FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman and Members of the Subcommittee:

I am pleased to present the views of theDepartment of the Treasury on issues in S. 460 and S. 570relating to the deductibility of health insurance premiums forthe self-employed, the deduction of home office expenses, workerclassification, and the Electronic Federal Tax Payment System(EFTPS), with a focus on their impact on small businesses.

DEDUCTION FOR HEALTH INSURANCE COSTS OFSELF-EMPLOYED INDIVIDUALS

Under current law, contributions by employers toaccident and health insurance for employees and their familiesare deductible and are excluded from employees’ income.Self-employed individuals generally are entitled to a deductionin computing adjusted gross income for a percentage of the healthinsurance premiums paid for themselves and their spouse anddependents. With the Administration’s support, the HealthInsurance Portability and Accountability Act of 1996 (HIPAA)increased this percentage from 30 percent in 1996 to 40 percentin 1997, and the percentage is scheduled to increase in stages to80 percent in 2006. The Administration has strongly supportedproposals to facilitate health insurance coverage for allAmericans, including the self-employed.

The proposal in Section 2 of S. 460 is ostensiblyaimed at providing parity between the tax treatment of healthinsurance costs for employees and for self-employed individuals.However, it is typical for employers to pay for only a portion oftheir employees’ (or retirees’) health care costs. Inmany situations, the remainder of the cost is paid by employeesand former employees in the form of after-tax contributions.Thus, the increase to an 80 percent deduction that theAdministration supported in HIPAA will come closer to providingrough parity between employees over their careers andself-employed individuals than a 100 percent deduction forself-employed individuals. We believe that HIPAA addresses thisissue in an appropriate manner.

DEDUCTIBILITY OF HOME OFFICE EXPENSES

With respect to the home office deduction, we are supportiveof the general approach taken in S. 460. The proposed reformswill help the tax law keep pace with changes that have occurredin the workplace. We believe, however, that certain technicalmodifications are necessary (1) to ensure that de minimismanagement activities would not qualify taxpayers for the homeoffice deduction, and (2) to prevent the bill from affecting thenondeductibility of commuting expenses.

Under current law, a home office deduction is generallyallowed with respect to the use of a taxpayer's residence only inlimited circumstances, including where a portion of the home is exclusivelyused on a regular basis as the taxpayer's "principalplace of business." In Commissioner v. Soliman, theSupreme Court disallowed a home office deduction to ananesthesiologist who practiced at several hospitals, butperformed his administrative activities in a home office becausehe was not provided office space by the hospitals. The Court heldthat the home office was not his principal place of business,because his primary services were performed at the hospitals.

In response to the Soliman case, several bills(including S. 460) have been introduced that would allow a homeoffice deduction to taxpayers who manage their business affairsfrom their home. For example, S. 460 would treat a home office asa "principal place of business" if (i) the office isexclusively used by the taxpayer to conduct Aessential@administrative or management activities on a Aregular andsystematic@ basis, and (ii) the taxpayer has no other location toconduct these essential administrative or management activities.Thus, under the bill, a home office deduction would be allowedunder circumstances where the taxpayer's home is not in factthe taxpayer's principal place of business.

While we generally agree with the bill’s approach to thehome office deduction, we believe that certain changes should bemade. In particular, the current rules were enacted by Congressin 1976 to reduce the substantial amount of litigation over thecircumstances under which a taxpayer who worked in his or herhome could deduct as a business expense a portion of the costsassociated with maintaining the home. We should avoid turningback the clock and creating a level of ambiguity that wouldresult in more disputes between taxpayers and the IRS. To addressthis concern, we believe that the services being performed in thehome office must be both Asubstantial and essential.@ This wouldavoid allowing a home office deduction where only a de minimisamount of administrative or management activities are conducted.

We are also concerned that the bill would affect more thanhome office deductions. Because the bill is drafted in a mannerthat changes what qualifies as a Aprincipal place of business,@it would appear also to permit deductions for currentlynondeductible commuting expenses. We believe the effects of theproposal should be limited to allowing home office expenses andthus certain drafting changes should be made to the bill.

In summary, we generally support the home office provisions inS. 460 and would be pleased to work with Congress to address theconcerns we have raised.

WORKER CLASSIFICATION

We are opposed to the independent contractor provisions in S.460, primarily because of our concern that the provisions couldresult in a loss of important worker protections due towidespread and disruptive shifting of employees to independentcontractor status.

Background

The classification of workers as employees or independentcontractors is a significant and complex issue. Whether workersare classified as employees or as independent contractors issignificant for both Federal income tax purposes and Federalemployment tax (i.e., Social Security, Medicare, Federalunemployment insurance and withholding) purposes. Legislativechanges in the standard for determining whether a worker is anemployee or an independent contractor also affect fundamentalissues under the existing legal system such as protection ofworkers’ safety, health and pensions.

Income, Social Security and Medicare taxes on employees arecollected mainly by employers through the withholding system,whereas the same taxes on independent contractors are collectedmainly through self-assessment under the estimated tax system.Independent contractors can offset income by deductions forbusiness expenses that generally are not as readily available toemployees (except to the extent that the employee itemizesdeductions, and business expenses and other miscellaneousitemized deductions exceed 2 percent of adjusted gross income).In contrast, certain fringe benefits provided by a business toemployees are eligible for greater tax preferences than areavailable to independent contractors. While independentcontractors can adopt tax-qualified self-employed retirementplans that can be similar to employer-sponsored plans foremployees, other benefits are only available or more cheaplyavailable through an employer (such as group health insurance,workers’ compensation insurance, and unemploymentinsurance).

The classification of workers as employees or independentcontractors also is significant under a variety of Federal andState labor and worker protection laws that cover only employees,such as unemployment insurance, workers' compensation, wage andhour requirements, and family and medical leave requirements.While different definitions may apply to worker classificationunder different laws, because of the distinctly differentpurposes they serve and the defining case law, theinterpretations under one law may influence, legally orpractically, the interpretations under other laws. For thesereasons, it is important that any legislation altering the statusof workers be carefully considered to determine its potentialimpact on worker protections.

For purposes of the Internal Revenue Code, most workers areclassified as employees or independent contractors based on thetraditional common-law test for determining the employer-employeerelationship. This test focuses on whether the employer has theright to control not only the result of the worker's services butalso the means by which the worker accomplishes that result.

The common-law control test by its nature depends on thespecific facts and circumstances of each situation. In an effortto administer this facts and circumstances standard better, theInternal Revenue Service (IRS) derived from the case law avariety of factors that courts considered, with more or lessweight being accorded to particular factors depending on thecontext. In most cases, the classification of a worker under thecommon-law standard is clear. However, because the control testis inherently a factual determination, there are cases in whichthe correct status of a worker is less obvious. The uncertaintyin these cases has been perpetuated by the long-standingstatutory moratorium on the issuance of public guidance throughregulations or revenue rulings regarding the properclassification of workers for employment tax purposes.

Current tax law does not consistently favor status as eitheran employee or an independent contractor. However, in particularcircumstances, one or the other of the classifications may beadvantageous to a service provider, the service recipient, orboth. A company's costs may, for example, be lower if its workersare classified as independent contractors rather than employeesto the extent the company can pay independent contractors lessthan the sum of the cash compensation, the costs of the company'sportion of Social Security and Medicare taxes, unemploymentinsurance, workers' compensation, other fringe benefits that thecompany incurs for employees, and the overhead costs ofwithholding and recordkeeping. In effect that would requireshifting such burdens to the workers without correspondinglyadjusting the worker’s compensation.

In addition, the income and employment tax provisions of theCode may favor classification as an independent contractor wherea worker has significant unreimbursed business expenses. This isprimarily because independent contractors face significantlyfewer restrictions on their ability to deduct trade or businessexpenses than employees, as noted earlier. Conversely, employeestatus may be advantageous for workers with few business expenseswho benefit from the tax advantages accorded to fringe benefits,especially those that cost less, or are only obtainable, throughan employer, such as employer-provided group health insurance,workers' compensation insurance, or unemployment insurance.

Workers who are classified as independent contractors may alsohave greater opportunities than employees to avoid fullcompliance with the tax laws. Independent contractors may find iteasier to omit some of their income on their tax returns withoutdetection, although underreporting of income becomes moredifficult when an independent contractor's gross income isreported to the IRS on information returns. Moreover, evenindependent contractors who report 100 percent of income havegreater opportunities to overstate deductible business expenses.(In addition, independent contractors can claim their deductiblebusiness expenses in full because they are not subject to therequirements that they itemize deductions and that their businessexpenses and other miscellaneous itemized deductions exceed 2percent of adjusted gross income.) Clearly, some taxpayers havemade use of these opportunities, resulting in noncompliance.

Legislative History

Since the late 1970s, Congress and the Department of theTreasury have considered numerous proposals aimed at resolvingissues associated with the classification of workers as employeesor independent contractors. Recent proposals have focusedprimarily on reducing uncertainty, simplifying the rules, andreducing the potential penalties for misclassification. Inaddition, there have been proposals that include attempts tochange Section 530 of the Revenue Act of 1978, which includes amoratorium on issuance of administrative guidance. Thismoratorium has increased uncertainty, particularly given thechanges in the American workplace and development of new servicerelationships that are inherent in a dynamic economy.

Section 530. In response to a number of largeretroactive employment tax assessments in the 1970s, Congressprovided certain employers with general statutory relief from IRSreclassification of workers from independent contractors toemployees. Section 530 of the Revenue Act of 1978 prohibits theIRS from correcting erroneous classifications of workers asindependent contractors for employment tax (but not for incometax) purposes, including prospective corrections, as long as theemployer has a reasonable basis for its treatment of the workersas independent contractors. A reasonable basis includes relianceon (i) judicial precedent, published rulings, letter rulings ortechnical advice memoranda; (ii) a past IRS audit (although priorto changes effective after 1996, not necessarily an employmenttax audit) in which there was no assessment attributable to theemployment tax treatment of the worker or of workers holdingsubstantially similar positions; (iii) a long-standing recognizedpractice of a significant segment of the industry in which theworker was engaged; or (iv) any other reasonable basis for theemployer's treatment of the worker.

The relief provided by section 530 is not available unless theemployer consistently treats the worker, and any other workerholding a substantially similar position, as an independentcontractor (sometimes referred to as the "substantiveconsistency" test) and complies with the statutoryrequirements for payments to independent contractors. Forexample, section 530 relief is not available if the employer hasfailed to comply with the information reporting requirementsassociated with its treatment of the worker as an independentcontractor.

Section 530 applies solely for purposes of the employment taxprovisions of the Code. It has no legal effect on an employer'streatment of a worker as an employee for income tax purposes.Further, it does not affect the worker's own tax treatment forany purpose. Consequently, section 530 can result in the receiptby the Social Security system of less than the appropriate amountof employment taxes for some workers. This is because theseworkers are simultaneously treated as employees for their own taxpurposes, and thus are subject only to the employee share ofSocial Security and Medicare taxes, and are treated asindependent contractors by their employers, which pay noemployment taxes with respect to these workers. As a result, anamount equal to the employer portion of Social Security andMedicare taxes is not paid. Section 530 also has no impact ondeterminations of employment status for other purposes, such aseligibility for pension and health benefits and workers'compensation and unemployment insurance.

Section 530 was enacted as a one-year "stopgap"measure until Congress could devise a less contentious standardfor classifying workers. It was extended several times andfinally extended indefinitely in 1982.

Section 3509. In the Tax Equity and FiscalResponsibility Act of 1982, Congress added section 3509 to theCode in order to mitigate employers' liabilities for retroactiveemployment tax assessments where section 530 relief was notavailable. Section 3509 generally limits an employer's liabilityfor failure to withhold income, Social Security, and Medicaretaxes on payments made to an employee whom it has misclassifiedas an independent contractor.

Under section 3509, an employer is liable for 1.5 percent ofthe wages paid to the employee, in lieu of the income taxes thatwere not withheld, plus 20 percent of the employee's portion ofthe Social Security and Medicare taxes on those wages. If theemployer has not complied with the information reportingrequirements associated with the treatment of the worker as anindependent contractor, however, these percentages are doubled to3.0 and 40 percent, respectively. In addition, the employer'sliability under section 3509 cannot be reduced by anyself-employment or income taxes paid by the misclassified worker.Section 3509 also does not relieve the employer of its liabilityfor 100 percent of the employer portion of Social Security andMedicare taxes. The relief provided by section 3509 is notavailable if the employer has intentionally disregarded thewithholding requirements with respect to the employee.

The rules of section 3509 were developed in an attempt toplace an employer and the Federal Government in approximately thesame financial position, on average, in which they would havebeen if the amount of taxes actually paid by the misclassifiedemployees had been determined and used to abate the employer'sliabilities, without the need actually to determine thoseamounts. Thus, section 3509 has no effect on an employer's ownliability for Federal or State unemployment insurance taxes orthe employer portion of Social Security or Medicare taxes. Also,in return for limiting the employer's liability for failure towithhold employee taxes, section 3509 prohibits the employer fromreducing its own liability by recovering any tax determined underthe section from the employee, and, as discussed above, gives itno credit for any taxes ultimately paid by the employee.

Section 1706. In the mid-1980s, some employers in thetechnical services industry complained that the relief grantedunder section 530 created an unfair advantage for certain oftheir competitors. They noted that section 530 affects differenttaxpayers differently, depending on whether they satisfy thestatutory conditions for relief. In particular, employers thathave consistently misclassified their employees as independentcontractors are entitled to relief under section 530, while otheremployers in the same industry (that, for example, have sometimestaken more conservative positions on classification issues) arenot entitled to relief because they cannot satisfy theconsistency requirements of section 530. The crux of theemployers' complaints was that certain taxpayers in the industryachieved unfair cost savings by having consistently treated andcontinuing to treat the service providers as independentcontractors.

As a result of these complaints, in section 1706 of the TaxReform Act of 1986, Congress excluded from the ambit of section530 taxpayers that broker the services of engineers, designers,drafters, computer programmers, systems analysts and "othersimilarly skilled workers engaged in a similar line ofwork," effective for payments made after December 31, 1986.Section 1706 applies exclusively to multi-party situations, i.e.,those involving (i) technical services workers, (ii) a businessthat uses the workers, and (iii) a firm that supplies the workersto the business. The effect of section 1706 is to deny section530 relief solely to the firm that supplies the workers. Section1706 did not affect the application of section 3509 to suchcases.

Small Business Job Protection Act of 1996 - Changes toSection 530. As part of the Small Business Job Protection Actof 1996 (the Small Business Act), Congress clarified and modifiedthe application of section 530, enacting provisions that codifiedcertain IRS positions and practices and changed others. Section1122 of the Small Business Act provided that: (1) the IRS mustprovide notice of the availability of section 530 relief at thebeginning of a worker classification audit (the IRS issuedPublication 1976 for use in satisfying this requirement inOctober 1996, IR-96-44); (2) beginning for audits commenced afterDecember 31, 1996, the prior audit safe harbor applies only ifthe audit included an examination for employment tax purposesregarding worker classification; (3) a "significantsegment" of the taxpayer’s industry does not requirethe practice by more than 25 percent of the industry; (4) anindustry practice need not have continued for more than 10 yearsin order for the practice to be considered long-standing; (5) apractice will not fail to be treated as long-standing merelybecause the practice began after 1978; (6) a worker does not haveto be otherwise classified as an employee in order for section530 to apply; (7) the fact that a taxpayer changes the treatmentof workers from independent contractors to employees foremployment tax purposes does not affect the applicability ofsection 530 for prior periods (adopting an IRS position stated inRev. Proc. 85-18); and (8) the determination as to whether anindividual holds a position substantially similar to a positionheld by another individual includes consideration of therelationship between the taxpayer and such individuals.

In addition, the Small Business Act modified the burden ofproof in section 530 cases by providing that if a taxpayerestablishes a prima facie case that it was reasonable not totreat a worker as an employee, the burden of proof shifts to theIRS with respect to such treatment. In order for the shift inburden of proof to occur, the taxpayer must fully cooperate withreasonable requests by the IRS for information relevant to thetaxpayer’s treatment of the worker. The shift in burden ofproof does not apply for purposes of determining whether thetaxpayer had any other reasonable basis for treating the workeras an independent contractor.

Recent Administrative Initiatives

Last year, the IRS announced several administrativeinitiatives to improve the current situation in the workerclassification area. These initiatives respond to concernsexpressed by taxpayers, particularly small businesses.

Training and Training Material for IRS Examiners. TheIRS developed new training materials for IRS examiners. Thetraining materials are intended to ensure that examiners makelegally correct determinations about whether workers are properlyclassified as employees or independent contractors under thecommon-law standard. The materials emphasize to examiners thatthey must approach the issue of worker classification in a fairand impartial manner, and remind examiners that either workerclassification -- independent contractor or employee -- can be avalid and appropriate business choice. These new trainingmaterials also demonstrate how the application of the common-lawstandard has evolved to reflect the changing nature of businessrelationships. Recognizing the importance of the workerclassification issue, and the need to make the training materialas clear and as useful as possible, the Service took the unusualstep of requesting public comments on the draft of the trainingdocuments. Between the original proposed draft and the finalversion, over 60 sets of comments were received. These commentsresulted in significant revisions. The usefulness of the trainingmaterials, not only to examiners but also to the public, isillustrated by the fact that the Web site containing thesematerials has received thousands of "hits" since thematerials were finalized in October of 1996.

The IRS training document also addresses in detail theapplication of section 530 of the Revenue Act of 1978. It makesclear to examiners that section 530 should be actively consideredduring an examination and that section 530 should be addressedbefore exploring worker status. In fact, the materials state thatexaminers are required to explore the applicability of section530 even if not raised by the taxpayer, in order to correctlydetermine the taxpayer's tax liability.

During 1996, the IRS undertook intensive retraining of itsexaminers in the area of worker classification, holding 34separate classes and investing more than 22,000 person hours inthe endeavor. Over 750 specialists in employment tax and relatedareas received training in these two-day courses. A follow-upvideo conference also was conducted. In addition, in November,the IRS conducted a three-hour video program for general revenueagents on the worker classification issue. The amount of timedevoted to training and the detail in materials provided toemployment tax specialists reflects an IRS commitment to ensurethat these specialists correctly and fairly classify workers andare informed of the availability of Section 530 and the specialrules applicable to classes of statutory employees, statutorynon-employees and other special classes of workers, as well asthe appropriate application -- in a wide variety of industriesand business practices -- of the common-law standard fordetermining whether a worker is an employee.

This does not mean that businesses need to analyze and undergothis type of training to determine whether their workers areemployees or independent contractors. Rather it shows acommitment to provide examiners with the background, training,and experience needed to understand the law, with all of itsexceptions and special procedures, and to understand the varietyof business practices to which the law is applied. A businessowner needs to focus only on application of the law to itsbusiness, not on understanding the entire spectrum of businessrelationships and statutory categories presented to theemployment tax specialist. Moreover, the IRS and Treasury haveprovided summary materials for use by small business. Forexample, a one-page description of Section 530 is provided tobusinesses, who can use this to gain a practical understanding ofsection 530 requirements, instead of reading the detailedbackground, legal support, and exercises provided to educateemployment tax specialists in this area. The training materials(including the opportunity provided for taxpayers and all otherinterested parties to comment on a draft of the materials) andthe IRS training program based on the new materials are intendedto promote both consistency and additional clarity concerning IRSapplication of the common-law classification standard.

Classification Settlement Program. Another significantinitiative taken by the IRS is a classification settlementprogram that allows businesses to resolve worker classificationcases earlier in the examination process, reduce taxpayer costs,and ensure the proper application of the provisions of section530. The classification settlement program is based on thefollowing key principles: Reclassification of workers who havecorrectly been treated as independent contractors must beavoided. Worker classification issues should be resolved quickly,and as early in the administrative process as possible. Workerclassification issues should be resolved uniformly throughout thecountry. Resolution of worker classification issues should takeinto account a taxpayer’s past compliance with section 530,as well as the common-law standard. The IRS’s complianceprograms should encourage correct classification and correctreporting of payments to workers.

Under the classification settlement program, businesses thathave misclassified their workers as independent contractors, havefiled Form 1099 information returns, but have failed to meet theother requirements for relief under section 530, can settle thematter with IRS examiners by reclassifying their workersprospectively and paying only limited tax assessments. Thiseliminates the risk that tax assessments could be applied formultiple years.

Participation by businesses in the settlement program isentirely voluntary, and businesses declining to participateretain all rights that exist under the IRS's current procedures.The program is intended to approximate the aggregate results thatwould be obtained under current law if businesses accepting theoffers had instead exercised their right to administrative orjudicial appeal. This program appears to have successfullyreduced the burdens involved in resolving worker classificationsettlements, as the rate of acceptance of settlement offersduring the quarter ending March 31, 1997 was 81.86 percent. Theprogram is in the second year of a test period that runs throughMarch 6, 1998. At the end of the test period, the program will beevaluated to determine whether it should be continued on a morepermanent basis.

Early Referral to Appeals. In addition, in March 1996,the IRS announced procedures for allowing businesses, at theiroption, to resolve employment tax issues more quickly byappealing these issues to the IRS Appeals function even while thedevelopment of other issues raised during an examination is stillin progress. In May this appeals procedure was extended for asecond year (Ann. 97-52, 1997-21 IRB 22).

These are significant administrative initiatives; they respondto concerns about worker classification expressed by smallbusinesses and other taxpayers and they materially improve theclimate for decisions on worker classification. These initiativesshould be allowed to go forward without disruption. TheAdministration has also proposed legislative changes, describedbelow, to lessen the stakes involved in misclassification byeliminating past employment tax liability in certain cases wheretaxpayers have a reasonable argument that they meet therequirements of Section 530 and by providing easier access to anindependent determination by the Tax Court. These proposals alsowill materially improve the current situation for taxpayers andthe IRS.

Administration’s Legislative Proposals Relatingto Section 530 and Tax Court Jurisdiction

Perhaps the greatest problem for business in the workerclassification area is not the possibility that an employertreating its employees as independent contractors will berequired to reclassify them as employees for the future, but therisk of substantial employment tax liability and penalties forprevious years, even if the employer had a reasonable argumentfor its classification decision or the belief that it wasentitled to section 530 protection.

To address this problem, last year we proposed that Congresspermit businesses that misclassify workers as independentcontractors and fail to meet the requirements of section 530 toreclassify their workers prospectively with no employment taxliability for prior years, provided that they satisfy certainconditions. To qualify for this relief, the business would haveto meet the section 530 reporting consistency condition and havea reasonable argument that it meets the section 530 substantiveconsistency and reasonable basis requirements. This proposal isintended to provide relief to taxpayers who fall just short ofmeeting those section 530 requirements. Of course, as undercurrent law, if workers are correctly classified as independentcontractors, or if the taxpayer meets section 530, then thebusiness would not be required to reclassify the workers asemployees. This proposal was included in theAdministration’s Tax Simplification Proposals, presented bySecretary Rubin on April 14 of this year.

Further, under the proposal, a taxpayer that believes the IRShas erred in its case would be given an expanded opportunity toobtain an independent review of the IRS decision. United StatesTax Court jurisdiction would be enlarged to cover workerclassification determinations for employment tax purposes. Ofcourse, the Tax Court would have the authority described above todetermine whether misclassified workers should be reclassified ona prospective basis only.

Access to the Tax Court would permit disputes to be resolvedmore quickly and at lower cost than in Federal District Court.Simplified procedures that might be adapted for small businesscases would be available in some circumstances. Tax Court judgeshave considerable experience in resolving tax cases involvingsimilar issues, and many small cases are currently resolvedwithout requiring the business to retain counsel. We believe thatthe expanded Tax Court jurisdiction would provide a business withincreased access to an independent judicial resolution if thebusiness believed its determination, rather than the IRSposition, was correct.

These legislative proposals -- to eliminate past employmenttax liability in certain cases where taxpayers fall just short ofmeeting section 530, and to increase a small business's access toan independent, third-party determination -- should further helptaxpayers and the IRS to resolve worker classification problemsin a fair and cost-effective manner. We believe that, incombination with the administrative steps described earlier, theywould provide significant relief to small businesses from themost serious problems relating to worker classification.

In addition, we believe that it may be possible to improveunderstanding of the common-law classification standard throughrevenue rulings or other guidance. The recently revisedIRS training materials take an important step in this directionby emphasizing that the true common-law test for purposes of theInternal Revenue Code is the right to "direct andcontrol" and that the "20 factors" that are oftenreferred to in connection with this test are relevant onlyinsofar as they provide evidence bearing on whether the test issatisfied.

At present, section 530 precludes the issuance of revenuerulings or guidance. We think that it would be helpful totaxpayers, and ensure uniform national treatment, if relief isprovided from this prohibition. This would permit issuance ofguidance that could help taxpayers focus on a few factors thatare most relevant to their particular situations. We would bepleased to explore with Congress the possibility of amendingsection 530 at least to the extent necessary to permitpublication of such guidance. Providing such guidance couldreduce uncertainty, and move toward greater simplification,without shifting the historic balance between classification ofworkers as employees or independent contractors in a way thatthreatens worker protections that are based on classification.

The guidance could build on one or more key factors, but itneeds to allow flexibility for interpretation consistent with thediffering and evolving factual settings in which the standardwould be applied. For example, administrative guidance couldbuild on the concept that a key factor in determining whether itis appropriate to classify a worker as an independent contractoris whether the worker has a real possibility of profit and bearsa genuine risk of economic loss.

We would intend that such guidance would first be issued inproposed form in order to provide an opportunity for public andCongressional comment and review as to the standards developed.While such guidance could not prescribe a purely mechanical testthat would apply in all circumstances, it could simplify theprocess and reduce uncertainty, without resulting in thewidespread and possibly unsettling shifting of current workerclassifications that would follow inevitably from some of thelegislative proposals that have been introduced in the past.

S. 460

You have asked for our views on the independent contractorprovisions of S. 460. We are opposed to these provisions in S.460 for the reasons stated below. In general, we are concernedthat the safe harbor proposed under S. 460 could result inwidespread and disruptive shifting of employees to independentcontractor status, causing loss of important worker protections,including employer-provided pension and health coverage. We alsohave grave doubts about other aspects of the proposal, especiallywhether a purely mechanical standard can ever be devised to dealappropriately with the wide variety of worker relationships andoccupations that characterize the complex and dynamic Americanworkplace.

In addition, we believe that now is not the time to overlayyet another piecemeal change to the substantive legislationgoverning worker classification. Just last year, several changeswere made to section 530. Also, new training of employment taxexaminers, new training materials, and a process permitting earlyreferral to appeals appear to be successfully reducing burdens inthis area. Our procedural legislative proposals relating tosection 530 and Tax Court jurisdiction would appropriately lowerthe stakes concerning worker classification determinations,without risking disruptive shifting of employees to independentcontractor status. Moreover, permitting us to issueadministrative guidance could also help simplify the process andreduce uncertainty.

Evaluating legislative proposals. Worker classificationis a difficult and long-standing issue that has far-reachingimplications. Fundamental legal and business issues, includingissues beyond the collection of income and employment taxes, maybe affected by legislative changes altering the standard fordetermining whether a worker is an employee or an independentcontractor.

Under current law, worker classification in the InternalRevenue Code directly affects income, Social Security andMedicare taxes. However, it also affects other issues such as theavailability of employer-provided pensions and group healthinsurance. For example, under current law, tax-qualifiedretirement plans sponsored by a business are permitted to coveronly the business's employees. Legislation that resulted in theconversion of employees into independent contractors for Federaltax purposes would reduce the number of people eligible to savefor retirement in tax-qualified employer-provided pension,401(k), and other retirement plans. These reclassified workerswould be free to establish their own tax-favored retirementplans. However, employer-sponsored plans have proven to be aparticularly effective means of promoting retirement savings forworkers, especially for middle- and lower-income workers whomight be less likely to save outside the workplace, in partbecause of automatic employer contributions, employee savingsthrough payroll deduction, employer matching contributions,employer education programs, and economies of scale. Maintainingand further increasing worker savings are important policy goalsfor both the Administration and the Congress. In addition,converting employees into independent contractors could result infewer people receiving the benefits of lower-cost group healthcoverage through their employers.

In evaluating any proposed legislation, it is also importantto consider whether a new statutory standard under Federal taxlaw would lead, legally or practically, to loss of employeeretirement or health benefits or coverage under other Federal andState laws, such as the laws that provide unemployment insurance,workers' compensation, minimum wage and maximum hour protections,workplace health and safety standards, and family and medicalleave protections to workers who are classified as employees.This might occur, for example, if businesses that reclassifiedworkers as independent contractors under a new Federal employmenttax standard also incorrectly treated those workers asindependent contractors for purposes of other laws that are basedon employee status. Broader reclassification under these otherstatutory provisions could also result from subsequent efforts,in the interest of simplification, to eliminate inconsistenciesbetween the classification standards under those State andFederal non-tax laws and a new Federal employment taxclassification standard by conforming them to the new standard.Also, the determination under the tax laws can be decisive inpractice, because of the inability of states to audit once adetermination is made for tax purposes. These potentiallysweeping implications should be explored carefully and thoroughlybefore enactment of any new statutory classification standard forFederal tax purposes.

As a general matter, experience suggests that it is difficultto legislate one simple, purely mechanical definition or safeharbor that applies appropriately to the many varied existingworker relationships and occupations. All verbal formulations aresubject to problems of manipulability or may be unclear whenapplied to these differing relationships and occupations.Moreover, specific statutory rules, by contrast to regulationsand rulings, are not easily adapted to the changes that areconstantly taking place in an area as complex and dynamic as theAmerican work place. There will always be people who operate withnew forms of employment not envisioned before. Further, differentbusinesses will choose to structure their relationships withworkers in different ways.

Evaluating S. 460. We have very serious concerns aboutthe safe harbor and burden of proof provisions of this bill.First, we are concerned that the new safe harbor could, and wouldover time, result in widespread and unsettling shifting ofemployees to independent contractor status, causing tax and otherlegal disruptions and loss of important worker protections,including employer provided pension and health coverage. Thisconcern is heightened because the bill would apply to workerclassification for income tax as well as employment tax purposes.

Second, we are concerned that the addition of this newstatutory safe harbor will increase rather than decrease burdensand complexity for businesses and the IRS. Businesses that haveuncertainties regarding worker status would potentially need toperform as many as three analyses: under the new safeharbor, under Section 530, and under the existing commonlaw rules. Adding new layers and standards can result in greateradministrative burdens on small business administration and onthe system generally.

In addition, we are concerned that further expansion of thekinds of cases in which the burden of proof is shifted to the IRScould undermine the voluntary compliance system and result in theloss of worker benefits and protections based on inadequateevidence.

Any changes in the worker classification area must be madewith care to ensure that they do not result in wholesalereclassification of great numbers of workers and concomitant lossof important worker benefits and protections.

We share the sponsors’ goal of providing a mechanism forbusinesses that reasonably believed their workers wereindependent contractors, and filed Form 1099s for these workers,to classify their workers without imposition of employment taxliability for past years, but we have serious concerns aboutelements of the prospective reclassification proposal containedin S. 460, particularly its extension beyond employment taxes toincome taxes.

Risk of shifting worker status. In an effort to achievemechanical simplicity in this area, S. 460 would prescribe"safe harbor" criteria for classification as anindependent contractor that could result in large-scale shiftingof workers from employee to independent contractor status.

The proposed safe harbor includes several requirements thatmust be met for a service provider to be treated as anindependent contractor. These elements of the safe harborgenerally are subject to risk of manipulation or can easily besatisfied by many workers who would historically be treated asemployees under the common law test and under common sense viewsof appropriate worker classification. The requirement that anemployee have unreimbursed expenses of at least 2 percent of AGIsuffers from several inherent problems. Many employees may haveunreimbursed expenses of at least this amount; the appropriatepercentage may depend on the circumstances involved; it isunclear why results should differ based on non-work relatedadjustments to income (such as alimony, IRA contributions, orearnings of a spouse); it is unclear how expenses would beallocated among contracts or work projects; it is unclear how thestandard would apply when the 2 percent threshold is determinedafter the end of a calendar year; the standard is subject tomanipulation by service recipients who can easily requireemployees to pay expenses and adjust their compensation toreflect the additional costs incurred; and it is unclear why thisstandard is necessary, given that unreimbursed expenses would betaken into account under the profit or loss requirement discussedbelow. The requirement that the service provider agree to performservices for a particular amount of time, or complete a specificresult or task, can easily be satisfied by providing a workerwith a contract for a specified period, such as month-to-month orpay-period-to pay-period.

The alternative requirements relating to principal place ofbusiness, provision of services, and use of facilities are alsoeasily satisfied or manipulated. The service provider can use hisor her home as a principal place of business, or can be chargedfair market rent for use of the service recipient’sfacilities, or can use equipment not supplied by the servicerecipient but have his or her compensation increased to reflectthese costs. The requirement that the worker not primarilyprovide the service at a single service recipient’sfacilities will be readily satisfied by many repair, maintenance,and delivery workers who may be employees, or by employees inother occupations that, by their nature, involve the performanceof services at more than one location. The requirement that theworker and service recipient enter into a written agreementconcerning worker classification also would fail to preventinappropriate recharacterization of employee status, particularlywhere workers have less bargaining power than the business.

The legislation also includes a verbally simple requirementthat the service provider have "the ability to realize aprofit or loss". We agree that the potentiality of sufferinga genuine economic loss would be, in cases where it occurs, a,perhaps the, key element in determining the proper classificationof a worker. In applying this standard, the ability to realize aloss must be a requisite component of the test. For thispotential loss standard to have meaning and not be a sham, therisk of loss must be real. Moreover, the potential to realize aprofit must also have genuine economic substance; certainly,contingent compensation is not itself an indicator of independentcontractor status.

As indicated above, we believe that administrative guidancecould address how this standard would be applied (if section 530were amended to permit the issuance of such guidance), andbecause of the need to allow for flexibility in interpretationconsistent with the different factual settings involved,administrative guidance would be the appropriate forum in whichto address this standard. We would have serious concerns aboutuse of such an imprecise standard as a statutory safe harbor. Weanticipate that to prescribe this standard by statute rather thanto permit it to be addressed through administrative guidance(where the subtleties and limitations could be addressed) mightencourage employers to treat it as a mechanical standard thatcould be satisfied in form rather than in substance. Employersmight then attempt to manipulate the requirement byrecharacterizing worker status without altering the underlyingrelationship between the worker and the employer.

It is not difficult for an employer to structure an artificialarrangement that would superficially appear to meet a requirementthat an individual be able to realize a profit or loss to beconsidered an independent contractor, yet would lack economicsubstance. For example, an employer could require the employee topurchase or rent certain tools and supplies used in generatingthe employer's product, but could protect the employee from lossby directly compensating the employee through a commensurate payincrease. This could permit an employee to appear to"realize a profit or loss" without changing the natureof the employer-employee relationship or the tasks that theemployee would undertake. While we would view all thesearrangements as insufficient to constitute the ability to realizea profit or loss, we are concerned that absent clearerlimitations or guidance, taxpayers would take such positions inpractice.

Two examples illustrate the basis for these concerns about thesafe harbor in S. 460. Assume that an employer has employees whoare janitors and wishes to shift them from the status ofemployees to independent contractors, even though the businesshired and trained them and provided detailed rules and directionson how offices should be cleaned. Assume further that thebusiness attempts to manipulate the profit and loss requirementby stating that it will only pay the worker if the workercompletes the work in accordance with industry standards ofcleanliness, but the employer has no intention of refusing to payon this basis. The other requirements of S. 460 may easily besatisfied even if the worker would appear to be an employee ofthe employer under the common law standards, and a common senseview. For example, the employer could tell its janitors that inthe future they would be required to provide their own mops,cleaning fluids, sponges, gloves, garbage bags, and vacuums (andarrange for them to rent the vacuums or larger machinery), whenoffering to hire them under the new terms, increasing the rate ofcompensation to reflect these expenses. For workers with lowwages or sufficient adjustments to income (such as alimony),expenses such as these should be sufficient to constitute atleast 2 percent of AGI (only $240 for someone with $12,000 AGIattributable to the employment). The janitors could be requiredto work on a month-to-month basis in order to satisfy therequirement that the worker agree to perform services for aparticular amount of time. The janitors would be operatingprimarily with equipment not supplied by the service recipientand might well work at a variety of sites. The employer couldalso require all janitors to sign a service agreement indicatingthat the janitor would not be treated as an employee with respectto janitorial services for Federal income tax purposes.Accordingly, under the safe harbor these janitors could betreated as independent contractors.

Similar arrangements could be made with the secretaries of theemployer. The secretaries could be charged fair market rent foruse of their office space, or rent their desk, computer and phone(based on rental rates for such equipment), in order to meet therequirements that unreimbursed expenses equal at least 2 percentof AGI, and that the worker pay a fair market rent for use of theservice recipient’s facilities. Employers might attempt tomeet the profit or loss requirement by including in the personnelmanual a statement that secretaries are compensated only if theirwork meets industry standards, even if the employer has nointention of refusing to pay on this basis. The employer couldalso insist that the secretaries execute a contract stating thatthe secretary would not be treated as an employee for Federalincome tax purposes with respect to provision of secretarialservices. The workers in both of these examples would beclassified as employees under the common law standard and under acommon sense definition of employee, but would be treated asindependent contractors under the safe harbor.

S. 460 would also provide an alternative safe harbor forworkers to be treated as independent contractors if services areperformed pursuant to a written contract that provides the workerwill not be treated as an employee for Federal tax purposes, theworker conducts services as a corporation or limited liabilitycompany, and the worker does not receive from the servicerecipient or payor benefits that are provided to employees of theservice recipient. We have serious concerns that this provisioncould also encourage widespread shifting of employees toindependent contractor status.

Increasing complexity by adding safe harbor to two othertiers of determinations. S. 460 would impose a one-way safeharbor on top of the current rules. Any employer that did notmeet the safe harbor would still need to operate under theexisting regime. Having a multiplicity of different tests andstandards creates burdens for small businesses. By overlaying anew safe harbor on the existing laws, the bill would require thatemployers learn and apply three different regimes: the safeharbor rules, Section 530, and the common law standards. Insteadof overlaying yet another set of legal standards on top ofexisting rules, we believe it would be preferable to explore waysto simplify and focus the current legal standards through theissuance of administrative guidance. For these reasons, wequestion the value of legislating the proposed safe harbor.

Partial shifting of burden of proof. Under current law,in civil tax litigation, the burden of proof generally lies withthe taxpayer. In Tax Court, the Commissioner’s notice ofdeficiency is presumed to be correct, and the taxpayer must proveit is incorrect. In the refund context, the challenged assessmentis presumed to be correct, and the taxpayer must prove his or herentitlement to, as well as the amount of, a refund. TheGovernment generally bears the burden of proof in civil tax casesonly where it asserts fraud. The Small Business Act modified theburden of proof in section 530 cases by providing that if ataxpayer "establishes a prima facie case that it wasreasonable" not to treat a worker as an employee, the burdenof proof with respect to the determination under Section 530shifts to the IRS, if the taxpayer "fully cooperates"with "reasonable requests" for information.

S. 460 expands application of the shifted burden of proof tocases involving income taxes as well as employment taxes, andwith respect to the service provider as well as the servicerecipient. This change would dramatically increase the scope andnumber of cases in which burden shifting could occur. Thisexpansion could seriously undermine tax enforcement andcompliance and could result in the loss of benefits to workers.

Proposals to shift the burden of proof in tax cases haveuniformly been condemned by knowledgeable tax practitioners as adrastic change that could cripple the voluntary compliancesystem. Any shift of the burden of proof, even a partial one,could make it more difficult for the IRS to examine taxpayersadequately and collect the correct amount of tax. It must beremembered that the taxpayer always has control of the facts andcan maintain the documentation necessary to substantiate taxconsequences. Indeed, this is the rationale for placing theburden of proof on taxpayers in the first place.

S. 460 gives the taxpayer the benefit of the shifted burden ifthe taxpayer has Afully cooperated@ with Areasonable requests@ bythe IRS. Whether a taxpayer has Afully cooperated,@ and whetheran IRS request is Areasonable,@ are factual questions that arelikely to spawn their own controversies and give rise toanomalous results. For instance, if the taxpayer has failed tomaintain supporting data, or if the data are not technicallyunder the taxpayer’s Acontrol@ (even if the taxpayer has thesame or better access to it than the IRS), the taxpayer mightnevertheless argue that it has fully cooperated and that theburden of proof shifts to the IRS.

Similarly, the Aprima facie case@ threshold would result inbifurcating the evidentiary issues into an initial, Aprima facie@case portion and an ultimate finding as to the merits of thedispute. Thus the proposal could lead to more, not less,litigation, with the attendant costs and delays for taxpayers.

Prospective reclassification without imposition ofemployment tax liability for prior years. As discussed in thedescription of the Administration’s legislative proposalsrelating to section 530, we propose to permit employers toreclassify workers prospectively with no employment tax liabilityfor prior years, provided that the business met the section 530reporting consistency condition, and had a reasonable argumentthat it meets the other section 530 requirements. This proposalis intended to provide relief to taxpayers who fall just short ofmeeting the section 530 substantive consistency and reasonablebasis requirements. S. 460 also provides for prospectivereclassification without imposition of tax liability for prioryears, if the service recipient or payor entered into a writtencontract with the service provider that the service providerwould not be treated as an employee for Federal income taxpurposes, and if the service provider demonstrates a reasonablebasis for determining that the service provider is not anemployee and that this determination was made in good faith.

We have several concerns with the proposal in S. 460 asdrafted. First, the proposal applies not only to past liabilityfor employment taxes, but with respect to all determinations ofworker status for income tax purposes. We are concerned thatemployers thereby could be excused from providing pension andhealth benefits to employees who would otherwise be covered.Second, our proposal, consistent with Section 530, requiresemployers to treat all similarly situated workers the same way.S. 460 would grant employers the special relief even if they pickand choose among workers, treating similarly situated workersdifferently.

Conclusion

Worker classification is a difficult and complex issue thathas far-reaching implications. Legislative changes that wouldresult in the reclassification of workers from employee toindependent contractor status could affect a variety ofprotections for these workers. Because of these concerns, weoppose the independent contractor provisions of S. 460. It isimportant to explore these potential consequences thoroughlybefore enacting any new statutory classification standard forFederal tax purposes. At the same time, we believe that Congressin the short run should consider proposals to eliminateretroactive employment tax liabilities in certain cases where anemployer has a reasonable argument that it meets the requirementsof section 530, and to permit taxpayers to resolve disputes withIRS in a simpler and more cost-effective manner.

EFTPS

You have also asked for our views on S. 570, a bill to exemptcertain small businesses from the mandatory electronic fundtransfer system. As background to this discussion, we would liketo bring to your attention some recent developments in this area,of which you may already be aware.

On Monday, the IRS announced that it would not imposepenalties through December 31, 1997, on businesses that becomesubject to the Electronic Federal Tax Payment System (EFTPS) onJuly 1, 1997, but fail to use EFTPS. These businesses will stillbe required to make timely deposits, using either paper couponsor EFTPS.

Under current law, businesses that had more than $50,000 offederal payroll tax deposits in 1995 are required to begin makingdeposits through EFTPS on July 1, 1997. The six-month waiver ofpenalties announced by the IRS will provide additional time forthese businesses to convert to the new electronic payment system.The IRS will use this additional time to continue its outreachefforts to small businesses. Businesses will be encouraged to getacquainted with EFTPS and to make payments under the new system.They can use this period to learn more about making electronicpayments and to make the switch to the new system comfortably andconfidently. Successful use of the new system will showbusinesses that they are correctly enrolled and that theirpayments can be processed without error. Businesses thatencounter problems will be able to make deposits by paper coupon,giving them time to get help and make adjustments without facinga penalty.

We want to stress, however, that the IRS and the smallbusiness community have already made substantial progress inconverting to the new electronic payment system. Over 1.1 millionof the approximately 1.2 million businesses that are required tobegin using EFTPS on July 1 have already enrolled in the system.Another 400,000 businesses that could have continued to use papercoupons have enrolled in EFTPS voluntarily. Moreover,approximately 300,000 businesses have voluntarily begun makingelectronic payments through the new system in advance of the July1 effective date. Since EFTPS became operational, the TreasuryDepartment has received over $100 billion of electronic paymentsthrough the new system.

Turning to the current statutory and regulatory provisions,businesses are required to withhold income taxes and FICA taxesfrom wages paid to their employees. Businesses also are liablefor their portion of FICA taxes, excise taxes, and estimatedpayments of their corporate income tax liability. Under section6302 of the Code, the Treasury Department has generally requiredthat these taxes be deposited with banks and other financialagents of the United States. Prior to 1994, all of thesedepository taxes could be remitted through deposits with a bankor other financial agent using a paper coupon.

In 1993, section 6302(h) was added to require the TreasuryDepartment to develop and implement an electronic fund transfersystem for the collection of these taxes. The Treasury Departmenthas developed EFTPS in response to this requirement.

Section 6302(h) requires the Treasury Department to collectspecified percentages of the depository taxes through electronicfund transfer. This requirement was phased in over a six-yearperiod, beginning with fiscal year 1994. For fiscal year 1997,58.3 percent of payroll taxes and 60 percent of all otherdepository taxes are required to be collected through electronicfund transfer. When fully phased in (in fiscal year 1999), 94percent of all depository taxes are required to be collected byelectronic fund transfer. The regulations implementing thisrequirement provide that taxpayers are required to use EFTPS iftheir annual payroll tax deposits exceed a specified threshold.The regulatory requirement is also phased in. For calendar years1995 and 1996, the thresholds were $78 million and $47 million,respectively. For calendar years 1997 and 1998, the threshold is$50,000.

Under the regulations the threshold is currently scheduled tofall again, to $20,000, in 1999. However, because participationin EFTPS has surpassed expectations, we will reach the targetimposed by section 6302(h) for 1999 and subsequent years withoutthe need to further reduce the threshold. Accordingly, I ampleased to announce that we intend to amend the regulationswithin the next month to make the $50,000 threshold permanent.Thus, businesses below the $50,000 threshold will not be requiredto use EFTPS in the future.

S. 570

S. 570 would modify the phase-in rules of section 6302(h).Instead of requiring the collection of specified percentages ofdepository taxes through electronic fund transfer, a businesswould be required to use electronic fund transfer for a calendaryear only if its depository taxes for the second precedingcalendar year exceeded a specified threshold. This is essentiallythe same approach as that of the current regulations, but thethresholds are generally much higher. For calendar year 1997, thethreshold is $47 million. The threshold drops to $30 million in1998, to $20 million in 1999, to $10 million in 2000, and to $5million in 2001 and subsequent years.

The Treasury Department believes this change is unnecessary.As noted above, the IRS and the small business community havealready made substantial progress toward implementation of a$50,000 threshold. As of June 2, all but 86,000 of the 1.2million businesses above the $50,000 threshold have alreadyenrolled in EFTPS. The waiver of penalties through December 31,1997, should provide sufficient time to complete the enrollmentprocess. Moreover, we continue to agree with the views expressedby Congress when it enacted section 6302(h). The reportaccompanying the legislation listed the following advantages ofan electronic fund transfer system:

Use of an electronic fund transfer system for the collection of tax will promote accuracy and efficiency in processing, and consequently, is expected to result in significant cost savings to the Government. Taxpayers will benefit from increased accuracy, reduction in paperwork burden, and availability of a user-friendly tax collection system.

We also note that 300,000 small businesses have effectivelyendorsed these views by voluntarily making electronic paymentsthrough EFTPS. These businesses have realized the advantages ofthe new system. EFTPS eliminates most of the paperwork in the oldpaper coupon system. With EFTPS, deposits may be made quickly andconveniently by telephone or personal computer. EFTPS does awaywith the need to write out a check, fill out a coupon, and walkor drive to the bank to make the deposit.

While we expect substantial voluntary participation in EFTPSto continue even if S. 570 is enacted, the increased thresholdsof S. 570 will inevitably result in some revenue loss. Wequestion whether this loss is justified in view of the many otherimportant tax policy objectives that the Administration andCongress are attempting to accomplish in this year’s budgetlegislation.

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The Treasury Department appreciates the opportunity to discussthese issues with the Members of this Subcommittee and we wouldbe pleased to explore these issues further.

Mr. Chairman, this concludes my formal statement. I will bepleased to answer any questions that you or other Members maywish to ask.