
How a Tax Law Helps Insure a Scarcity of Programmers (1998) - Jasber
http://www.nytimes.com/1998/04/27/business/how-a-tax-law-helps-insure-a-scarcity-of-programmers.html?pagewanted=1
======
grellas
I have dealt with this law in depth, from every angle, from its inception in
1986 and have a few observations to make about it:

1\. The technical issue concerns the tax risk to an employer whether someone
functioning as an independent contractor might be reclassified as an employee
via an IRS audit that finds that the person is in fact functioning as an
employee and not as someone who runs his own business. This risk exists for
every business, large or small, that hires contractors. And the rules by which
the outcome is determined are positively byzantine and pretty hostile to
employers (and to contractors). They are set forth in IRS Revenue Ruling 87-41
and are summarized here
([http://www.morebusiness.com/running_your_business/taxtalk/in...](http://www.morebusiness.com/running_your_business/taxtalk/indvsemp.brc)).
In general, they state that if an employer has the right to control the means
and manner by which someone performs his duties, as opposed to being concerned
strictly with the result, then the person is functioning as an employee. They
also set forth a list of 20 factors that auditors are to use to help to decide
the issue, making this legal determination a very detailed facts-and-
circumstances determination that can easily turn one way or the other
depending on how an auditor chooses to apply a range of detailed factors. In
the background, the law also has cases, precedents, administrative decisions
and rulings, etc. that boggle the mind in their complexity concerning how the
"rules" work. Moreover, the penalties associated with having a group of
contractors reclassified as employees can be extreme. The employer must not
only pay employment taxes (Social Security, etc.) for all such persons but
also associated penalties and interest. The kicker in the case of a major
audit covering several years is even worse because, if the employer can no
longer locate the persons involved to get them to sign affidavits attesting
that they in fact paid income tax on the income received, the employer also
gets stuck having to pay the estimated _income_ taxes for each such
reclassified person. In practice, this can amount to a penalty that amounts to
nearly half of the wage base involved in the dispute.

2\. As one might imagine, this is a horrible landscape for companies to try to
traverse without something that eliminates or sharply limits the above risks
when they deal with contractors. And, to what should be nobody's surprise,
such limits have historically existed to enable companies to have some
rational means of dealing with the contractor issue. The limits appear in what
are called "safe harbor" classifications. This means that a company hiring
contractors can _know with reasonable certainty_ that there will be no
reclassification of the contractors as employees as long as the company
complies with the safe harbor rules. These rules in turn vary from industry to
industry but every industry has them. This is how companies hire sales people
as contractors, for example, without incurring major risks of tax liabilities.

3\. The 1986 law referred to in this article repealed the "safe harbor"
provisions for providers of high-tech services. Thus, there was no law passed
that said, "You are barred from hiring tech service providers as contractors."
Companies can hire such contractors as much as they like. The repeal of the
safe harbor for this type of service provider (and for _no other_ ) had the
practical effect of making such service providers unmarketable to companies
that had no interest whatever in taking on major tax risks just to be dealing
with contractors as opposed to employees.

4\. Just a background note on this repeal. Before the 1986 repeal, it was true
that companies throughout Silicon Valley would hire "contractors" who would
literally do, e.g., a 3-year stint working full-time at one desk for one
supervisor on one project. Whatever else these persons were, they were clearly
functioning as employees. They had to report for work at designated times and
in a designated place. They took direct orders from supervisors on when, how,
and where to perform specific duties throughout the course of a project or
series of projects. There was nothing in such relationships remotely
resembling a situation of a company dealing with a person who was in his "own
business." In essence, what the companies were doing was hiring employees,
calling them contractors, and saving the trouble of having to pay them
employee benefits and employment taxes for their services. These were clearly
abuses, and they prevailed at all sorts of Valley companies (Intel, HP, all
the biggies). Thus, by 1986, this was an area ripe for attack. How did this
happen in Congress? Well, 1986 was the great bipartisan coming-together for
the lowering of individual tax rates in exchange for closing a variety of tax
loopholes and tightening of tax requirements. In the midst of this bipartisan
compromise, Congress took note of the abuses happening in Silicon Valley and
repealed the safe-harbor classifications for high-tech service providers as a
means of eliminating what was perceived as an abusive loophole.

5\. While the above explains why the tech industry happened to get singled out
as it did in 1986, it does _not_ eliminate the fact that this safe-harbor
repeal was in fact a highly discriminatory act in that every industry in
American had safe-harbor rules available to it so that it could reasonably
hire contractors while the tech industry was suddenly left without any such
rules at all. Thus, from 1986 forward, tech companies became terrorized at the
thought of hiring contractors under any circumstances (by the way, one of the
last holdouts, Microsoft, continued to use large numbers of contractors and
got slammed for this in major rulings that came out by the early 1990s, if I
recall, though that case involved much more than tax issues).

6\. Almost instantly from 1986 and on, a cottage industry sprang up of
"placement agents" who would, in effect, assume the employee risk by hiring
the tech-service providers directly and, in turn, contracting with companies
to place them there as contractors. This worked for the tech companies
because, from their perspective, they simply signed a contractor agreement
with the placement firm and paid for the work as contract work. The placement
firm, for its part, would then hire the tech-service providers mostly as W-2
employees and occasionally (if they were adventuresome) as contractors. If
they retained individuals as contractors, though, they ran the risk of having
those persons reclassified as employees and so faced the risk at their level
that the tech companies once had directly. Because of this risk, most
placement firms would not take on tech people as contractors unless they could
have what they perceived as a strong case of calling them true contractors.
The practical result of this was that, if a tech-service provider wanted to
hire on to a placement firm as a contractor, he would first have to
incorporate himself and then the placement firm would take on his company. The
irony here is that the tax regulations behind the 1986 repeal specifically
provided that it was irrelevant whether or not a sole contractor had
incorporated himself and that this fact was to be disregarded in making the
tax determination. Thus, though the fact of incorporation was technically
irrelevant, most placement firms were happy to take people on as contractors
once they had become incorporated. Go figure. (This article, by the way,
discusses how the IRS would target such incorporated individuals in search of
audit opportunities).

7\. After 1986, it became virtually impossible for a tech service provider to
hire himself out directly to a company as a contractor. Every one of the large
Valley companies adopted strict rules forbidding this. In rare cases, someone
might get through the rules if the person was incorporated but even then most
times the answer from the company was no. Companies simply re-did their hiring
practices and thereafter took on contractors pretty much strictly through
placement firms and no longer directly.

8\. For a tech service provider looking to go into business, this essentially
put up an impregnable practical wall to finding reasonable opportunities to
work independently in the tech world, at least in terms of providing services
to the larger companies. This remains the case today as well, since the law
has not changed in the decade following publication of this article.

9\. By the way, this is not just a "big company" issue. Even little businesses
can get into trouble without the benefit of safe-harbor protections. If you as
a founder hire an early-stage contractor (which is often done) and later
terminate the relationship, that person can go file for unemployment on the
theory that he was in fact an employee of your company and had functioned as
such. This in turn can easily trigger an audit of your entire company's
history in this area (1099s you have issued are an easy way for the auditors
to focus on key areas). Should this happen to you, you find yourself going
down a rabbit hole that is likely to be unpleasant. (An aside: one reason to
incorporate as a startup is that reclassification penalties/taxes apply only
to the entity and not to the founders directly).

10\. To sum up, then: there is no law forbidding tech people from offering
their services as independent contractors but such persons face serious
practical barriers in building a service business because employers will not
hire them as contractors for fear of having their status reclassified in a
later audit. This is pure discrimination against tech people. No one else is
burdened in this particular way in wanting to set up a service business. The
fix is an easy one for Congress to make but I have seen no movement on this
whatever. For the near future, I am afraid tech service providers are stuck
and have no real remedy for this problem.

~~~
nazgulnarsil
I seem to recall that at one point in american history^1, courts could and
would strike down laws that were deemed unnecessarily esoteric to the point
that they were incomprehensible to the "common man". when you see a system
with decades or even centuries of regulations built up via 'regulation,
loophole, regulation etc.' you have to wonder if we don't need a clean sheet
design.

1\. inherited from european common law.

~~~
bd_at_rivenhill
That would be a great idea, but I don't think the courts would ever make a
ruling that would cause the entire tax system to collapse, which would be the
only logical result of eliminating laws that are unnecessarily esoteric.

~~~
apotheon
Too bad. The tax code needs to be nuked and paved.

------
jbooth
For those who didn't read all the way down, this law was passed in order to
pass a tax cut on overseas operations that IBM was lobbying for. PAYGO rules
and all that.

Your congress at work -- raise taxes on the little guy in order to give tax
breaks to the wealthiest.

~~~
CulturalNgineer
Absolutely right! This is the problem...

Which is also why we've developed such an imbalance in wealth!

We've got a serious problem with an imbalance in INFLUENCE!!!

Actually that's my own focus for technological innovation...

Realtime Networked Citizen Lobbying and distributed credit creation... (no
pitches here, see my blog if interested)

Fortunately I don't fly planes and still have a sense of humor.

~~~
tpyo
[1-6] Is this an ironic joke?

[6] Are you jealous?

~~~
CulturalNgineer
Nope, I'm an anthropologist.

Extremes in wealth are not compatible with a stable free society. Though I'm
open to contrary evidence.

~~~
adharmad
So was the soviet society stable and free?

~~~
ynniv
Your statement attempts to show evidence that a society with no wealth
diversity is unstable. That has no bearing on the original hypothesis that
high diversity is unstable. Still it fails in this attempt because the
historical instability in Communism has always been due to high wealth
diversity that arises from political corruption, which ironically supports the
original hypothesis.

So... try again?

~~~
jekyllnhyde
ynniv - you got him all wrong. He said "Extremes in wealth are not compatible
with a stable free society." Could he be any clearer? Everything you said
agrees with that.

------
tedunangst
Have things changed? I had no trouble working as a 1099 for a while, nor did
any friends. HN and reddit are filled with posts by people claiming to be
independent contractors.

How is that one guy with plane is affected by this law, but nobody I've ever
talked to is?

~~~
jfager
IANAL, and I might be misreading the law
(<http://www.synergistech.com/1706.shtml>), but the way I understand it is
that if non-tech company A needs some tech work done, and they hire tech
service company B to get it done for them, company B is not allowed to farm
out that work to individual contractor C without treating C as an employee for
tax purposes.

So if you're an independent contractor and you get your own business, you
should be fine.

If someone knows this to be incorrect, please let me know.

EDIT: nevermind me, read grellas comment.

~~~
ssanders82
I am individual contractor C, and company B pays me hourly as a contractor. I
do most (95%) of my work for various clients of company B, but they are mainly
concerned with my results, not every detail of my work. If I have questions, I
usually ask the A's directly.

I believe I am operating properly here.

------
ww520
Here's my experience working as an independent status. Once a megacorp wanted
to hire me as a consultant. The problem was that this megacorp had a list of
"approved-vendors" to do consulting work for them. To get into the list was a
time consuming and expensive hurdle. What did the hiring manager do? He asked
me to join one of these approved vendors temporarily and billed through them.
And this vendor got a cut out of it. Apparently it's a common problem that
they did it alot. When I told the consulting firm my agreed rate was $200/hr,
the guy said their contracting rates were never even close to that. Sweet
time.

~~~
euroclydon
That's not really a complete story.

~~~
rozim
In particular, did the middleman vendor take a cut?

~~~
ww520
I'm sure the middleman vendor took a cut above my rate. I'm not sure how much
though. I won't reduce my rate to give them a cut. The megacorp had to cough
up the difference.

------
andrewljohnson
Insure -> Ensure

As an ex-college-newspaper editor, this error always stands out to me. And the
NYT should know better.... even in 1998. YC's headine is the same as the
Times.

~~~
liamkf
Hmm, it seems like they're pretty much interchangeable at this point:
<http://dictionary.reference.com/browse/Insure>

~~~
andrewljohnson
It's true you can be lenient about this, but the Associated Press style is to
distinguish: <http://www.wsu.edu/~brians/errors/assure.html>. I would have
thought the Times would follow suit.

They really are two different words.

------
Psyonic
Thanks for posting this. It provided the best explanation so far (for me, at
least) of the law that so pissed off Joe Stack.

~~~
mattm
Thanks for the link. Obviously, I don't follow the news that much.

------
retro
Does this mean if you're a freelance programmer, you're at risk of running
afoul of this law - as Joe Stack did - if you're trying to negotiate
programming contracts directly with the client rather than through an agency?

My understanding is that you can protect yourself from this law by working
through employment agencies as a W2 or Corp-Corp contractor?

Is that correct?

Is so, then perhaps the programmers I've met who said they were "independent
consultants" were likely working through agencies since the risks of being
truly independent are too high?

~~~
jhancock
Some clients, usually larger ones, can be risk adverse to working directly
with an independent contractor. Its not hard for an independent contractor to
be "independent" per these tax rules. However, many clients don't want to take
the risk that the contractor is doing their end right. Whether this is real or
perceived risk on the part of the client is not clear to me.

The bottom line is if you are an independent contractor, you should do all
your work through an LLC or S/C-Corp and manage your tax filings well. Some
clients may still not accept dealing with your LLC directly and hand you a
list of "approved contractors" to bill through. The only way you may get in
trouble past this is if all you work is for one client and the IRS feels your
really acting as an employee.

~~~
SriniK
On the tax side, there is W2 or 1099. When you get W2(salary), taxes are
usually withheld. In case of 1099 no taxes are withheld. So, you(as the
contractor or LLC owner or Corp owner) have to estimate taxes every quarter.

LLC and Single person corps were treated badly 10yrs ago. Now pretty much
every state recognizes LLCs/S-Corps and yes, one can be owner and single
employee.

------
fnid2
_''This is Catch-22,'' he said. ''If you are not legitimate because you start
out as a one-person corporation and you haven't been in business for a year,
then how do you ever start your business? It is nonsensical.''_

Save up at least a year's living expenses, get rid of everything you own,
travel the world for a year. You'll save money over keeping it, see the world,
write some code on your laptop at hotels. Get one of those netbooks that will
fit in a backpack. Charge it up at the coffee shop. You can get good wireless
cheap overseas. Room and board is cheap.

Make arrangements to work with companies while you are away. Start getting
paid the next tax year.

 _''Basically the I.R.S. is saying it would rather collect less revenue with
less cheating than collect more revenue with more cheating. Does that make
economic sense?''_

It is interesting that what is proposed here as more profitable government
policy encourages cheating, something we don't appreciate in our species.

~~~
barrkel
In my experience traveling with a laptop, a lot of coffee shops will cut off
power to their sockets to avoid giving you free electricity.

~~~
fnid2
Hotels, Hostels, solar panels. There is plenty of energy in the world for a
laptop and you don't have to write code every day, only when you have enough
electricity to sit in the park write or check emails. Use a notepad. Write
stuff down. Draw diagrams. Think more, code less.

You have a guaranteed income when you get back just don't run out of money
that's all. If you _do_ run out of money, go back to employment and start
over. Find a job while you are away.

The world outside employment is full of green pasture and sun for programmers
as individuals and the future of the world alike.

------
CoryMathews
Wow.. just wow. what a load of crap, I cannot even imagine how many people are
working "illegally". Most every programmer I know does some work on the side
as a 1 person operation.

~~~
crpatino
For what I understand, if you are doing work on the side, you should not be
reclassified as employee. You do not work exclusively for the customer, nor
with their hardware, neither full time, and probably not even on site.

------
scotty79
In my country there is a problem with employers forcing their employees to
fictionally incorporate, so employer can save on social security (in case of 1
person companies social security is not associated with actual income, but can
be paid in low minimal monthly amount, of course lower monthly social security
payments means lower retirement benefits which is not good for fictionally
incorporated employees).

Our IRS equivalent decides that incorporation was fictional if former employee
has 1 person company, has only one client and this client is his former
employer. If you have multiple clients and none of them hired you before you
started your own company then you are safe.

------
fexl
The movie "Brazil" premiered in 1985, the year before strutting beasts wrote
this statute in defiance of common law. Many wilt helplessly at the sound of
such braying -- but not Tuttle, who embraces the dangerous life of peaceful
production.

------
ajross
This is confusing. The clear text of the article says that programmers can't
do individual contracting, which is insane and clearly wrong. The examples
(e.g the contracting company with 50 "workers", none of whom were technically
"employees" of anyone but themselves) don't seem nearly so clear cut.

I mean, if this is really an important law to understand, wouldn't the idea of
good journalism be to tell me how to avoid breaking it? I don't see that at
all here. It reads like just another "tax is bad" screed.

A pointer to the text of the law, or a less sensationalist presentation would
be very appreciated.

~~~
lsc
text of the law: <http://www.synergistech.com/1706.shtml>

the problem is that it's pretty unclear how to avoid violating it.

------
artanis0
Anyone know if any laws like this exist for Canada?

~~~
3pt14159
They do not. Anyone is free to create a sole
proprietorship/partnership/corporation provided that there is not national
security implications ("Pam and Tom's Atomic Weapons" - Disallowed "Pam and
Tom's Fighter Craft Displays" - Allowed) or confusion in the marketplace or
depletion of nation resource (fishing companies, dairy companies, logging,
etc). Actually, small business law in Canada is extremely well thought out.
There is rarely a tax reason to incorporate, unlike other companies. For
example, incorporating and paying out dividends will run you just as much tax
as running as a sole proprietor. Usually. There are tricks you can pull, Turks
and Caicos QA companies that reduce your profit to nearly 0 but reinvest the
profits overseas. Plus IRAP funding is intense if you are large enough to
float a couple salaries and you can handle mountains of paperwork.

~~~
scotty79
Can you as us citizen register company in Canada and provide your services in
US? Is there anything against it? Import tax on services?

~~~
cperciva
You can do that, but it won't help. My understanding (as a non-US tax expert)
is that if you're providing a service in the US you have to pay taxes in the
US -- at least, last time I did consulting for a US company I had to fill out
paperwork confirming that I was Canadian and doing all of the work from Canada
in order to avoid all sorts of US tax paperwork.

------
huherto
Isn't the root cause of all of this, the high cost of employing people(as
opposed to just contracting them). I don't know if it is the situation
elsewhere but here in Mexico; the benefits than a low income employee gets are
worth the extra employments cost; but for higher income, you just get too many
taxes and little benefits, so it is costly for companies without the employees
getting much. So people hire contractors to avoid paying so much in benefits
that are not worth much.

------
prgmatic
This is rediculous, I'm just glad to see that this has resurfaced and people
are taking notice.

------
petercooper
There's a similar law in the UK. It was passed in the early 2000s, I believe -
it's called IR35: <http://www.contractoruk.com/ir35/what_is.html>

------
sown
Wait.

Does this mean that my dream of starting a side business of writing kernel
code for hire in SV is DoA?

~~~
lsc
No.

It just means that it will be quite difficult to find people who will hire you
without going through a headhunting firm that will take half your pay, and
that if you do manage to find a small corp that will hire you directly as an
independent contractor, and you write off business expenses against that
income, there is a chance the IRS will invalidate those writeoffs, which often
results in big debit that can't be discharged by bankruptcy.

------
kevinpet
Is this the reason Joseph Stack flew his plane in the IRS building?

~~~
araneae
Well, probably not _the_ reason (I would say some sort of mental disorder was
primary.) But yes, is was one of the reasons stated on his website.

------
CoryMathews
anyone got a link to the actual law itself?

~~~
jfager
<http://www.synergistech.com/1706.shtml>

------
dnsworks
Reading through that article a couple of times was like a high school student
attempting to write in the spirit of Kafka. It almost feels like an urban
legend amongst geeks.

