Tuesday, February 23, 2010

The Austin Pilot Had a Valid Tax Beef About § 1706

Following up on my recent posts (links below) on the substance of the Austin pilot's tax complaint against the IRS:

Congressional Research Service, Independent Contractors: Repeal of Section 1706 of the Tax Reform Act of 1986 for Technical Service Workers: S.1924 (Report 98-481) (May 19, 1998):

In 1978, Congress provided statutory relief by enacting section 530 of the Revenue Act of 1978 (P.L. 95-600). Section 530 did three things: (1) It terminated any retroactive employment tax liability for employers who had treated workers as independent contractors before January 1, 1980, unless there was no reasonable basis for not treating the worker as an employee. (2) It spelled out reasonable bases for classifying a worker as an independent contractor, requiring consistent treatment of the worker and similarly situated workers as independent contractors, and reliance on judicial or administrative precedent, past IRS audit, or longstanding industry practice. (3) It prohibited the IRS from issuing regulations or revenue rulings addressing the status of workers as employees or independent contractors for employment tax purposes. Originally, section 530 was intended to be temporary legislation to retain the status quo while Congress took time to figure out what the correct solution should be. ...

In section 1706 of the Tax Reform Act of 1986 (P.L. 99-514), which originated as a Senate floor amendment, a subsection (d) was added to section 530 of the Revenue Act of 1978. The provision barred technical service placement firms from claiming the protections of the section 530 safe harbors. This meant that placement firms could rely only on the common law as a defense for their classification of the workers, and it meant that the IRS was not prohibited from issuing regulations or rulings relating to the employment status of technical service workers in three-party situations.

Empowered by section 1706, the IRS promptly issued Revenue Ruling 87-41, 1987-1 CB 296. The ruling spelled out the types of arrangements where the IRS would treat a placement firm as the employer of technical service employees. Basically, if the placement firm retained the right to control the worker, either by supervising performance or hours worked or guaranteeing the quality of the work of the worker to the client, then the relationship was an employer-employee relationship. If the placement firm simply acted as a broker with no guarantees about performance of the worker and no supervision of the worker's hours or relationship to the client, then the worker was an independent contractor and the firm was not the worker's employer. Although there was dissatisfaction with the Revenue Ruling on the part of workers and firms who could not arrange for their desired employment classification, the ruling had the advantage of providing clear standards for technical service workers in three-party situations.

New York Times op-ed, Our Low-Tech Tax Code, by Harvey J. Shulman (Tax Lawyer, Washington, D.C.):

Nothing can excuse the murderous intentional plane crash into the IRS office in Austin, Tex., on Thursday. The rambling, profanity-filled suicide note that the pilot, Andrew Joseph Stack III, posted on the Web is an indication of his unbalanced state and the senselessness of the act.

In the days since the crash, people pondering Mr. Stack’s unforgivable act have been surprised to find a reference in his note to an obscure federal tax law, Section 1706 of the 1986 tax act. Mr. Stack, a technology worker, claimed that the provision essentially declared him a “criminal and non-citizen slave” and ruined his career.

The story of Section 1706 is a curious one. Most American workers perform jobs as either employees or “self-employed” workers of a company — that is, independent contractors. Yet the common-law test used by the IRS to determine who is an actual employee is vague and unpredictable. The determination is often made years after a worker is hired, during an audit of the company.

If the IRS determines that a self-employed worker should have been an employee, it imposes substantial back taxes, penalties and interest on the hiring company — even if the self-employed worker fully paid his taxes.

That hazy situation led Congress in 1978 to adopt an alternative test — the so-called “safe haven” rule codified under Section 530. Under this rule, if a company has a “reasonable basis” to treat a worker as self-employed, has filed IRS Form 1099 to report its payment to the worker, and has consistently treated similar workers the same way, then the company would not be required to pay more taxes or withhold taxes from the worker’s paychecks.

Basically, the safe-haven rule provided commonsense relief from potentially devastating IRS audits to companies that operated reasonably, consistently and in good faith.

The technology industry used many self-employed workers in the 1980s. While in other industries, workers were forced to become self-employed by companies looking to avoid giving out benefits, in technology it was the professionals themselves who demanded contractor status. They were willing to forgo employer-provided benefits to maintain their independence and expand their businesses.

Many of them were not hired by the technology company they did work for, but by staffing firms that placed them at corporations as subcontractors. In passing Section 1706 in 1986, Congress singled out the programmers, engineers, analysts and many other technical workers by mandating that staffing firms no longer be protected by Section 530’s safe haven. Soon enough, the IRS began auditing staffing firms around the country, often subjecting their customers to questioning as well.

This caused an upheaval in the technology industry. Hundreds of high-tech firms, from Wall Street to Silicon Valley, stopped using self-employed workers. Tens of thousands of technology professionals who had formed their own one-person consulting businesses could no longer find work — unless they agreed to abandon their enterprises and become payroll employees. ...

The rationale for passing Section 1706 was that it would recoup tax revenue that the government was losing from self-employed technology workers who were allegedly cheating when they filed. It was also claimed that few of these workers would qualify as self-employed under the common-law test, so the safe haven should be eliminated for them.

Over the past 20 years, there have been several studies dismissing the factual and legal grounds asserted for the rule, and more than 60 senators — from Daniel Patrick Moynihan to Jesse Helms to Ted Kennedy — have sought its repeal.

A Treasury Department study in 1991 also thoroughly undermined the justifications for the law. It found that tax compliance for technology professionals was actually among the highest of all self-employed workers and that Section 1706 probably raised no additional tax revenue and perhaps even resulted in losses, because self-employed workers did not enjoy as many tax-free benefits as employees.

Section 1706 is an example of how Congress enacted a discriminatory law that hurt thousands of technology consultants, their staffing firms and customers. And despite strong bipartisan efforts and unbiased studies supporting that law’s repeal, it remains on the books.

Reform has gotten lost among the “bigger issues” like capital gains and estate tax reform, and the contractors and firms involved are not big-name, big-dollar political contributors. But they are the information workers who maintain America’s innovation advantage in the global economy. Is continuing to limit their opportunities really something Congress should tolerate?

(Hat Tip: Calvin Johnson.) See also The Tax Lawyer's Blog, Tax Bomber Stack Wanted Independent Contractor Status to Avoid Paying Taxes. Prior TaxProf Blog posts:
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