Jennings, Strouss & Salmon, PLC: Publications

LLC Payment Classifications: Member Distributions vs. Compensation: Beware of Unintended Consequences

Those who do business through a closely-held limited liability company (LLC) often receive their share of business profits in the form of member distributions instead of guaranteed payments (compensation). [1] They may be advised, for example, that there are tax advantages to doing so.[2] What they may not realize, however, is that paying LLC members in the form of distributions instead of compensation may impair the limited liability protection otherwise afforded to LLC members and expose them to creditors’ claims, at least where the LLC engages in activities with a high risk of liability and/or becomes insolvent.

While there may be reasons for choosing to give members distributions instead of compensation, there are potential risks to the LLC’s members from a creditor standpoint. A.R.S. § 29-706 provides that a limited liability company “shall not make a distribution to its members to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company would exceed the fair value of the assets of the limited liability company….” Liability is imposed on each member who receives such distributions for the amount of such distributions.[3]

Take, for example, a medical practice that conducts its business as a professional limited liability company[4] and for which there has been a large malpractice claim. If the medical practice thereafter continues to pay its doctor members in the form of distributions instead of compensation, each member potentially can be personally liable for distributions received at any point after the company’s liabilities exceed its assets.

Other legal doctrines[5] can lead to the same result; and similar rules can apply in the context of corporations[6] and limited partnerships.[7] Thus, while there may be good reasons for classifying payments to members as distributions instead of compensation, beware the unintended consequences of doing so: it may adversely affect the limited liability protection otherwise afforded an LLC’s members.

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[1] Pursuant to IRS regulations, compensatory payments to LLC members are to be treated as guaranteed payments (similar to payments to an independent contractor) rather than salary.

[2] Whether or not there are actual tax advantages is beyond the scope of this discussion. For example, LLC members may still be liable for self-employment taxes at the personal level, whether they receive distributions or guaranteed payments or neither.

[3] Subsection D provides: "If a member receives a distribution with respect to his interest in a limited liability company in violation of this chapter or an operating agreement, he is liable to the limited liability company for a period of six years thereafter for the amount of the wrongful distribution."

[4] A.R.S. § 29-706 is made applicable to professional limited liability companies through A.R.S. § 29-843

[5] In Hullet v. Cousin, 32 P.3d 44 (Div. 1 2001), for example, the Arizona Court of Appeals applied fraudulent transfer law. There, after a limited partnership sold its only asset (an apartment complex), it distributed the net proceeds to its partners. A creditor later sued the limited partnership for claims related to the apartment complex. The creditor obtained a default judgment against the partnership, but the judgment was uncollectible because there were no assets remaining in the partnership. The creditor then sued the limited partners, arguing that the limited partnership's transfer of assets to them was voidable as fraudulent pursuant to Arizona Revised Statutes "A.R.S." sections 44-1004 and 44-1005. The Arizona Court of Appeals directed that judgment be entered in favor of the creditor on his fraudulent transfer claim against the limited partners. In so holding, the Court (citing to the functional equivalent of A.R.S. §29-706 as respects limited partnerships) recognized that a “limited partner is not entitled to distribution from a limited partnership to the extent that it would cause the liabilities of the limited partnership, other than those to partners on account of their partnership interests, to exceed the fair value of the limited partnership's assets. A.R.S. § 29-337 (1998).”

[6] A.R.S. §10-640(C).

[7] A.R.S. § 29-337.

Arizona's Minimum Wage Increases January 1, 2012

On January 1, 2012, Arizona’s minimum wage will increase by 30 cents to $7.65 per hour. Arizona’s minimum wage is higher than the federal minimum wage, which is currently $7.25 per hour.

In 2006, Arizona voters enacted a voter initiative, known originally as the “Raise the Minimum Wage for Working Arizonans Act” (the “Arizona Minimum Wage Act”). The Arizona Minimum Wage Act, which became effective January 1, 2007, established an Arizona minimum wage and also provided that the minimum wage was subject to an annual increase based on the increase in the cost of living. The cost of living is measured by the federal Consumer Price Index for All Urban Consumers, U.S. City Average, for all items during the 12 months ending each August 31. Pursuant to the authority granted by this law, the Industrial Commission reviewed the cost of living information and determined that Arizona’s minimum wage would be increased for calendar year 2011. In October 2011, the Industrial Commission of Arizona determined that the state’s hourly wage should increase based on a 3.8 percent increase in the federal Consumer Price Index this year.

Under federal law, a state may require a minimum wage that exceeds the federal wage. If there is a difference between the laws, the employer must follow the requirement that is the most beneficial to the employee. Thus, an Arizona employer that is subject to both the federal and state laws must pay the Arizona minimum wage rate. Further, Arizona employers must make sure they are in compliance with both the federal and the state laws. Our labor and employment attorneys can answer questions regarding the laws and regulations, and advise you on compliance issues. As you review your individual compliance, some further information regarding the Arizona Minimum Wage Act and regulations may be helpful.

Exceptions

The Arizona Minimum Wage Act provides only a few exceptions from its coverage. One exception is for small businesses that generate less than $500,000 in gross annual revenue, if that small business is not covered by the federal Fair Labor Standards Act (FLSA). From a practical standpoint, most employers are subject to the FLSA. Another exception applies to the state of Arizona and the U.S. government. Additionally, the Arizona Minimum Wage Act does not apply to any person who is employed by a parent or a sibling, or who is employed performing babysitting services in the employer’s home on a casual basis.

EEOC Releases Opinion Letter Regarding Pre-Employment Inquiries into Arrests & Convictions

The EEOC has released a letter outlining its general position with respect to employers using arrest and conviction records in pre-employment screening. Generally, the EEOC admonishes employers to distinguish between arrest and conviction records warning that arrest records are susceptible to errors and do not reflect whether the person was convicted of a crime. It also warned employers to tailor the use of conviction records to the position to be filled. Finally, if the use of conviction records results in a disparate impact on minorities, the employer should not use them. For more information on pre-employment inquiries regarding arrests and convictions from the EEOC, click here.

Each case a business or individual may face is unique and may require legal advice. If you would like additional information regarding the content of this article, please contactthe author, Keith Overholt, or the Chairof our Labor and Employment Department, John Egbert.

FASB Has Reissued its Accounting Standards Update

We previously advised our friends and clients about the Financial Accounting Standards Board (FASB) decision to withdraw the requirement that an employer contributing to a multi-employer pension plan must include the employer's share of the plan's unfunded liability on its financial statement. FASB has now reissued its Accounting Standards Update (No. 2011-09). Although employers will not have to include a calculation of their share of a plan's unfunded liability, they will have to include funding information about multi-employer pension plans to which they are obligated to contribute. Employers should work with their counsel to determine how to obtain that information from the plans. The new rule applies to all nongovernmental employers contributing to multi-employer pension plans. It is effective for fiscal years ending after December 15, 2011 for publicly held employers, and for fiscal years ending after December 15, 2012 for non-publicly held employers. The Accounting Standards Update can be found here.

Each case a business or individual may face is unique and may require legal advice. If you would like additional information regarding the content of this article, please contactthe author, Keith Overholt, or the Chair of our Labor and Employment Department, John Egbert.

NRLB Requires Employers to Post Notice Regarding Employee's Rights to Join a Union

Effective November 14, 2011 virtually all employers which are not in the agricultural, railway or airline business will be required to post a notice advising their employees of their right to be represented by a labor union. If 20% or more of the employees speak a foreign language, the notice must be in the foreign language. It will be an unfair labor practice to fail to post the notice. Although the National Association of Manufacturers has filed a lawsuit in federal court in the District of Columbia to contest the NLRB's authority to require the notice, the regulation currently remains in effect. The notice can be obtained here and can be posted as one 11x7 notice or two 8x11 pages.

Each case a business or individual may face is unique and may require legal advice. If you would like additional information regarding the content of this article, please contactthe author, Keith Overholt, or the Chair of our Labor and Employment Department, John Egbert.

Rev. Rul. 87-41, 1987-1 CB 296 -- IRC Sec. 3121

Rev. Rul. 87-41, 1987-1 CB 296 -- IRC Sec. 3121

Sec. 3121 -- Definitions

26 CFR 31.3121(d)-1: Who are employees.(Also Sections 3306, 3401;

31.3306(i)-1, 31.3401(c)-1.)

HEADNOTE:

Employment status under section 530(d) of the Revenue Act of 1978.

Guidelines are set forth for determining the employment status of a taxpayer

(technical service specialist) affected by section 530(d) of the Revenue Act

of 1978, as added by section 1706 of the Tax Reform Act of 1986. The

specialists are to be classified as employees under generally applicable

common law standards.

Text:

Rev. Rul. 87-41, 1987-1 CB 296 -- IRC Sec. 3121

ISSUE

In the situations described below, are the individuals employees under

the common law rules for purposes of the Federal Insurance Contributions

Act (FICA), the Federal Unemployment Tax Act (FUTA), and the Collection

of Income Tax at Source on Wages (chapters 21, 23, and 24 respectively,

subtitle C, Internal Revenue Code)? These situations illustrate the

application of section 530(d) of the Revenue Act of 1978, 1978-3 (Vol.

1) C.B. 119 (the 1978 Act), which was added by section 1706(a) of the

Tax Reform Act of 1986, 1986- 3 (Vol. 1) C.B. 698 (the 1986 Act)

(generally effective for services performed and remuneration paid after

December 31, 1986).

FACTS

In each factual situation, an individual worker (Individual), pursuant

to an arrangement between one person (Firm) and <Page 297> another

person (Client), provides services for the Client as an engineer,

designer, drafter, computer programmer, systems analyst, or other

similarly skilled worker engaged in a similar line of work.

Situation 1

The Firm is engaged in the business of providing temporary technical

services to its clients. The Firm maintains a roster of workers who are

available to provide technical services to prospective clients. The

Firm does not train the workers but determines the services that the

workers are qualified to perform based on information submitted by the

workers.

The Firm has entered into a contract with the Client. The contract

states that the Firm is to provide the Client with workers to perform

computer programming services meeting specified qualifications for a

particular project. The Individual, a computer programmer, enters into

a contract with the Firm to perform services as a computer programmer

for the Client's project, which is expected to last less than one year.

The Individual is one of several programmers provided by the Firm to the

Client. The Individual has not been an employee of or performed

services for the Client (or any predecessor or affiliated corporation of

the Client) at any time preceding the time at which the Individual

begins performing services for the Client. Also, the Individual has not

been an employee of or performed services for or on behalf of the Firm

at any time preceding the time at which the Individual begins performing

services for the Client. The Individual's contract with the Firm states

that the Individual is an independent contractor with respect to

services performed on behalf of the Firm for the Client.

The Individual and the other programmers perform the services under the

Firm's contract with the Client. During the time the Individual is

performing services for the Client, even though the Individual retains

the right to perform services for other persons, substantially all of

the Individual's working time is devoted to performing services for the

Client. A significant portion of the services are performed on the

Client's premises. The Individual reports to the Firm by accounting for

time worked and describing the progress of the work. The Firm pays the

Individual and regularly charges the Client for the services performed

by the Individual. The Firm generally does not pay individuals who

perform services for the Client unless the Firm provided such

individuals to the Client.

The work of the Individual and other programmers is regularly reviewed

by the Firm. The review is based primarily on reports by the Client

about the performance of these workers. Under the contract between the

Individual and the Firm, the Firm may terminate its relationship with

the Individual if the review shows that he or she is failing to perform

the services contracted for by the Client. Also, the Firm will replace

the Individual with another worker if the Individual's services are

unacceptable to the Client. In such a case, however, the Individual

will nevertheless receive his or her hourly pay for the work completed.

Finally, under the contract between the Individual and the Firm, the

Individual is prohibited from performing services directly for the

Client and, under the contract between the Firm and the Client, the

Client is prohibited from receiving services from the Individual for a

period of three months following the termination of services by the

Individual for the Client on behalf of the Firm.

Situation 2

The Firm is a technical services firm that supplies clients with

technical personnel. The Client requires the services of a systems

analyst to complete a project and contacts the Firm to obtain such an

analyst. The Firm maintains a roster of analysts and refers such an

analyst, the Individual, to the Client. The Individual is not

restricted by the Client or the Firm from providing services to the

general public while performing services for the Client and in fact does

perform substantial services for other persons during the period the

Individual is working for the Client. Neither the Firm nor the Client

has priority on the services of the Individual. The Individual does not

report, directly or indirectly, to the Firm after the beginning of the

assignment to the Client concerning (1) hours worked by the Individual,

(2) progress on the job, or (3) expenses incurred by the Individual in

performing services for the Client. No reports (including reports of

time worked or progress on the job) made by the Individual to the Client

are provided by the Client to the Firm.

If the Individual ceases providing services for the Client prior to

completion of the project or if the Individual's work product is

otherwise unsatisfactory, the Client may seek damages from the

Individual. However, in such circumstances, the Client may not seek

damages from the Firm, and the Firm is not required to replace the

Individual. The Firm may not terminate the services of the Individual

while he or she is performing services for the Client and may not

otherwise affect the relationship between the Client and the Individual.

Neither the Individual nor the Client is prohibited for any period after

termination of the Individual's services on this job from contracting

directly with the other. For referring the Individual to the Client,

the Firm receives a flat fee that is fixed prior to the Individual's

commencement of services for the Client and is unrelated to the number

of hours and quality of work performed by the Individual. The

Individual is not paid by the Firm either directly or indirectly. No

payment made by the Client to the Individual reduces the amount of the

fee that the Client is otherwise required to pay the Firm. The

Individual is performing services that can be accomplished without the

Individual's receiving direction or control as to hours, place of work,

sequence, or details of work.

Situation 3

The Firm, a company engaged in furnishing client firms with technical

personnel, is contacted by the Client, who is in need of the services of

a drafter for a particular project, which is expected to last less than

one year. The Firm recruits the Individual to perform the drafting

services for the Client. The Individual performs substantially all of

the services for the Client at the office of the Client, using materials

and equipment of the Client. The services are performed under the

supervision of employees of the Client. The Individual reports to the

Client on a regular basis. The Individual is paid by the Firm based on

the number of hours the Individual has worked for the Client, as

reported to the Firm by the Client or as reported by the Individual and

confirmed by the Client. The Firm has no obligation to pay the

Individual if the Firm does not receive payment for the Individual's

services from the Client. For recruiting the Individual for the Client,

the Firm receives a flat fee that is fixed prior to the <Page 298>

Individual's commencement of services for the Client and is unrelated to

the number of hours and quality of work performed by the Individual.

However, the Firm does receive a reasonable fee for performing the

payroll function. The Firm may not direct the work of the Individual

and has no responsibility for the work performed by the Individual. The

Firm may not terminate the services of the Individual. The Client may

terminate the services of the Individual without liability to either the

Individual or the Firm. The Individual is permitted to work for another

firm while performing services for the Client, but does in fact work for

the Client on a substantially full-time basis.

LAW AND ANALYSIS

This ruling provides guidance concerning the factors that are used to

determine whether an employment relationship exists between the

Individual and the Firm for federal employment tax purposes and applies

those factors to the given factual situations to determine whether the

Individual is an employee of the Firm for such purposes. The ruling

does not reach any conclusions concerning whether an employment

relationship for federal employment tax purposes exists between the

Individual and the Client in any of the factual situations.

Analysis of the preceding three fact situations requires an examination

of the common law rules for determining whether the Individual is an

employee with respect to either the Firm or the Client, a determination

of whether the Firm or the Client qualifies for employment tax relief

under section 530(a) of the 1978 Act, and a determination of whether any

such relief is denied the Firm under section 530(d) of the 1978 Act

(added by section 1706 of the 1986 Act).

An individual is an employee for federal employment tax purposes if the

individual has the status of an employee under the usual common law

rules applicable in determining the employer-employee relationship.

Guides for determining that status are found in the following three

substantially similar sections of the Employment Tax Regulations:

sections 31.3121(d)-1(c); 31.3306(i)- 1; and 31.3401(c)-1.

These sections provide that generally the relationship of employer and

employee exists when the person or persons for whom the services are

performed have 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 as to how it shall

be done. In this connection, it is not necessary that the employer

actually direct or control the manner in which the services are

performed; it is sufficient if the employer has the right to do so.

Conversely, these sections provide, in part, that individuals (such as

physicians, lawyers, dentists, contractors, and subcontractors) who

follow an independent trade, business, or profession, in which they

offer their services to the public, generally are not employees.

Finally, if the relationship of employer and employee exists, the

designation or description of the relationship by the parties as

anything other than that of employer and employee is immaterial. Thus,

if such a relationship exists, it is of no consequence that the employee

is designated as a partner, coadventurer, agent, independent contractor,

or the like.

As an aid to determining whether an individual is an employee under the

common law rules, twenty factors or elements have been identified as

indicating whether sufficient control is present to establish an

employer- employee relationship. The twenty factors have been developed

based on an examination of cases and rulings considering whether an

individual is an employee. The degree of importance of each factor

varies depending on the occupation and the factual context in which the

services are performed. The twenty factors are designed only as guides

for determining whether an individual is an employee; special scrutiny

is required in applying the twenty factors to assure that formalistic

aspects of an arrangement designed to achieve a particular status do not

obscure the substance of the arrangement (that is, whether the person or

persons for whom the services are performed exercise sufficient control

over the individual for the individual to be classified as an employee).

The twenty factors are described below:

1. Instructions. A worker who is required to comply with other persons'

instructions about when, where, and how he or she is to work is

ordinarily an employee. This control factor is present if the person or

persons for whom the services are performed have the right to require

compliance with instructions. See, for example, Rev. Rul. 68-598,

1968-2 C.B. 464, and Rev. Rul. 66- 381, 1966-2 C.B. 449.

2. Training. Training a worker by requiring an experienced employee to

work with the worker, by corresponding with the worker, by requiring the

worker to attend meetings, or by using other methods, indicates that the

person or persons for whom the services are performed want the services

performed in a particular method or manner. See Rev. Rul. 70-630,

1970-2 C.B. 229.

3. Integration. Integration of the worker's services into the business

operations generally shows that the worker is subject to direction and

control. When the success or continuation of a business depends to an

appreciable degree upon the performance of certain services, the workers

who perform those services must necessarily be subject to a certain

amount of control by the owner of the business. See United States v.

Silk, 331 U.S. 704 (1947), 1947-2 C.B. 167.

4. Services Rendered Personally. If the services must be rendered

personally, presumably the person or persons for whom the services are

performed are interested in the methods used to accomplish the work as

well as in the results. See Rev. Rul. 55-695, 1955-2 C.B. 410.

5. Hiring, Supervising, and Paying Assistants. If the person or persons

for whom the services are performed hire, supervise, and pay assistants,

that factor generally shows control over the workers on the job.

However, if one worker hires, supervises, and pays the other assistants

pursuant to a contract under which the worker agrees to provide

materials and labor and under which the worker is responsible only for

the attainment of a result, this factor indicates an independent

contractor status. Compare Rev. Rul. 63-115, 1963-1 C.B. 178, with Rev.

Rul. 55-593, 1955-2 C.B. 610.

6. Continuing Relationship. A continuing relationship between the worker

and the person or persons for whom the services are performed indicates

that an employer-employee relationship exists. A continuing

relationship may exist where work is performed at frequently recurring

although irregular intervals. See United States v. Silk.

7. Set Hours of Work. The establishment of set hours of work by the

person or persons for whom the services are performed is a factor

indicating control. See Rev. Rul. 73-591, 1973-2 C.B. 337.<Page 299>

8. Full Time Required. If the worker must devote substantially full

time to the business of the person or persons for whom the services are

performed, such person or persons have control over the amount of time

the worker spends working and impliedly restrict the worker from doing

other gainful work. An independent contractor, on the other hand, is

free to work when and for whom he or she chooses. See Rev. Rul. 56-

694, 1956-2 C.B. 694.

9. Doing Work on Employer's Premises. If the work is performed on the

premises of the person or persons for whom the services are performed,

that factor suggests control over the worker, especially if the work

could be done elsewhere. Rev. Rul. 56-660, 1956-2 C.B. 693. Work done

off the premises of the person or persons receiving the services, such

as at the office of the worker, indicates some freedom from control.

However, this fact by itself does not mean that the worker is not an

employee. The importance of this factor depends on the nature of the

service involved and the extent to which an employer generally would

require that employees perform such services on the employer's premises.

Control over the place of work is indicated when the person or persons

for whom the services are performed have the right to compel the worker

to travel a designated route, to canvass a territory within a certain

time, or to work at specific places as required. See Rev. Rul. 56-694.

10. Order or Sequence Set. If a worker must perform services in the

order or sequence set by the person or persons for whom the services are

performed, that factor shows that the worker is not free to follow the

worker's own pattern of work but must follow the established routines

and schedules of the person or persons for whom the services are

performed. Often, because of the nature of an occupation, the person or

persons for whom the services are performed do not set the order of the

services or set the order infrequently. It is sufficient to show

control, however, if such person or persons retain the right to do so.

See Rev. Rul. 56-694.

11. Oral or Written Reports. A requirement that the worker submit

regular or written reports to the person or persons for whom the

services are performed indicates a degree of control. See Rev. Rul.

70-309, 1970-1 C.B. 199, and Rev. Rul. 68- 248, 1968-1 C.B. 431.

12. Payment by Hour, Week, Month. Payment by the hour, week, or month

generally points to an employer-employee relationship, provided that

this method of payment is not just a convenient way of paying a lump sum

agreed upon as the cost of a job. Payment made by the job or on a

straight commission generally indicates that the worker is an

independent contractor. See Rev. Rul. 74-389, 1974-2 C.B. 330.

13. Payment of Business and/or Traveling Expenses. If the person or

persons for whom the services are performed ordinarily pay the worker's

business and/or traveling expenses, the worker is ordinarily an

employee. An employer, to be able to control expenses, generally

retains the right to regulate and direct the worker's business

activities. See Rev. Rul. 55-144, 1955-1 C.B. 483.

14. Furnishing of Tools and Materials. The fact that the person or

persons for whom the services are performed furnish significant tools,

materials, and other equipment tends to show the existence of an

employer- employee relationship. See Rev. Rul. 71-524, 1971-2 C.B. 346.

15. Significant Investment. If the worker invests in facilities that

are used by the worker in performing services and are not typically

maintained by employees (such as the maintenance of an office rented at

fair value from an unrelated party), that factor tends to indicate that

the worker is an independent contractor. On the other hand, lack of

investment in facilities indicates dependence on the person or persons

for whom the services are performed for such facilities and,

accordingly, the existence of an employer-employee relationship. See

Rev. Rul. 71-524. Special scrutiny is required with respect to certain

types of facilities, such as home offices.

16. Realization of Profit or Loss. A worker who can realize a profit or

suffer a loss as a result of the worker's services (in addition to the

profit or loss ordinarily realized by employees) is generally an

independent contractor, but the worker who cannot is an employee. See

Rev. Rul. 70-309. For example, if the worker is subject to a real risk

of economic loss due to significant investments or a bona fide liability

for expenses, such as salary payments to unrelated employees, that

factor indicates that the worker is an independent contractor. The risk

that a worker will not receive payment for his or her services, however,

is common to both independent contractors and employees and thus does

not constitute a sufficient economic risk to support treatment as an

independent contractor.

17. Working for More Than One Firm at a Time. If a worker performs more

than de minimis services for a multiple of unrelated persons or firms at

the same time, that factor generally indicates that the worker is an

independent contractor. See Rev. Rul. 70-572, 1970-2 C.B. 221.

However, a worker who performs services for more than one person may be

an employee of each of the persons, especially where such persons are

part of the same service arrangement.

18. Making Service Available to General Public. The fact that a worker

makes his or her services available to the general public on a regular

and consistent basis indicates an independent contractor relationship.

See Rev. Rul. 56-660.

19. Right to Discharge. The right to discharge a worker is a factor

indicating that the worker is an employee and the person possessing the

right is an employer. An employer exercises control through the threat

of dismissal, which causes the worker to obey the employer's

instructions. An independent contractor, on the other hand, cannot be

fired so long as the independent contractor produces a result that meets

the contract specifications. Rev. Rul. 75-41, 1975-1 C.B. 323.

20. Right to Terminate. If the worker has the right to end his or her

relationship with the person for whom the services are performed at any

time he or she wishes without incurring liability, that factor indicates

an employer-employee relationship. See Rev. Rul. 70-309.

Rev. Rul. 75-41 considers the employment tax status of individuals

performing services for a physician's professional service corporation.

The corporation is in the business of providing a variety of services to

professional people and firms (subscribers), including the services of

secretaries, nurses, dental hygienists, and other similarly trained

personnel. The individuals who are to perform the services are

recruited by the corporation, paid by the corporation, assigned to jobs,

and provided with employee benefits by the corporation. Individuals who

enter into contracts with the corporation agree they will not contract

directly with any subscriber to which they are assigned for at least

three months after cessation of their contracts with the corporation.

The corporation assigns the individual to the subscriber to work on the

subscriber's premises with the subscriber's equipment. Subscribers have

the right to require that an individual furnished by the corporation

cease <Page 300> providing services to them, and they have the further

right to have such individual replaced by the corporation within a

reasonable period of time, but the subscribers have no right to affect

the contract between the individual and the corporation. The

corporation retains the right to discharge the individuals at any time.

Rev. Rul. 75-41 concludes that the individuals are employees of the

corporation for federal employment tax purposes.

Rev. Rul. 70-309 considers the employment tax status of certain

individuals who perform services as oil well pumpers for a corporation

under contracts that characterize such individuals as independent

contractors. Even though the pumpers perform their services away from

the headquarters of the corporation and are not given day-to-day

directions and instructions, the ruling concludes that the pumpers are

employees of the corporation because the pumpers perform their services

pursuant to an arrangement that gives the corporation the right to

exercise whatever control is necessary to assure proper performance of

the services; the pumpers' services are both necessary and incident to

the business conducted by the corporation; and the pumpers are not

engaged in an independent enterprise in which they assume the usual

business risks, but rather work in the course of the corporation's trade

or business. See also Rev. Rul. 70-630, 1970-2 C.B. 229, which

considers the employment tax status of salesclerks furnished by an

employee service company to a retail store to perform temporary services

for the store.

Section 530(a) of the 1978 Act, as amended by section 269(c) of the Tax

Equity and Fiscal Responsibility Act of 1982, 1982-2 C.B. 462, 536,

provides, for purposes of the employment taxes under subtitle C of the

Code, that if a taxpayer did not treat an individual as an employee for

any period, then the individual shall be deemed not to be an employee,

unless the taxpayer had no reasonable basis for not treating the

individual as an employee. For any period after December 31, 1978, this

relief applies only if both of the following consistency rules are

satisfied: (1) all federal tax returns (including information returns)

required to be filed by the taxpayer with respect to the individual for

the period are filed on a basis consistent with the taxpayer's treatment

of the individual as not being an employee ("reporting consistency

rule"), and (2) the taxpayer (and any predecessor) has not treated any

individual holding a substantially similar position as an employee for

purposes of the employment taxes for periods beginning after December

31, 1977 ("substantive consistency rule").

The determination of whether any individual who is treated as an

employee holds a position substantially similar to the position held by

an individual whom the taxpayer would otherwise be permitted to treat as

other than an employee for employment tax purposes under section 530(a)

of the 1978 Act requires an examination of all the facts and

circumstances, including particularly the activities and functions

performed by the individuals. Differences in the positions held by the

respective individuals that result from the taxpayer's treatment of one

individual as an employee and the other individual as other than an

employee (for example, that the former individual is a participant in

the taxpayer's qualified pension plan or health plan and the latter

individual is not a participant in either) are to be disregarded in

determining whether the individuals hold substantially similar

positions.

Section 1706(a) of the 1986 Act added to section 530 of the 1978 Act a

new subsection (d), which provides an exception with respect to the

treatment of certain workers. Section 530(d) provides that section 530

shall not apply in the case of an individual who, pursuant to an

arrangement between the taxpayer and another person, provides services

for such other person as an engineer, designer, drafter, computer

programmer, systems analyst, or other similarly skilled worker engaged

in a similar line of work. Section 530(d) of the 1978 Act does not

affect the determination of whether such workers are employees under the

common law rules. Rather, it merely eliminates the employment tax

relief under section 530(a) of the 1978 Act that would otherwise be

available to a taxpayer with respect to those workers who are determined

to be employees of the taxpayer under the usual common law rules.

Section 530(d) applies to remuneration paid and services rendered after

December 31, 1986.

The Conference Report on the 1986 Act discusses the effect of section

530(d) as follows:

The Senate amendment applies whether the services of [technical service

workers] are provided by the firm to only one client during the year or

to more than one client, and whether or not such individuals have been

designated or treated by the technical services firm as independent

contractors, sole proprietors, partners, or employees of a personal

service corporation controlled by such individual. The effect of the

provision cannot be avoided by claims that such technical service

personnel are employees of personal service corporations controlled by

such personnel. For example, an engineer retained by a technical

services firm to provide services to a manufacturer cannot avoid the

effect of this provision by organizing a corporation that he or she

controls and then claiming to provide services as an employee of that

corporation.

. . . [T]he provision does not apply with respect to individuals who

are classified, under the generally applicable common law standards, as

employees of a business that is a client of the technical services firm.

2 H.R. Rep. No. 99-841 (Conf. Rep.), 99th Cong., 2d Sess. II-834 to 835

(1986).

Under the facts of Situation 1, the legal relationship is between the

Firm and the Individual, and the Firm retains the right of control to

insure that the services are performed in a satisfactory fashion. The

fact that the Client may also exercise some degree of control over the

Individual does not indicate that the individual is not an employee.

Therefore, in Situation 1, the Individual is an employee of the Firm

under the common law rules. The facts in Situation 1 involve an

arrangement among the Individual, Firm, and Client, and the services

provided by the Individual are technical services. Accordingly, the Firm

is denied section 530 relief under section 530(d) of the 1978 Act (as

added by section 1706 of the 1986 Act), and no relief is available with

respect to any employment tax liability incurred in Situation 1. The

analysis would not differ if the facts of Situation 1 were changed to

state that the Individual provided the technical services through a

personal service corporation owned by the Individual.

In Situation 2, the Firm does not retain any right to control the

performance of the services by the Individual and, thus, no employment

relationship exists between the Individual and the Firm.

In Situation 3, the Firm does not control the performance of the

services of the Individual, and the Firm has no right to affect the

relationship between the Client and the Individual. Consequently, no

employment relationship exists between the Firm and the Individual.

HOLDINGS

Situation 1. The Individual is an employee of the Firm under the common

law rules. Relief under section 530 of the 1978 Act is not available to

the Firm because of the provisions of section 530(d).

Situation 2. The Individual is not an employee of the Firm under the

common law rules.<Page 301>

Situation 3. The Individual is not an employee of the Firm under the

common law r