Face To Face With The Irs

What's Washington doing to make life easier--or harder--for small business?

Small-business owners say the government agency that most affects their lives is the Internal Revenue Service. With tax-filing season under way, BUSINESS WEEK asked Internal Revenue Commissioner Margaret M. Richardson and National Federation of Independent Business President S. Jackson Faris to address independent contractors, auditing, and IRS efforts to make paying taxes easier for small businesses. Washington Correspondent Mike McNamee led the discussion.

Q: Commissioner, you've paid a lot of attention to small business--creating the Office of Small Business Affairs and holding town meetings. Why?

Richardson: We have an interest obviously in all our customers--large businesses and individuals and small businesses. For an awful lot of people--individuals--the tax system is simple and straightforward, despite what we hear. And large corporations can afford tax assistance. Unfortunately, many small businesses have to obey the same rules, keep the same records, as large businesses. So small business seems a natural place to focus our attention--to see what we can do to make it easier.

Faris: Small businesses are caught in the middle. People have to understand that a small-business owner is often one person who comes in the morning and fills in for whoever doesn't show up. You know, for every $100 a small business pays in taxes--all taxes, not just the IRS--we spend $386 in compliance.

Richardson: I'll do everything I can to try to make the situation simpler. Most of the issues that were addressed at the White House Conference on Small Business require legislative changes. Deductibility for meals, estate tax reform--those are issues that we're not really in a position to do anything about.

Q: For many small businesses, one of the most vexing issues is how to classify workers. You've paid someone to work as an independent contractor, but the IRS says he or she is really an employee, so you owe payroll tax and have to withhold income taxes. Congress hasn't written a clear definition of independent contractors. What's the problem here?

Faris: Business owners say, "Well, I had one IRS agent tell me it was O.K. to treat my workers as independent contractors, and then two years later another agent says it's not."

Richardson: The rules are fairly well set out. What has led to a lot of concern are the ambiguities of the 20 factors, the common-law factors [that the IRS uses to classify workers]. From an administrator's standpoint, it would be better to have an objective standard, bright lines. The same is true for the business side--when you know something with certainty, it makes it a lot easier.

Faris: Right now, they enforce the rules, but everybody's fuzzy on the rule.

Richardson: One of the concerns we've heard is that maybe our training materials were biased against agents ever classifying anybody as a contractor, not recognizing there are legitimate instances when people aren't employees. I undertook to review the materials. We will be issuing revisions [in early March] and we will present them to you, Jack, for your comment. Another program that we'll be implementing right away will let you resolve classification issues on appeal very quickly.

Where we are caught is in some of the areas where the nature of the work and the way the people are used has changed over the years.

Faris: The fastest growing segment of the small business community is female, and the fastest growing part of that is operating out of their home. Fax machines, modems are changing the work environment. So what happens is you've got a person at home with her own computer contracting to do correspondence work--what we used to call a secretary.

Richardson: One of the things we did, Jack, was put out this publication for people like that, called Starting a Business & Keeping Records. This is really geared for new business owners and particularly those who might own a very small business.

Q: Representative [Jon] Christensen [R-Neb.] has a bill to simplify worker classification. Does that work?

Richardson: The biggest concern we have about that bill is that we'd like to have very clear, bright-line standards so that there are no ambiguities. And that bill does not address that concern.

We need to have rules that don't involve wholesale reclassification. Not that everybody has to be an employee, but that people are treated alike. I think one thing we need to do is sit down and talk with NFIB and Treasury to really see what we can do administratively.

Faris: Well, I think everyone who has a dog in this fight could fit around this table right here.

Q: Besides taxes, many other rules are tied to employee status--benefits, age discrimination, overtime. When the IRS classifies workers, is it enforcing those?

Richardson: No, we are really charged with administering the tax law, and that's it. My concern is that people are reporting their income accurately. What we know is, where you have withholding, as you do with employees, you have much higher levels of compliance. It is virtually 99%. Where you have information reporting, we have high levels of compliance. It is where you have neither that compliance drops dramatically.

Faris: There's an assumption that if you're an independent contractor, you haven't filed your taxes.

Richardson: Well, take the construction industry. We have complaints from people who pay their workers as employees and pay the benefits that come with that. And they are at a competitive disadvantage to people who underbid them, because they aren't paying the benefits that go with employee status.

Q: The General Accounting Office suggests requiring businesses to withhold taxes on contractors' pay.

Faris: Here's another `let the entrepreneur deal with it' idea.

Q: Mr. Faris, does the IRS have an attitude problem?

Faris: This is the biggest complaint we get. When the agent comes in, the attitude is, `You're guilty and the only question is, just how guilty and how much are we going to fine you.' Our people end up writing checks for $500, $1,000, $2,000 when they don't feel like they owe it. And you can't win because you're guilty until proven innocent.

Richardson: I think that we've gone a long way in terms of our own agents and fairness. I think that sometimes this is overstated, that people are presumed guilty until proved otherwise. It's certainly not company policy.

Faris: That is something the Commissioner has talked about. But it is extremely difficult for her, from her office on Constitution Avenue, to get the agent in Hendersonville, Tennessee, to go into a small business with the attitude of, `You're an honest person.'

How do you measure the success of an agent? Do you measure how much he helped and corrected a taxpayer, or how much he collected in fines?

Richardson: That's a major challenge. The reward should be for getting it right and helping taxpayers, as opposed to fines and penalty.

Q: We hear complaints about "lifestyle audits"--the IRS calls them "economic reality audits."

Faris: I got a phone call from a friend. He said, `Well, Jack, I'm going to fax you a copy of the questions the IRS asks. "How often do you take your wife to dinner? Where and what is the average price? How often do you take the car to a car wash? Where and how much does it cost? Where do you buy clothes? Where do you go on vacation?"' That's just going too far.

Richardson: We have one audit technique, we call it looking at economic reality. It's good audit standards, whether you are a private auditor or in our business. We want to make sure that we have an accurate reflection of the taxpayer's income. What our agents have been instructed to do is look at the return and look at the facts and circumstances. If it appears that there may be underreported income, ask some questions beyond what is on the face of the return. That is where the economic reality technique got its name.

Faris: It's the level of intrusiveness. What we think is that you're spending $100 to collect $10.

Richardson: I think we are trying to make sure that people use proper audit techniques. I can't tell you that somebody doesn't do it wrong. But we're trying to make sure that people tailor their questions to the situation.

We're also trying to get our people specialized training, so they can audit a gas station one day, a bank the next, and an oil company the next. You audit them differently. So we're working hard to understand various market segments.

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