How a Tax Law Helps Insure a Scarcity of Programmers (1998)
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...). 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.