Ms./Mr. Independent Contractor rep: Imagine yourself as an employee. As in “working for” your broker/dealer. Don't laugh, it could happen. If federal legislation passes as is, you — an independent contractor rep — would be considered by the IRS to be an employee.

Everything would change. For starters, you're payout would probably be cut to between 20 and 45 percent, the typical range for employee-based brokerages. Your office space and employees would likely be taken over by the b/d — even your clients might then be considered to be property of the b/d. Imagine your b/d's logo gracing more than just your clients account statements. Or you might simply be out of a job. If your b/d had to convert its affiliated independent contractor reps into employees, it might just shut down.

That's what some indie brokerages are predicting if the legislation to stop worker misclassification passes as it is currently being discussed in Congress. Cadaret, Grant, an independent brokerage based in Syracuse, NY, claims it would go out of business. The firm has been operating with an independent contractor model for 23 years. CEO Arthur Grant says if he had to convert the firm's 900 or so independent contractor reps into employees, it would be a disaster. “If that was the case, we would provide them with office space, we would do the things that Merrill Lynch does, I mean, we would be Merrill Lynch,” says Grant. “They're [advisors] not employees and they would not want to be employees, so we could not convert to an employer/employee relationship. We would simply close, and we would leave 100,000 clients without any investment place.”

Legislative Action

That is, of course, the absolute worst-case scenario for b/ds if the federal government decides to amend worker classifications and tax rules, namely Section 530 of the Fair Labor Standards Act of 1938 and the Revenue Act of 1978, respectively. The federal government and employers have been fighting over the definition of what an “independent contractor” is for years. (In the 1990s, the IRS successfully pursued Microsoft's use of long-term independent contractors and demanded Microsoft pay Social Security and other taxes on the employees.)The Obama administration and Democrats in the House of Representatives, led by Rob Andrews (D-N.J.), have recently proposed legislation that would restrict employers' ability to classify workers as independent contractors. While the legislation failed to become law, Andrews has confirmed his intent to re-introduce the legislation in the 111th Congress this year. And this time, he may well win the support of President Obama, who co-sponsored a similar bill in 2007 when he was a U.S. senator. U.S. labor unions, major supporters of Obama's candidacy, are urging Democrats to get the legislation going.

As it stands, independent-contractor reps are classified as just that, independent contractors. The bottom line: It's cheaper to use independent contractors than to employ people. Unlike employees, independent contractors don't qualify for workers' compensation coverage, minimum wage, overtime protections and family and medical leave, nor do they have the right to organize and collectively bargain. In addition, employers don't withhold taxes for independent contractors. Not surprisingly, some in Washington say that employers abuse the classification — identifying workers who are really full-time employees as independent contractors in order to benefit the corporate bottom line. The IRS wants to catch employers who misclassify workers as independent contractors and collect unpaid taxes and penalties.

The Financial Services Institute, the independent b/d industry's lobbying group, has responded to Capitol Hill with a concern of its own. FSI is worried that if the safe harbor provision which allows b/ds to classify reps as indie contractors for income tax and employment tax purposes were repealed, the independent b/d model would be opened up to IRS scrutiny not only for worker classification, but also possible back taxes, fines and court fees that could financially cripple the independent-contractor business model.

“We wanted to make sure we didn't have a knee-jerk reaction to something that wasn't a threat,” says Dale Brown, FSI president. Brown says FSI was paying attention to the issue in 2007, but was not as concerned as it is now. “We determined it is a number three priority on the labor unions list of issues, and there is a high likelihood it will be a policy priority for the Obama administration — given the economic situation, the Obama administration is looking for revenue sources,” he says.

What Do You Mean I'm An Employee?!

Anyone in the independent space will tell you his/her affiliated reps are independent contractors when held up to the common law test, which determines the degree and type of control an employer exercises over a worker. The IRS's common law test measures an employer's behavioral control and financial control over the worker, and the type of relationship that employers have with workers to determine worker classification.

So if independent b/ds are in fact correctly classifying independent reps as independent contractors, why are some worried? “There is all of this muddling of the water for people and industries, which are really legitimate like ours,” says Grant. “We don't provide any of the indications of employment. We do not set hours; we do not provide clients; we don't provide office space, computers, nothing of the employer-employee relationship. We do not have control.” But he adds, “We do have a responsibility to supervise.”

And therein lies part of the concern. The fact is that the federal line separating independent contractors from employees is murky at best. The government now wants to make the law easier for the IRS to navigate — and easier for it to collect taxes on independent contractors.

In 1978, Congress passed the safe harbor provision Section 530 of the Revenue Act of 1978 to allow organizations to treat a worker as an independent contractor for income tax and employment tax purposes even if a common law test classifies workers as employees. Currently, Section 530 relief is offered to an employer who files all appropriate tax and information returns (a 1099 form), classifies workers as independent contractors in a consistent manner, and has a “reasonable basis” for believing that the workers are contractors, such as a past IRS audit of the employer's business permitting such classification, or a long-standing recognized practice in the employer's industry.

Of course, the only time an employer needs 530 relief is when the IRS determines that workers are misclassified and have issued fines to employers. Fines for an intentional misclassification can equal the total amount of federal income and employment taxes owed for the weeks or months the individual worked going back three years. The stakes might get larger as the government is looking to make stricter worker classification guidelines and increased penalties for employers. Legislation proposed during the last Congress sought to amend the internal revenue code and labor laws regarding the misclassification of employees as independent contractors.

In 2007, then-Senator Obama introduced the Independent Contractor Proper Classification Act of 2007, a particularly onerous bill (for employers, anyway) that would have amended the Revenue Act of 1978. Among other things, the bill would have eliminated the ability of employers to rely on industry practice as a basis for claiming the safe harbor, seeking to eliminate its use by some employers as a tax loophole. The bill would have also allowed the IRS to write rules, regulations and guidance for employers on how to properly classify employees for employment tax purposes, since the current law bars the IRS from doing so. The legislation would also require the IRS to communicate with the Department of Labor, to better monitor employers who are not only misclassifying workers for tax purposes, but also to avoid compliance with labor laws, such as minimum wage and overtime pay, and finally, would have required employers to notify independent contractors of their rights and the ability to seek a determination from the IRS on whether properly classified as an independent contractor.

While Obama's bill never became law (it was read twice and referred to the Committee on Finance) the bill would have ultimately had negative tax consequences for independent b/ds. Although the bill may not necessarily directly require b/ds to reclassify their independent contractor reps as employees, it opens up b/ds to audits where the IRS could determine an indie b/d misclassified its brokers as independent contractors. Furthermore without the safe harbor, b/ds can no longer use the defense that classifying reps as independent contractor is a long standing industry practice. In order for b/ds to contest the IRS' determination they would have to go to court, and attorneys say appeals are expensive and could run from $150,000 to as high as $500,000 dollars in litigation costs.

In addition, a similar bill was introduced in the House by Rep. James McDermott (D-WA) last April. The Taxpayer Responsibility, Accountability and Consistency Act of 2008 also sought to change the tax rules relating to the treatment of individuals as independent contractors or employees. While Congressman McDermott's office did not return phone calls to confirm his plans to reintroduce the bill, if he did, the bill would set forth criteria and rules relating to the treatment of workers as employees and independent contractors and would also increase penalties for filing incorrect tax return information.

A third bill was introduced by Andrews last spring, The Employee Misclassification Prevention Act of 2008. The bill, slated for reintroduction this year, would have increased the penalties for worker misclassification and imposed new record-keeping requirements on employees.

You're Not The Man, Man

In short, there are lots of bills out there — one might actually make it through. On top of that the IRS is making worker classification a central area of focus this year. Almost a third (30 percent) of IRS audits over the coming year will be based on employee classification issues, John Tuzynski, chief of Employment Tax Operations in the Small Business/Self-Employed Division, said at a workshop during the American Payroll Association's 26th Annual Congress. Furthermore, a new report by the Treasury Department's inspector general released in early February found that misclassified workers account for a significant portion of the tax gap (taxes not paid) and recommends the IRS build an agency-wide tax program to address the issue of worker classification to ultimately reduce the tax gap. In fact, of the approximately $345 billion tax gap the IRS estimates underreporting accounts for, about $54 billion with an estimated $1.6 billion collectible on worker misclassification. However, the $1.6 billion estimate is based on tax year 1984 data — that figure is surely higher today.

With some 98,000 registered reps who operate in the independent contractor model — over 40 percent of all advisors in FINRA membership — it's no wonder independent b/ds and their lobbying groups are worried. Many IBDs say challenges to their independent contractor status could pull the rug out from underneath one of the fundamentals of their business model. Not to mention, this legislation could open them up to audits, drive up b/d costs, and possibly lead to IRS determination that affiliated reps are not independent contractors.

Brian Kovack, one of the National Association of Independent Broker Dealers board members and co-founder and President of Kovack Securities, which has 250 independent contractor reps, says, “Ultimately [if reps had to be reclassified as employees], it would result in firms reducing payouts in order to pay The Federal Insurance Contributions ACT [FICA], in addition to having to pay for healthcare and increased litigation to possible regulatory actions against employees,” Kovack says.

Thin Gruel

At the end of the day, pre-tax margins at some independent b/ds are as low as two to three percent, says Kovack. He says some firms are already in the red due to the economy and the market, and, when you add 7.5 percent FICA tax, firms will have even less net income. Kovack says this means b/ds would have to restructure payouts to capture more revenue from reps. Not to mention, the rep in the field has his own OSJ or branch office and his own office expenses, which would then have to be shouldered by the b/d if they were classified as employees.

FSI has been making the rounds on Capitol Hill meeting with officials to help them work on the issue and are trying to get FSI members involved in the outreach to their local elected officials. Brown says, while the future remains unclear, they would ultimately hope to explore some kind of carve out to make sure the independent business model is not harmed by any legislation that amends worker classification status. Meanwhile, the Securities Industry and Financial markets Association, says it is also concerned about the proposed legislation. In a statement SIFMA said, “We are making the industry's concerns about this bill known to members of Congress, including the bill's authors.”