avoid. State agencies can also enforce various state IC regulations.
Is there actual substance to the Independent Contractor’s corporation? The definition of an independent business is not limited to whether or not the Independent Contractor has filled out all of the government mandated legal paperwork, such as tax returns, minutes of board meetings, etc.,. All of the aforementioned items could simply be called an appearance, or “form,” of a corporation.
One major question is: “Does the IC corporation operate as an independent business?” For example, some factors include the IC’s measure of control over his business, the IC’s risk of profit/loss, or the IC’s contracting with other clients or searching for new clients.
Control can also be defined as the measure of control the client has over the IC’s activities. If the client has too much control, the government will try to classify the IC as an employee. The definition of “too much control” has both objective and subjective elements, and some of these elements can vary depending on the industry and type of work involved. A general rule of thumb is that if the client has the authority to direct the IC as to the details on how to complete a task, the IC may be subject to reclassification as an employee. If it is left to the IC to decide how to produce a product or provide a service, then the IC is on the way to being classified as a “valid IC corporation.”
Whose decisions affect the profit or loss of an IC corporation? If the IC’s decisions determine whether or not the corporation makes a profit or sustains a loss, then this is also one more indication the IC is a “valid IC corporation.”
Does this IC corporation have other clients? If there are other clients, this is a determining factor, but it is not a conclusive indication of IC status to most government agencies. Does this IC corporation have an active advertising or networking campaign to secure other clients? What does that mean? What constitutes “active advertising”? This definition is also subjective. It differs widely according to various work specialties. An independent welder may not need to “actively” advertise because everyone in his community already knows he is the guy who does all the welding.
When I was a kid, there was a man who owned a service station. I never saw or heard an advertisement for his business. All he had was a sign above the station. He pumped a limited amount of gas, but only because gas was expected in that industry. His main business was car repair. Everyone in his community knew where to go for quality auto repair. He did not “actively” advertise, yet he was always busy. This would still constitute an independently active business.
Independent Contractors must operate independently in order to have a valid IC corporation. However, this is still no guarantee of a determination favoring IC classification.
The problem is no matter what the situation, no matter the degree of compliance, no matter what the facts are, there will always be a government agency prepared to argue that whatever the IC corporation does is insufficient to meet the various legal definitions of being an Independent Contractor. Nothing is conclusive to a government agency, unless the agency wins. The IRS and state taxing agencies are bound by a prescribed agenda.
So, for a business looking to hire an Independent Contractor, what constitutes a valid IC corporation? The definition should be straight forward and simple, but it is not. There are the Federal Twenty Common Law Factors prescribed by federal courts and fifty variations of classifications for each of the fifty states in the Union.
Life consists of taking risks. When a businessman starts a business, he is taking a calculated risk on success. When you leave your home, you are taking a calculated risk you will make it back alive.
The same is true with hiring an IC corporation. If you hire Independent Contractors, your business has an increased chance of success due to lower costs and greater flexibility; however, you might run afoul of onerous government rules and regulations.
Essentially, there are two methods to turn hiring an IC corporation into a reasonably calculated risk. Both reduce the risks of hiring ICs and utilize lower cost advantages:
A business can hire someone with practical, operational experience to design a compliant system of hiring and working with Independent Contractors. This system requires regular attention and maintenance, so the system does not accidentally slip into noncompliance through a lack of oversight, fine-tuning, or consistency. A workable system must also include continuous legal updates.
A business can transfer the risk to a workforce management company which specializes in this area. This option nearly eliminates the risk of your business getting tangled up in ill-defined government rules and regulations regarding classification because the ICs essentially become employees of a third-party workforce management company.
When you first got into your business, you took a calculated risk. Likewise, when you hire Independent Contractors, you must also determine the level of risk you are willing to accept to maintain an acceptable profit margin.
David Sity holds a CPA (WI) and is a Corporate Tax Compliance Consultant who worked as an Employment Tax Specialist with the IRS for nearly fifteen years. Mr. Sity assists clients in determinations of IC legal status for risk assessment and/or mitigation and has successfully represented clients in front of taxing authorities.