Title: Employee or independent contractor
Full Citation
Permanent Link: http://ufdc.ufl.edu/UF00102829/00001
 Material Information
Title: Employee or independent contractor
Physical Description: Book
Language: English
Creator: Stewart, Dave Nelson, 1952-
Copyright Date: 1980
 Record Information
Bibliographic ID: UF00102829
Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: oclc - 06800179
ltuf - AAL4039

Full Text







Copyright 1980


Dave Nelson Stewart


I wish to thank John L. Kramer, the chairman of this dissertation

committee, for his guidance and support throughout the course of

this study. Professor Kramer has given unselfishly of his time,

especially in the reading and commenting on different drafts of

this dissertation.

My entire dissertation committee has contributed greatly to

this project. Professor William A. Collins, Dennis A. Calfee, and

John C. Henretta have each shared freely of their knowledge and

expertise. They have never been too busy to sit down and discuss

the progress of this study. Valuable criticisms and suggestions

were also received from the Ph.D. students and faculty at the

University of Florida Accounting Workshop.

Finally, I would like to thank my dear wife, Jane. She not

only provided constant encouragement and support, but her typing and

editing skills were invaluable to the production of the finished paper.



ACKNOWLEDGEMENTS . . . . . . . . ... . . .iii

LIST OF TABLES . . . . . . . ... ...... vi

ABSTRACT . . . . . . . ... . . . . . .vii


I. INTRODUCTION . . . . . . .. .. ... . 1

Significance of the Problem . . . . . . . 2
Research Methodology . . . . . . . . . 7
Research Questions . . . . . . . . 7
Data Collection . . . . . . . . . 8
Research Question 1 . . . . . . . . 9
Research Question 2 . . . . . . . .. 10
Research Question 3 . . . . . . . . 11
Research Question 4 . . . . . . ... 12
Limitations . . . . . . . . ... . . 13
Summary of Chapter Contents . . . . . ... .14
Notes . . . . . . . . . . ... 15

II. HISTORICAL BACKGROUND . . . . . . . ... 19

Development of Legislative History . . . . .. 19
Social Security Act of 1935 . . . . ... 19
Common Law Definition of Master-
Servant Relationship ............. 21
Social Security Amendments of 1939 . . ... .24
Income Tax Withholding Provisions . . . ... 26
Judicial Interpretation . . . . . .. 27
Social Security Amendments of 1950 . . ... .34
Current Legislative Status . . . . . . ... 38
Revenue Act of 1978 . . . . . . ... 43
Current Proposed Solutions . . . . . . ... 44
General Accounting Office . . . . . . 44
H.R. 3245; Safe Harbor Remedy . . . . ... 46
Department of the Treasury . . . . ... .49
Notes . . . . . . . . . . . ... 50




Research Question 1 . . .
Variable Identification
Operational Definitions of
Coding of the Variables
Research Question 2 . . .
Mathematical Techniques in
Discriminant Analysis .
Logit Analysis . . .
Research Question 3 . . .
Research Question 4 . . .
Notes . . . . . . .



Tax Research

. . .

Research Question 2 . . . . . .
Discriminant Analysis Results .
OLS Regression Results .. . ...
Logit Analysis Results . . . .
Comparisons of Discriminant, OLS
Regression, and Logit Analyses .
Research Question 3 . . . . . .
Research Question 4 . . . . . .
Notes . . . . . . . . .

Summary and Conclusions . . . . .
Historical Background of Common Law
Variable Identification . . .
Empirical Results . . . . .
Temporal Stability of the Model .
Current Legislative Proposals .
Choice of Legal Forum . . . .
Recommendations . . . . . . .
Suggestions for Future Research . . .
Notes . . . . . . . . .


. . . 121

. . . 121
. . . 121
. . . 136
. . .. 142


.. .

. . .
. .
. .





. 172


BIBLIOGRAPHY . . . . . . . . ... ... . 177

BIOGRAPHICAL SKETCH . . . . . . . . ... . . 187

. 57




FOR 1978 THRU 1987 . . . . .

4.1 BMDP 6-VARIABLE MODEL . . . . .

4.2 SPSS 9-VARIABLE MODEL . . . . .
















. . . 122

. . . 124

. . . 126

. . . 127

. . . 129

. . . 131

. . . 132

. . . 135

. . . 137

. . . 139

. . . 143

. . . 145

. . . 147

. . . 152

. . . 155

. . . 157

Abstract of Dissertation Presented to the Graduate Council
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy



Dave Nelson Stewart

June 1980

Chairman: John L. Kramer
Major Department: Accounting

The distinction between an employee and an independent contractor

is crucial in the application of the federal employment tax laws. If

a worker is classified as an employee, the employer must (1) withhold

income taxes, (2) withhold social security taxes, (3) match the social

security taxes paid by the employee, and (4) pay unemployment taxes.

If the worker is classified as an independent contractor, the employer

need not pay or withhold any of the above mentioned taxes. Instead,

the independent contractor is responsible for paying his own income

and self-employment taxes.

The Internal Revenue Code statutorily defines several occupational

categories that are treated as employees for employment tax purposes.

The most prominent of these categories is that of a "common law"

employee. However, the scope of the Code and Regulations is sufficiently

limited to leave the common law employee definition shrouded in uncer-

tainty. It is this ambiguity, coupled with the IRS's increased


enforcement of employment taxes, that has resulted in pressure on

Congress to enact legislation that will add a degree of certainty

to the definition of a common law employee. The legislation being

considered by Congress would result in several "safe harbor" criteria

that if satisfied would automatically indicate employee status.

The purpose of this study is to develop a mathematical model

that will empirically identify those variables used by the federal

courts in employee versus independent contractor cases in hopes

that these variables may provide direction to tax policymakers.

A sample of 148 District Court and Court of Claims cases was iden-

tified and used as the data with which the mathematical models were

estimated. Discriminant analysis, OLS regression analysis, and a

non-linear logit analysis were all used to identify those variables

deemed most important by federal judges.

A forward stepwise discriminant procedure resulted in a 6-variable

model that was able to correctly classify 96.6 percent of the cases.

A forward stepwise OLS regression procedure resulted in a 7-variable

model that correctly classified 95.3 percent of the cases and explained

80 percent of the variance of the model. The non-linear stepwise

logit procedure resulted in a 5-variable model that was able to correctly

classify 97.3 percent of the cases. Both the linear and non-linear

techniques produced substantially identical results.

When compared with the proposals presently being considered by

Congress, three of the variables recommended by the Congressional

subcommittee are also included in this study. Using these three vari-

ables as the model, approximately 90 percent of the cases were correctly


A secondary question addressed in this study is whether the choice

of legal forum is important in an employment status tax case. Through

a comparison of the discriminant classification accuracy rates and the

Chow test applied to the OLS results, it was concluded that for employ-

ment tax cases the two Federal Courts use very similar decision-making


The findings of this study suggest several conclusions. First,

the use of the non-linear analysis did not produce substantially

different results than did the linear regression or discriminant

analysis procedures. Second, there are factors that have been used

successfully by federal judges in employment tax cases that could

provide direction to tax policymakers attempting to statutorily define

a common law employee. Third, the decision-making models employed by

the District Courts and the Court of Claims are not significantly

different for federal employment tax cases.



Until the 1960's, the collection of federal employment taxes--

withholding, social security, and unemployment--followed a relatively

smooth course for employers and other taxpayers. However, since the

late 1960's, the Internal Revenue Service (IRS) has increased its en-
forcement of the employment tax laws. The question of employment

status generally centers around the classification of whether a worker is

an independent contractor or an employee. Because so few categories

of employees are statutorily defined, the question of whether a worker

is an independent contractor or an employee generally centers around the

issue of what constitutes a "common law" employee. The common law

definition of employee has evolved from a substantial body of case law.3

Congress initially felt that all uncertainty in the classification of an

individual as an employee or an independent contractor would "vanish if

only common law principles distilled from many decisions by many courts

were applied to factual situations as they arose." The assumption that

. there is some simple, uniform and easily applicable
test which the courts have used . unfortunately . .
is not true. Few problems in the law have greater variety
of application and conflict in results than the cases arising
in the borderland between what is clearly an employer-employee
relationship and5what is clearly one of independent-entrepre-
neurial dealing.
The substantial amount of litigation in the federal employment tax

area is evidence that the common law definition of an employee is easier

stated than applied. The determination of employment status is an


issue on which both the taxpayer and the government desire some degree

of closure. The taxpayers complain that the retroactive reclassification

of workers as employees and the resulting taxes, interest, and penalties

are causing interruption of business activities and financial hardship

through severe cash flow demands.7 The IRS is claiming that with the

uncertainty surrounding the common law rules that taxpayers are able to
easily avoid employee status. Since this results in no withholding of

taxes by the employer, independent contractors are easier able to

escape detection should they fail to file their tax returns.

Consequently, proposals have been forthcoming from a Congressional
9 10 II
subcommittee, the General Accounting Office, and the IRS that

recommend the solidification of the many factors that determine a common

law employee into a smaller number of factors that provide a more clear-

cut test. However, these factors lack theoretical support and in some

cases even lack the desirable tax characteristics of simplicity and

certainty. The purpose of this study is to determine those factors that

the courts have found significant in defining employment status with

the hope that these variables may prove helpful to tax administrators

as they search for an appropriate definition of the employee-employer

relationship. Such a study could provide valuable insight into what

factors can be consistently applied when individuals are faced with the

task of determining if a worker is an employee or independent contractor.

Significance of the Problem

Once the court determination is made that a certain individual is

an "employee," the employer may have the following responsibilities:

(1) withhold social security taxes under the Federal Income Contributions

12 13
Act (FICA),12 (2) withhold federal income taxes, 13 (3) match the FICA
taxes paid by the employee, and (4) pay unemployment taxes under the

Federal Unemployment Tax Act (FUTA).15 When an individual is clas-

sified as an independent contractor the purchaser of his services

need not pay or withhold any of the above mentioned taxes. The pur-

chaser of the services may only need file an information return (Form

1099).16 It is then the responsibility of the independent contractor

to pay self-employment taxes under the Self-Employment Contributions

Act (SECA)17 and pay his own income taxes through the use of the

estimated tax procedures.8 With inflation pushing wages into higher

tax brackets and prospective increases in both the FICA and SECA wage
bases and rates,9 the amount of employment taxes can vary substantially

according to one's employment status.

Table 1.1 represents the present and proposed FICA and SECA tax

rates and wage bases from 1978 to 1987. Columns (5) and (6) illustrate

that the social security taxes are substantial and will drastically

increase in the next ten years. Column (7) shows the differences in the

actual tax that goes into the Social Security Fund depending on the

employment status. The difference in what an employer must pay is even

more pronounced when one includes the FUTA taxes (3.4% of the first

$6,000 of wages per employee). For example, using the maximum wages

applicable to employment taxes for 1980, Column (7) shows that an ad-

ditional $1,077.44 of taxes are paid into the federal treasuries if a

worker is an employee versus an independent contractor. This difference

of $1,077.44 should be increased by the FUTA taxes of $204 (3.4% x

6,000) that are also imposed thereby resulting in a total difference

of $1,281.44. Consequently, Column (7) probably represents for most


FOR 1978 THRU 1987

(1) (2) (3) (4) (5) (6) (7)

Max. Max. Excess FICA
Maximum over
FICA SECA Wage FICA SECA Maximum over
Year Ratea Rate Basec Tax Tax Maximumd

7 % $ $ $ $

1978 12.10 8.10 17,700 2,141.70 1,433.70 708.00

1979 12.26 8.10 22,900 2,807.54 1,854.90 952.10

1980 12.26 8.10 25,900 3,175.34 2,097.90 1,077.44

1981 13.30 9.30 29,700 3,950.10 2,762.10 1,188.00

1982 13.40 9.35 31,800 4,261.20 2,973.30 1,287.90

1983 13.40 9.35 33,900 4,542.60 3,169.65 1,372.95

1984 13.40 9.35 36,000 4,824.00 3,366.00 1,458.00

1985 14.10 9.90 38,100 5,372.10 3,771.90 1,600.20

1986 14.30 10.00 40,200 5,748.60 4,020.00 1,728.60

1987 14.30 10.00 42,600 6,091.80 4,260.00 1,831.80

aThis percentage includes both the employer's and the employee's
portion of the FICA tax. This percentage includes the social security
rate and hospital insurance rates as contained in Section 3101.

This percentage includes the self-employment rate and the hospital
insurance rate as contained in Section 1401.

CAny wages above these specified amounts are not subject to FICA
or SECA tax.

This amount is obtained by subtracting column (6) from column


taxpayers a conservative estimate of the total additional taxes paid

when a worker is deemed to be an employee.

The preceding illustration is based simply on the differences in

employment taxes between an independent contractor (self-employed) and

an employee. The determination of employment status can be much more

critical if the IRS should choose to reclassify an independent contrac-

tor as an employee. The employer would then be assessed for the income
taxes he failed to withhold, both the employer and employee FICA
taxes that should have been paid by the employer, and the FUTA taxes

that should have been paid,22 plus the appropriate interest and penal-
ties. Such assessment can be made retroactively for all tax years

that remain open under the statute of limitations (generally three

years under Section 6501). Only if the employer can furnish certifi-

cates signed by his employees stating that they have paid the proper

amount of income tax, can the employer possibly have the assessment
reduced.24 The employer can have the employee's share of the FICA tax

abated by the SECA tax already paid only if the employee is prevented
by law from filing for a refund of the SECA tax that he paid in error.2

This situation obviously results in a double payment of the employee's

share of the FICA tax.

A reclassification by the IRS causes even more problems for

employers because of the Tax Court's lack of jurisdiction over employ-
ment taxes. Therefore, a suit cannot be instigated by a taxpayer

without payment of the assessed tax because the District Courts and

Court of Claims require the payment of the assessment prior to their

judicial review. To require a business to pay three years worth of

income, FICA, and FUTA taxes while instituting a legal action against

the government could impose severe hardship and cost upon a firm.

However, since employment taxes are generally paid on a quarterly basis,

the taxpayerordinarily files a return covering one quarter's employment

taxes and then sues for a refund of that amount and abatement of the

yet unpaid amount.27 This partial payment procedure can still involve

a considerable amount of funds when dealing with industries that have

a large number of workers that would be affected by such a determination.

Jerome Kurtz, Commissioner of the Internal Revenue Service, in a speech

before the American Bar Association pointed out:

The employee independent contractor issue has generated a
staggering problem for employers assessed with huge liabili-
ties for past noncompliance. At present, in two districts
of one region alone there are three potential assessments
against taxpayers ranging from $6 million to $60 million . .
and reclassification of independent contractors as employees
result in deficiency assessments estimated at $107,000,000

Even if the taxpayer only has to pay one quarter's worth of employment

taxes to initiate a suit for refund and abatement of the IRS assessment,

the IRS is not precluded from seizing a taxpayer's property in this

type of partial payment litigation.29 This action is not taken in most

situations unless the IRS feels there are circumstances which might

jeopardize the availability of the taxpayer's funds subsequent to the
litigation.30 This threat exists in employment tax cases as evidenced

by American Consulting Corporation v. U.S.31 where the IRS seized a bank

account owned by the plaintiff whose employment status was being ques-


The determination whether a worker is an employee or an independent

contractor is far more reaching than simply the employment taxes in-

volved. The reclassification of an independent contractor can have

adverse effects on a firm if it has a qualified pension, profit-sharing,

or stock bonus plan. Such a reclassification may cause the plan to

violate the minimum participation requirements. This could cause the

disallowance of deductions taken for contributions to the plan and

possibly even taxation of the trust's income.32 This would most

likely result in termination of the plan by the employer because of the

increased expense or at best the effect would be to reduce the benefits

available to the employees. Workers who consider themselves self-

employed and establish Keogh plans for their own retirement may find

that prior contributions are disallowed or the plan frozen with

respect to any future tax exempt contributions.

Reclassification of workers as employees instead of independent

contractors affects various other fringe benefits. Employees exclude

from income any contribution paid by their employer for accident and
33 34
health plans,33 employee education assistance plans,34 certain employer-
provided life insurance and death benefit programs, and the value of

any meals or lodging furnished for the convenience of the employer.36

Independent contractors are not afforded these privileges. In addition,

other sections of the Code that apply specifically to employees would

be affected by any reclassifications by the IRS. For example, the

WIN tax credit for wages paid to certain employees hired under the
Federal Work Incentive program37 and the targeted jobs credit for wages

paid to certain new employees are all examples of areas of the tax

law affected by reclassifying independent contractors as employees.

Research Methodology

Research Questions

The four major research questions that are studied in this

dissertation are:

Research Question 1.

Research Question 2.

Research Question 3.

Research Question 4.

What factors or variables have been used in
determining employment status?

In constructing a mathematical model of the
courts' decision-making behavior, which of the
variables espoused in Research Question
I prove to be significant?

In determining the employment status of the
cases examined, do the different courts of
original jurisdiction (District Courts versus
Court of Claims) use similar factors in the
rendering of decisions?

a) Do the variables determined in Research
Question 2 have any similarity with the
criteria in the current proposals before

b) What possible recommendations might these
results suggest?

Data Collection

The Regulations specifically state that a common law employee is to
be determined according to the facts of each case. The facts of a

case are determined in the original court of jurisdiction. In this type

of study, the assumption must be made that because of the possibility

of appeal to a higher court, judges attempt to include in their opinions

a discussion of the relevant facts in their decision-making process.

With this assumption, the Lexis computer data bank was used to search
for all employee versus independent contractor cases.0 From Lexis and

other manual research methods a total of 179 cases were identified for

the 1940 through 1979 period. The year 1940 represents the first year

in which a significant number of cases were tried that dealt with the

employment status question in connection with federal employment taxes.

The study also includes all the cases that could be found through

the end of the 1979 calender year.

Of the 179 cases, 24 were tried with a jury. In this situa-

tion, the written opinions contain only the instructions to the jury

and the actual verdict. Therefore, these 24 cases were eliminated

from the study. Sixteen cases also were eliminated because there was

not sufficient information in the opinion to determine what factors

the judge considered in his decision. This leaves a total of 139

cases of which 119 were tried in the District Courts and 20 were tried

in the Court of Claims (for a list of cases see Appendices A and B).

A small number of cases were discovered at the appellate level that

had not been reported at the District Court or Court of Claims level.

These cases were also excluded because the facts of a case are determined

in the court of original jurisdiction.

Research Question 1

The sources examined to determine the relevant factors in deciding

employment tax cases for federal tax purposes include the following:

(1) the Internal Revenue Code, (2) the corresponding Treasury Regula-
tions, (3) certain landmark judicial decisions,1 and (4) a BNA Tax
Management portfolio entitled Employee Defined.42 Another source that

proved helpful was the Employment Tax Procedure audit guidelines
published by the IRS for their agents.43 The list of factors that was

compiled was reduced as the court cases were read and it became evident

that certain factors seldom were discussed in the court opinions or

that two variables were so highly correlated that they were combined

and represented as only one variable. A list of the complete set of


variables used in this study is contained in Chapter III with additional

explanation of the selection process, operational definitions of the

respective variables, and how they were measured for this study.

Research Question 2

In constructing a mathematical model of a court's decision-making

behavior, three different approaches were taken. First, a discrimi-

nant analysis model was built using the variables espoused in the

results of Research Question I and the model was used to classify the

court cases as either an employee or an independent contractor outcome.

The P7M program of the Biomedical Computer Programs P-Series (BMDP)44

computer software package was used to derive the discriminant function.

From this discriminant function, classification functions for each of

the two groups were derived. Each case was then assigned to the group

in which the highest probability of membership existed.

A frequently recommended technique to test the accuracy of the

classification function is that of using a holdout sample. However,

with the limited number of cases available in this study, an alternate

test was applied.45 This technique calculated n-1 discriminant func-

tions where n is equal to the number of cases in the sample. The

procedure involved calculating a discriminant function with all but

one case, and then that function was used to classify the left out

case. The procedure was repeated n-1 times, and the number of incor-

rectly classified cases was used as an estimate of the probability of

misclassifying an employee versus independent contractor case.

Second, an ordinary least squares (OLS) regression model was built

using the variables espoused in the results of Research Question 1.

The OLS model was used to generate a probability of an employee

finding versus an independent contractor finding for each case.

These probabilities were used to classify each case. These classi-

fications were compared with those obtained from the discriminant

model to determine if these two linear statistical techniques gener-

ate different results.

Certain statistical assumptions are violated by using either of

the preceding linear modeling techniques. Therefore, the third

approach taken was to use logit analysis which is a non-linear es-

timation technique. Logit analysis assumes that the underlying func-

tional form of the relationship being studied is curvilinear and

estimation of the model allows for interaction of the independent

variables. The logit model involves a transformation of the depen-

dent variable from a binary to a continuous random variable. The
logit model was estimated using the Nerlove and Press and the
BMDP stepwise logistic regression programs which generate maximum

likelihood (ML) estimates. The ML estimates were used to generate

probabilities for each case by which they could then be assigned

to either the employee or independent contractor groups. These

results were compared with the discriminant analysis and OLS re-

gression results to determine if linear and non-linear estimation

techniques produced different results.

Research Question 3

To determine if the District Courts and Court of Claims apply

different factors in deciding an employee versus independent contrac-

tor case, the first approach used in this study was to build a

discriminant function using only the District Court cases. The

resulting classification functions were used to classify both the

District Court and Court of Claims cases. If the misclassification

rates are significantly higher for the Court of Claims cases, this

will be taken as evidence that the two courts use different decision-

making models.

The second approach used to determine if the District Courts

and Court of Claims use different decision-making models was to

build two additional OLS regression models. The first model was

based exclusively on the District Court cases and the second model

was based exclusively on the Court of Claims cases. The Chow test4

was used to determine if the two regressions came from the same

population. The results of this test along with the results of the

discriminant analysis test were used to draw conclusions pertaining

to the similarity of the two courts with respect to deciding common

law employee versus independent contractor cases.

Research Question 4

The preceding research questions were designed to discover which

variables are significant to the courts in deciding the employee

versus independent contractor question. The results are based on

the facts of the cases as discussed by the respective judges. The

logical extension of this research is to determine if the variables

found to be significant in Research Question 2 are related to the

criteria contained in the proposals before Congress. If the criteria

are quite different from those determined in this study, tax policy

makers may want to reconsider those variables that have been suggested


in order to provide a more certain definition of an independent con-

tractor. If the results of this study produce variables that have

been consistently used by judges in rendering decisions in employ-

ment status cases, it would seem that these variables would be a

good starting point for legislation. Therefore, the factors ob-

tained from Research Question 2 were compared with the current

proposals before Congress. Similarities were noted and recommen-

dations made of additional factors that Congress may want to con-

sider in the actual drafting of legislation in the employment tax



This study attempts to identify those factors that a diverse

set of judges have consistently used in deciding the employee versus

independent contractor question. To do so, a research methodology

was used that provides for a more systematic approach than the

legal analysis that is generally used to study problems of this

type. While the advantage may be that the approach is more objec-

tive than legal analysis which depends on the researcher's own

heuristics, it also suffers from certain limitations. The greatest

limitation of this type of study is the reliance on the fact that

the judge has actually included in his written opinion all of the

significant variables he used in his decision process. If a sig-

nificant variable is not included in the written opinion, it can

not be measured and considered in this type of study. This problem

is somewhat mitigated by the fact that the judge knows his opinion is

subject to reversal for failure to consider all relevant facts.

The ability to reduce the data in the written opinions into a

numerical form also presents some problems. In an attempt to re-

duce the subjectivity involved in actually obtaining the data, a

variable generally was not assumed present unless it was explicitly

noted in the text of the case. Each case was read several times

by the author in an attempt to be consistent in the actual coding

of the variables.

It should also be noted that because of the dynamic structure

of the tax law and the legal process, that the results of this study

are not predictive in a future sense unless one assumes stability

for all the factors affecting the employee versus independent con-

tractor question. The fact that the data are based only on cases

that were actually litigated also produces a potential sample bias.

The majority of cases that are actually litigated are cases in which

both parties feel they have a reasonable chance of winning. It

is not clear if this bias is very crucial because it is those very

situations where the decision is in doubt that this study is in-

terested in investigating.

Summary of Chapter Contents

This study is divided into five chapters. Chapter I is the

introduction to the study which includes a brief discussion of the

nature and scope of the problem, the research questions to be

addressed, the basic research methodology to be used, and possible

limitations of the study.

Chapter II provides a historical perspective of the common

law definition of employee by tracing its use through the Code and

corresponding regulations. This historical background is supple-

mented by a discussion of the current legislative status of common

law employees and also proposed legislation that is currently being

considered by Congress.

Chapter III presents a more detailed outline of the research

methodology that was used. Chapter III also examines Research

Question I which outlines the selection of the variables used in

the study along with their operational definitions.

Chapter IV describes the discriminant, OLS regression, and

logit analyses that were used to model the courts' decision-making

behavior. The empirical results of each of the three techniques

are analyzed. The differences and similarities of the three

techniques are then evaluated.

Chapter V summarizes the preceding chapters. In addition,

implications of this study are discussed and recommendations for

future research are made.


ISmith, Independent Contractor or Employee?--That is the
Question, 33 N.Y.U. INSTITUTE ON FEDERAL TAXATION 578 (1975).



S. REP. No. 1255, 80th Cong., 2d Sess., p. 7 as cited
in M.F.A. Mutual Insurance Co. v. U.S., 314 F. Supp. 595 (W.D. Mo.

5National Labor Relations Board v. Hearst Publications,
322 U.S. 120,121 (1944).

See the list of cases in Marmoll, 391 TAX MNGM'T (BNA),
'EMPLOYEE' DEFINED, pp. c-6 thru c-10 (1979).

GENERAL ACCOUNTING OFFICE, supra note 3, at 13.

Id. at 23.

H.R. 3245, 96th Cong., 1st Sess., 125 CONG. REC. E 1342
(daily ed. March 27, 1979) (remarks of Rep. Gephardt).


1 Hearings on H.R. 3245 Before the Subcommittee on Select
Revenue Measures, 96th Cong., Ist Sess. 5 (1979) (statement of
Donald C. Lubick).
12 Section 3102(a).
13I.R.C. Section 3102(a).

14I.R.C. Section 3402(a).

15I.R.C. Section 3301.
16I.R.C. Section 6041(a).

I7.R.C. Section 1401.

18I.R.C. Section 6015.

I91.R.C. Sections 1401, 3101, and 3111.
I.R.C. Section 6205(a)(I) and Treas. Reg. Section 31.620
I.R.C. Section 6205(a)(1) and Treas. Reg. Section 31.620
22I.R.C. Section 6157(a).
2.R.C. Sections 6601,6651, and 6653.

2I.R.C. Section 3402(d).

I.R.C. Section 6521(a).

I.R.C. Section 7442 and Shaw v. U.S., 331 F. 2d. 493
(CA 9th 1964).
2See Marvel v. U.S., 548 F. 2d. 295 (10th Cir. 1977) as
cited in JOINT COMMITTEE ON TAXATION, supra note 2, at 8.



2North, The Employment Tax Morass, 11 CREIGHTON LAW REVIEW
797 (1978).
29I.R.C. Sections 6321, 6331, and 6862.

30JOINT COMMITTEE ON TAXATION, supra note 2, at 9.

311 F. Supp. 715 (W.D. Pa. 1970).

I3.R.C. Section 404(a)(5).

I.R.C. Section 106.
34I.R.C. Section 127.
35.R.C. Section 79.

I.R.C. Section 119.
37I.R.C. Sections 40, 50A and 50B.
38I.R.C. Section 51.

39Treas. Reg. Section 31.3121(d)-l(c)(3).

40Lexis computer data bank is simply a huge data base con-
sisting of several libraries, one of which is the Tax Library. In
this library, among other things, all reported cases since 1960
for the District Courts and all cases since 1942 for the Court of
Claims are stored in its memory. Through a determination of words
and phrases common to a selected subject, the researcher can obtain
a listing of all cases relevant to that issue. For the years not
contained in the Lexis system a manual search was performed to
identify the relevant cases.

4U.S. v. Silk, 331 U.S. 704 (1947) and Bartels v. Birm-
ingham, 332 U.S. 126 (1947).
4Marmoll, supra note 6.

ch. 4600, pp. 8463-1 thru 8463-5.

& M. Brown ed. 1979).
4Lachenbruch, On Expected Probabilities of Misclassifi-
cation in Discriminant Analysis, Necessary Sample Size and a Relation
with the Multiple Correlation Coefficients, 24 BIOMETRICS 823-834
M. Nerlove & M. Press, Univariate and Multivariate Log-linear


4BMDP, supra note 44, at 517.
4Chow, Tests of Equality between Sets of Coefficients
in Two Linear Regressions, 28 ECONOMETRICA 591 (1960).



Development of Legislative History

Social Security Act of 1935

With the devastating effects of the great depression on

unemployment, attention was keenly focused on establishing the

means by which such a calamity might be avoided in the future.1

On January 28, 1934, an Executive Order of the President of the

United States created the Committee on Economic Security.2 On

January 15, 1935, the Committee submitted its report which Congress
promptly used as the substance for the drafting of legislation.

The Social Security Act of 19354 came after long deliberation by

both the President and the Congress on "the evil of the burdens

that rest upon large numbers of our people because of the insecur-

ities of modern life, particularly old age and unemployment."5

The original Social Security Act included eleven "Titles." Of

principal concern for this study is Title VIII which created provi-

sions dealing with old age benefits, Title IX which created provi-

sions dealing with unemployment compensation, and Title XI which

provided the definitions to be used in the other ten Titles. The

principal solution adopted by Titles VIII and IX was to provide for

periodic payments similar to annuities to the elderly and to provide



for compensation to workers during sustained periods of unemployment.

The enactment of employment taxes was the method adopted by Congress

to fund payments to the elderly and the unemployed.

The primary purpose of this study is to determine the parties

to whom the employment taxes apply. Title VIII of the original

Social Security Act, provided for a tax on both the employee and

employer of percent of the employee's "wages." Wages were defined

in Section 811 of the Social Security Act as

. all remuneration for employment, including the cash
value of all remuneration paid in any medium other than
cash; except that such term shall not include that part of
the remuneration which, after remuneration equal to $3,000
has been paid to an individual by an employer with respect
to employment during any calendar year, is paid to such
individual by such employer with respect to employment
during such calendar year. (Emphasis added)

One of the key terms used in this definition of wages was "employ-

ment" and Section 811 defined employment as "any service, of what-

ever nature, performed within the United States by an employee or

his employer."

The unemployment provisions of Title IX basically provided for

an excise tax to be levied on employees of 1 percent of the employees'

wages if the employer had eight or more employees. The determination

of whether an individual qualifies as an employee is critical in the

application of the Title IX provisions. Title XI simply defines an

employee as "an officer of a corporation." The absence of an elab-

orate definition of employee in either title seems to imply a "will-

ingness of Congress to allow the courts to determine to whom the

statute should apply."6

Regulations were issued in 1936 by the Treasury that expanded

the employee definition for both the old-age and the unemployment

tax provisions. The Regulations provide in part that

. within the meaning of the Act, any person is an
employee if he is in the service of one or more employers
. for compensation. An individual is in the service
of an employer if he is subject to the continuing authority
of the employer to supervise and direct the manner in
which he renders services for compensation. 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.
The right of an employer to discharge an individual is
also an important factor indicating that the individual
is an employee. Other factors indicating that an indivi-
dual is an employee are the furnishing of tools and the
furnishing of a place to work by the employer to the
individual who performs the services. In general, if an
individual is subject to the control or direction of an
employer merely as to the result to be accomplished by
the work and not as to the means and methods for accom-
plishing the result, he is an independent contractor.
An individual performing services as an independent
contractor is not, as to such services, an employee
within the meaning of the Act.

A comparison of this Regulation to the "definition" found in leading

cases and legal authorities will disclose that the Regulation is

substantially a brief statement of the common law definition of

the master and servant relationship.

Common Law Definition of Master-Servant Relationship

Maitland provides the following as a reasonable definition of

the common law:

The Common Law (called also the unwritten law, or from
its mode of development, the customary law) embraces
those rules of civil conduct which originated in the
common wisdom and experience of society, became in time
established customs, and finally received judicial
sanction and affirmance in the decisions of the courts
of last resort.0

This system of common law was originally established through the

decisions reached by the English common law courts of Exchequer,

Common Pleas, and the King's Bench as early as the year 1300.11


What helped promote the advancement of the common law was the

increase in the recording of court decisions and the resulting

increased availability of admissible legal precedent.12 At first,

court proceedings were circulated primarily only to judges and
select lawyers.3 But as the availability of court decisions

became more widespread, citation of precedent also became more
prevalent by lawyers and more accepted by the courts. From

this beginning, "the common law system was refined, worker over,

modified, improved, and increased as the centuries passed until

there developed an entire body of law."15

Even though the acceptance of the English system of law by

the early American colonists was not immediate, the English system

eventually did triumph as the principal source of American law.1

With England's control over the original colonies, legal matters
generally dealt with England and the English system. This also

resulted in the training received by the early American lawyers to
be heavily concentrated in English law. In addition to England's

influence on the colonies, another significant reason for the accep-

tance of the English system was the fact that English was the primary

language of Americans and the majority of early legal writing was
done in English.9 For whatever reasons, the English system of law

(including its common law) was the basis of the early American system

of law.

The common law is a "comprehensive body of law" providing a

"comprehensive system of remedies."20 Contained within this broad

system of law is a body of case law and legal thought dealing with

the master and servant relationship. The determination of whether


or not a master-servant relationship existed was of primary impor-

tance under English common law in assessing the "liability of a

master for a tort committed by a servant who was acting within the

scope of his employment.21 The question of a master-servant rela-

tionship also has become important in cases involving workmen's

compensation, contracts, and of primary importance to this study,

the area of employment taxes.

The 1936 Treasury Regulations dealing with employment taxes

were promulgated pursuant to the common law definition of the

master-servant relationship as defined by the American judicial

system. An early example of the application of the common law

definition of the master-servant relationship was in an 1889

Supreme Court case dealing with whether a corporation which had

hired a commission salesman was liable for a negligent act of that
same salesman.22 The salesman was furnished with a wagon which

was to be used exclusively in canvassing for sales.23 The salesman

was convicted of driving the corporation's horse and wagon care-

lessly which resulted in personal injury to Katie Rohn as she
crossed a local street. The Supreme Court held that the salesman

was a servant of the corporation and that such corporation was
responsible for Katie Rohn's injuries.25 In arriving at this

decision, the Supreme Court cited Railroad Co. v. Hanning as

authority for the definition of a master-servant relationship

that follows:

S. the relation of master and servant exists when-
ever the employer retains the right to direct the manner
in which the business shall be done, as well as the
result to be accomplished, or, in other words, "not
only what shall be done, but how it shall be done."26

In a later case, the Supreme Court used this same definition

in a situation dealing specifically with employees and independent

contractors.27 In concluding that the workers involved in this

case were independent contractors, the Supreme Court held that the

parties had the "liberty of action which excludes the idea of that

control or right to control by the employer which characterizes

the relation of employer and employee and differentiates the

employee or servant from the independent contractor."28

From this evolution of the common law comes the concept of

the master-servant relationship that is contained in the two

Supreme Court decisions discussed previously. Even though the

term common law employee is not specifically mentioned in the

1936 employment tax Treasury Regulations, the definition attri-

buted to an employee by the Treasury Department is similar to that

espoused by the two decisions discussed above. These two decisions

are merely representative of many early decisions that use this

same common law definition.29 Consequently, at the very incep-

tion of the social security provisions, the notion of a common law

employee assumed a position of importance as far as determining

to whom the provisions applied.

Social Security Amendments of 1939

The social security provisions were re-examined four years

after the enactment of the original Social Security Act and prior

to the codification of the existing tax law into the 1939 Code.

The Social Security Board recommended that the coverage of the

social security provisions be expanded.30 Arthur J. Altmeyer.


Chairman of the Social Security Board, in hearings before the House

Ways and Means Committee recommended that the social security pro-


S. be expanded to the extent feasible to cover more
of the persons who furnish primarily personal service.
The intention of such an amendment would be to cover
persons who are for all practical purposes employees,
but whose legal status may not be that of an employee.

Using essentially the same language, the House adopted the

Board's recommendation for the old-age insurance portion of the

social security provisions.32 However, for some unexplained reason

the House failed to include this expanded definition for the unem-

ployment tax provisions.33 When the House proposal went to the

Senate Finance Committee, the expanded definition of employee was

deleted from the bill because it was "believed inexpedient to
change the existing law which limits coverage to employees."

Therefore, the employee definition that was codified in the 1939

Code was substantially unchanged from the original Social Security

Act of 1935. Title VIII was codified into the 1939 Code as Sec-

tions 1400 through 1432, referred to as the Federal Income Con-

tributions Act (FICA). The unemployment tax provisions were codi-

fied into the 1939 Code as Sections 1600 through 1611, referred

to as the Federal Unemployment Tax Act (FUTA). The 1939 FICA

Treasury Regulations were also substantially unchanged from the

language contained in the original 1936 employment tax Treasury


Income Tax Withholding Provisions

In 1942, in an attempt to raise additional funds to support the

war effort, Congress enacted what was known as the Victory Tax.38

This tax was a temporary income tax that was levied in addition to

the normal tax and surtax. The Victory tax amounted to 5 percent

of "Victory Tax net income," but was limited in as much as it could

not result in a total tax greater than "90 percent of the indivi-

dual net income."39

Because of the substantial tax rates that existed during World

War II, the Treasury suggested for the first time that income taxes

be withheld at the source.40 The Treasury recommended this pro-

cedure as a method of aiding taxpayers in meeting their tax payments

with a minimum strain.

Greater equity and fairness is gained for the great body
of income-tax payers by more uniform application of the
law, and the administrative problem of collection, espe-
cially in the case of taxpayers who move from one locality
to another, will be made easier.4

The House adopted the recommendation of the Treasury and intro-

duced legislation that would require withholding of income taxes at
the source on dividends, bond interest, and wages. As with the

FICA and FUTA provisions, the question of whether the withholding

requirements applied to a given individual had to be answered. The

House expressed the view that the common law rules which developed

largely in the field of tort law would be "unnecessarily restric-
tive if they stood alone as the tests for withholding tax purposes.

The definition of employee is accordingly drawn to cover
all common law servants, and in addition such other indi-
viduals performing services as are not in reality inde-
pendent businessmen or independent practitioners of a


profession, whether or not they are "independent contrac-
tors" at common law. Thus under this definition an indi-
vidual may be an employee even though he is not subject
to control."4

The Senate for reasons of "simplicity" and "ease of administra-

tion" required that collection at the source of payment be limited

to salaries, wages and other forms of compensation for personal

services."45 The more surprising result, and of greater impor-

tance to the tracing of the common law definition of an employee,

was the fact that in the Conference Committee the scope of the

withholding provisions was limited to those individuals coming

under the common law definition of an employee.46

A year later, the definition of employee that became incor-

porated in the Victory Tax provisions was extended to the regular

income tax area by the Current Tax Payment Act of 1943.47 By so

doing, Congress expanded the application of the common law employee

definition from the social security tax area to the income tax

area while at the same time resisting pressure to expand the def-

inition of employee beyond that encompassed by the common law rules.

Therefore, it was not until 1947 and the introduction of the eco-

nomic reality test that the common law definition of employee was

again challenged.

Judicial Interpretation

Economic Reality Test. In 1947, the Supreme Court considered

three federal employment tax cases which gave rise to what has been

termed the "economic reality test.48 Of these three cases, the

Supreme Court decided both the Silk and Greyvan Lines cases together

on June 16, 1947.

The Albert Silk Coal Company was in the business of selling

coal at retail in the city of Topeka, Kansas. The question being

considered by the Supreme Court in this case was whether workmen

engaged in unloading railroad cars and truck drivers who made

retail deliveries of the coal were employees for purposes of the

employment tax provisions. The unloaders were paid an agreed

price per ton to unload coal from the railroad cars. The men

provided their own tools, worked when they desired, and were free

to work for other employers.49 When an unloader came to the yard

he was assigned a car to unload and told where it was to be unloaded.

Some of the unloaders were quite regular workers while others were

"floaters"and came to the yards only intermittently.50

Since Silk owned no trucks of his own, he contracted with

individuals who owned their own trucks to deliver the coal at an

agreed upon price per ton. The truckers were able to come and go

as they pleased, were able to haul for others if they desired,

paid all their own operating expenses, furnished their own helpers

when needed in delivering the coal, and were able to refuse to make
certain deliveries without suffering any penalties. The truckers

were not instructed in how to perform their services, but simply

were given a delivery ticket and told whether the purchase was cash
or charge.52 No record was kept of the truckdrivers' time and they

settled up with Silk Coal Company by the trip, by the day, or by

the week according to the truckdriver's wishes.

Greyvan Lines, Inc.,was a household-furniture trucker operating

in thirty-eight states and part of Canada.54 Similar to Silk, the

question that was decided by the Supreme Court was whether the

truckmen who hauled the household furniture were employees under

the employment tax provisions. These truckers were required to

furnish their own trucks, haul exclusively for Greyvan Lines, pro-

vide any assistants needed to deliver the furniture, pay all oper-

ating expenses, carry the specified insurance coverage, drive their

own trucks, and follow any regulations and instructions issued by

Greyvan Lines.55 These instructions covered directions as to where

and when to load and deliver the furniture. Compensation was deter-

mined on a commission basis with a bonus for successful completion

of a job.

The Supreme Court held that the unloaders in the Silk case

were employees.56 The Court explained its decision as follows:

(1) the tools the unloaders provided were only picks and shovels,

(2) they had no opportunity for gain or loss except through their

own manual labor, (3) the fact that many did not work regularly

was insignificant, and (4) since the unloaders did work in the

course of the employer's regular trade or business, they should

come under the employment tax provisions.5

On the other hand, the Supreme Court held that the truckers

in both cases were independent contractors. Even though on the

surface, the description of the relationship of the truckers to

their respective employers seemed quite different, the Supreme

Court's opinion did not distinguish between the two cases with

respect to the trucker's verdict. The Court indicated that even

though the Greyvan Line truckers hauled just for one firm. this


distinction was not controlling in the rendering of its decision.59

The Court held that the truckers were small businessmen who owned

their own trucks and that "it is the total situation, including

the risk undertaken, the control exercised, the opportunity for

profit, from sound management, that marks these driver-owners as

independent contractors.

The Silk and Greyvan decisions themselves are not the most

significant factors of these two cases. Despite the Congressional

mandate that the common law rules were to determine if the employ-

ment relationship existed in other than the statutorily defined

cases,61 the Supreme Court in Silk opted for an expanded defini-

tion of employee.

As the federal social security legislation is an attack
on recognized evils in our national economy, a con-
stricted interpretation of the phrasing by the courts
would not comport with its purpose. . Here the
District Courts and the Circuit Courts of Appeals deter-
mined the cages largely if not indeed exclusively by
applying the so-called "common law control" test as
the criterion. This was clearly wrong in view of the
Court's present ruling.62 (Emphasis added)

The Supreme Court in Silk also listed the following factors as

important in determining whether employment status actually is

present: (1) degree of control, (2) opportunities for profit or

loss, (3) investment in facilities, (4) permanency of relation,

and (5) skill required.63 With respect to these factors, the

Court states that "no one factoriess controlling nor is the list

complete."64 The Supreme Court's opinion definitely speaks of

the degree of control as simply one of several factors to be

applied and not as the overall test.

The Supreme Court upheld both the Silk and Greyvan Lines

opinions a week later in another employment status case, Bartels

v. Birmingham.65 This case deals with orchestras hired to play

for limited engagements; usually one-night stands. The question

being decided by the Supreme Court in this case is whether the

band leaders and other members of the band were the employees of

the dance establishments.

These bands are "built around a leader whose name, and

distinctive style in the presentation and rendition of dance

music, is intended to give each band a marked individuality."66

The leader hires and fires the musicians, fixes their salaries,

tells them what and how to play, and pays all of their transpor-
station and operating expenses. It is also the band leader who

contracts with the dance establishments to play at a specified

The Supreme Court held that the band leaders were the employers

of the individual musicians and in turn the band leaders were

independent contractors with respect to the dance establishments.69

In explaining its opinion, the Supreme Court stated that a band

leader organizes and trains the band, selects the members, and

bears the risk of losses that might occur.70 The relationship

between the band leader and his orchestra is relatively permanent,

while the relationship between the band and the dance establish-

ments is only temporary.7

In issuing the Bartels opinion, the Supreme Court cited the

Silks case and restated the notion that the common law employee

definition for employment tax purposes was "not to be determined

solely by the idea of control which an alleged employer may or

could exercise over the details of the service rendered to his
business by the worker or workers.72 The Court goes on to suggest

that determination of an employer-employee relationship is a matter

of "economic reality."73 Again, the Supreme Court was emphasizing

that it is the total situation that controls, not simply the

the common law control test.

These three 1947 cases were not the first instancesin which

the economic reality test was espoused by the Supreme Court.

Before the test was introduced into the employment tax area, the

Supreme Court had already applied the economic reality doctrine
in National Labor Relations Board v. Hearst Publications. In

Hearst Publications, the Supreme Court held that newsboys were

employees under the National Labor Relations Act.7 In interpreting

the Act, the court stated that "Congress had in mind a wider field

than the narrow technical legal relation of master and servant"

and because of the broad language in the Act's definitions, there

is "no doubt that its applicability is to be determined broadly,

in doubtful situations, by underlying economic facts rather than

technically and exclusively by previously established legal classi-

fications."76 After the economic reality test was introduced in

the labor relations area, the Supreme Court held in the Silk case

that "application of the social security legislation should follow

the same rules that we applied to the National Labor Relations
Act in the Hearst case. This then completes a brief history

of the advent of the economic reality test and its integration

into the federal employment tax area.

Status Quo Amendment. With the success of the Supreme Court

in altering the common law employee definition first in the labor

relations area and then in the federal employment tax area, the

Treasury Department quickly attempted to alter its employee defi-

nition by issuing Proposed Regulations in 1947.78 These Regula-

tions attempted to substitute the economic reality test for the

common law control test in determining employment status for FICA

and FUTA purposes.79 These Regulations would have reduced the

"right to control the performance of services by an individual"

to simply one of several factors that should be examined in deter-

mining employment status instead of the overall test as envisioned

by Congress in the original enactment of the social security pro-


Congress viewed the Proposed Regulations as an attempt by the

Treasury Department to usurp the authority of Congress in making

The issue involved in the proposed regulations is whether
the scope of social-security coverage should be deter-
mined by Congress or by other branches of the Government
. accordingly, under the proposed regulations, the
question of coverage will be determined, not by Congress,
but by the Social Security Agency, the Treasury, and the

By joint resolution, Congress responded to the Proposed Regulations

by passing legislation that would maintain the "status quo" of the

current statutes and regulations and reaffirm the legislative intent

of the original Social Security Act of 1935. The intent was that

the usual common law rules, realistically applied, would continue

to be used to determine employment status for social security pur-

poses.83 The accompanying Senate Report stated emphatically that

the "end point determination" is whether there is an absence or

existence of control and that whatever factors are pertinent to

this determination should be used.84 But the final determination

is whether or not control actually exists.

To further emphasize their desire to have the common law

control test be the primary test of employment status, Congress

added the following language to the FICA and FUTA provisions:

. such term does not include (1) any individual who,
under the usual common law rules applicable in determining
the employer-employee relationship, has the status of an
independent contractor or (2) any individual (except an
officer of a corporation) who is not an employee under
such common law rules.

This is the first time that the common law definition of employee

was officially included in the statute. Previously, support for

its application had been obtained either from legislative history

of the social security provisions or the employment tax Treasury


Social Security Amendments of 1950

Congressional support for the Status Quo Amendment was strong

enough that it was passed over the veto of President Truman.86

Representative Gearhart explained the actions of Congress as


If this Congress had not interfered, tens of thousands
of people in America who never dreamed they were employed
by anybody and never for one moment thought they were
covered by social security or subject to payroll taxes
would have found that they had been swept into the social
security system by bureaucratic ukase. In other words,
they would suddenly have found that they had more employers
than a dog has fleas. So, to end this confusion, Congress
acted promptly and, after thorough-going debate, by a

vote of nearly 7 to 1, proceeded by legislation to put
the matter in order once again by restoring the ancient
doctrine of the common law defining the relation of
master and servant, employer and employee.87

Despite this strong Congressional reaction to the Treasury's

Proposed Regulations, in the very next Congressional session the

Social Security Administration recommended the repeal of the Status
Quo Amendment and enactment of the economic reality test.8 The

House adopted the proposal and passed H.R. 6000 which would have

incorporated the economic reality test as a general definition of
an employee for social security purposes.8 Also the bill stat-

utorily determined that the following seven occupational groups

would be classified as employees for the withholding and payment

of social security taxes: (1) an outside salesman in the manufac-

turing or wholesale trade, (2) a full-time life insurance salesman,

(3) a driver-lessee or a taxicab, (4) a home worker, (5) a contract

logger, (6) a mining lessee or licensee, and (7) a house-to-house


The Senate did not accept H.R. 6000 as it was passed by the

House. Instead, the Senate deleted the economic reality test,

reaffirmed the common law definition of employee, and reduced the

number of occupational categories to certain agent or commission

drivers and full-time insurance salesmen.9 Therefore, the economic

reality test was again specifically rejected by Congress for use in

resolving the employment status question. For FICA purposes, the
same definition of employee that was enacted in 19502 has not

been substantially changed to date. In the next section of this

chapter, this definition is reproduced in its full text as Section

3121(d) of the Internal Revenue Code of 1954.


Before analyzing the current legislative status of the common

law definition of employee, it is appropriate to consider another

relevant piece of legislation that was introduced by the Social

Security Amendments of 1950. To this point, this entire histor-

ical background discussion has been concerned with the FICA and

FUTA provisions as they relate to the overall social security package

adopted by Congress. No mention has been made of the status of

the self-employed worker who did not come under the social security

provisions discussed thus far. Another significant aspect of the

1950 amendments was the extension of the social security provisions

to self-employed individuals.93

The self-employment tax provisions were codified in the 1939

Code as Sections 480-482. Section 482(b) states that subchapter

E (which contains Section 480-482)may be cited as the Self Employ-

ment Contributions Act (SECA). The original SECA provisions pro-

vided for a tax on "self-employment income."95 Self-employment

income was defined as "net earnings from self-employment derived

by an individual" except (1) those net earnings from self-employment

that are less than $400 and (2) those net earnings from self-

employment in excess of $3,600 (which first had to be reduced by

any wages received that had been subjected to the FICA taxes under

Section 1426(b) of the 1939 Code).96

The term "nct earnings from self-employment" were defined as

the "gross income derived by an individual from any trade or busi-

ness carried on by such individual," less certain deductions.97

The term trade or business was defined to have the same meaning

as it did in Section 23 of the 1939 Code which dealt with the


ordinary and necessary expenses incurred in connection with a trade

or business that could be deducted in arriving at net income.98

Section 481(c) contained an except clause that applied to the

Section 23 definition of a trade or business which resulted in

the exempting of certain activities from the self-employment tax.

The most important 481(c) exception for this study was the "per-

formance of services by an individual as an employee.99 Section

481(d) referred to the FICA provisions to define the term employee.

The FICA definition of employee, as has been discussed in considerable

detail, means a common law employee. With this link to the FICA

provisions, Congress had effectively extended the coverage of the

social security provisions beyond merely employees and provided the

means by which self-employed persons would now be subject to employ-

ment taxes.

Sections 1401-1403 are the 1954 Code counterparts of Sections

481-483 of the 1939 Code. In substance, the self-employment tax

provisions have been altered slightly in the past 30 years, but

essentially their import is the same.00 The most salient aspect

of the SECA provisions for this study is that because of their

construction, they provide a clear distinction between how an

employee and and independent contractor will be treated for employ-
ment tax purposes. It is this distinction that has contributed

to the increased importance of being able to determine when a

common law employer-employee relationship actually exists.

Current Legislative Status

For FICA purposes, the Internal Revenue Code of 1954 defines

an employee substantially as it was defined after the 1950 amend-

ments. Section 3121(d) defines an employee for FICA purposes as:

(1) any officer of a corporation; or
(2) any individual who, under the usual common law
rules applicable in determining the employer-employee rela-
tionship, has the status of an employee; or
(3) any individual (other than an individual who is an
employee under paragraph (I) or (2)) who performs services for
renumeration for any person--
(A) as an agent-driver or commission-driver engaged
in distributing meat products, vegetable products, bakery
products, beverages (other than milk), or laundry or dry-
cleaning services, for his principal;
(B) as a full-time life insurance salesman;
(C) as a home worker performing work, according to
specifications furnished by the person for whom the services
are performed, on materials or goods furnished by such a person
which are required to be returned to such person or a person
designated by him; or
(D) as a traveling or city salesman, other than as
an agent-driver, engaged upon a full-time basis in the
solcitation on behalf of, and the transmission to, his
principal (except for side-line sales activities on
behalf of some other person) of orders from wholesalers,
retailers, contractors, or operators of hotels, restaurants,
or other similar establishments for merchandise for
resale or supplies for use in their business operations;
if the contract of service contemplated that substantially all
of such services are to be performed personally by such in-
dividual; except that an individual shall.not be included in
the term "employee" under the provisions of this paragraph if
such individual has a substantial investment in facilities
used in connection with the performance of such services
(other than in facilities for transportation), or if the
services are in the nature of a single transaction not part of
a continuing relationship with the person for whom the services
are performed. (Emphasis added)

It is Section 3121(d)(2) dealing with common law employees

that is of principal interest in this study. A common law employee

is one of the classes of employees that is subject to the FICA

withholding and payment requirements. However, all six categories

of employees defined in paragraph (d) are subject to the if clause

that follows the Section 3121(d)(3)(D) definition of a traveling or

city salesman. Ignoring the language not pertinent to this study,

paragraph (d) could be paraphrased as follows: an individual is

treated as an employee- for the FICA provisions if he is considered

an employee under the usual common law rules applicable in determining

the employer-employee relationship if the contract of service

contemplates that all the services would be performed personally

by the common law employee in question; except if such common law

employee has a substantial investment in facilities used in con-

nection with the performance of such services or if the services

are in the nature of a single transaction and not part of a con-

tinuing relationship with the person for whom the services are


This interpretation of the statute would mean that a common

law employee is subject to the FICA withholding and payment re-

quirements only if he satisfies the "if clause" discussed above and

also does not come within either of the situations described in the

"except clause." Even though personal performance of the services,

substantial investment, and a continuing relationship are all

factors that are considered in applying the usual common law

definition of employee, this statutory construction places these

three factors as additional requirements that must be satisfied

before an adjudged common law employee can be subjected to the FICA


In the 139 cases included in this study, the argument never

was presented to the courts that a common law employee should be

excepted from the FICA withholding and payment requirements due to

the statutory exceptions contained in paragraph (d) of Section

3121. Marmoll concludes that "there has been a tendency in the

authorities to de-emphasize--primarily through silence--the statu-

tory exceptions set forth in Section 3121(d)."I02 Additional dis-

cussion is devoted to these statutory exceptions in Chapter III

when the factors are defined that are used in building the mathe-

matical models developed in this study. The additional discussion

in Chapter III is included in the definitions of factor 3 (right

to delegate) and factor 4 (continuing relationship).

Treasury Regulation Section 31.3121(d)-l(c) further elaborates

on the term common law employee for FICA purposes.

(c) Common law employees. (I) Every individual is an
employee if under the usual common law rules the relationship
between him and the person for whom he performs services
is the legal relationship of employer and employee.
(2) Generally such relationship exists when the person
for whom services are performed has 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 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 he has the right to do so.
The right to discharge is also an important factor indicating
that the person possessing that right is an employer. Other
factors characteristic of an employer, but not necessarily
present in every case, are the furnishing of tools and the
furnishing of a place to work, to the individual who performs
the services. In general, if an individual is subject to the
control or direction of another merely as to the result to be
accomplished by the work and not as to the means and methods
for accomplishing the result, he is an independent contractor.
An individual performing services as an independent contractor
is not as to such services an employee under the usual common
law rules. Individuals such as physicians, lawyers, dentists,
veterinarians, construction contractors, public stenographers,
and auctioneers, engaged in the pursuit of an independent
trade, business, or profession, in which they offer their
services to the public, are independent contractors and not

(3) Whether the relationship of employer and employee
exists under the usual common law rules will in doubtful cases
be determined upon an examination of the particular facts of
each case. (Emphasis added)

The FICA Regulation pertaining to the common law definition of

an employee states that an individual is an employee for FICA

purposes if a legal relationship of employer and employee exists

under the usual common law rules. The legal relationship of employer

and employee generally exists when the following factors are pre-

sent: (1) the right to control and direct the individual who

performs the services, (2) the right to discharge, and (3) the

furnishing of tools and a place to work by the employer.

Treasury Regulation Section 31.3121(d)-l(c) further states

that an individual performing services as an independent contractor

is not considered a common law employee. Instead of defining

factors that are characteristic of an independent contractor, the

Regulation simply gives examples of several professions that are

in the pursuit of an independent trade and who offer their services

to the public; such as, lawyers, physicians, dentists, etc. Finally,

the Regulation states that determining an employer-employee rela-

tionship under the usual common law rules is a question of fact

and must be determined for each case individually.

While Section 3121(d) and its corresponding Treasury Regulation

provide some elaboration on the definition of a common law employee

for FICA purposes, the incompleteness of the statutory authority is

evident by the substantial amount of litigation in this area.103

It has been left largely to the courts to determine when a common

law employer-employee relationship exists within the broad guidelines

contained in Section 3121(d) and Treasury Regulation Section 31.3121


For FUTA purposes, Section 3306(i) states that "the term

employee has the meaning assigned to it by Section 3121(d), except

that subparagraphs (B) and (C) of paragraph (3) shall not apply."

This means that with the exception of certain types of home workers

and full-time insurance sales persons, the FICA and FUTA definition

of employees are identical.

For the withholding of income taxes, Section 3401(c) simply


For purposes of this chapter, the term "employee" includes
an officer, employee, or elected official of the United
States, a State, or any political subdivision thereof,
or the District of Columbia, or any agency or instru-
mentality of any one or more of the foregoing. The term
"employee" also includes an officer of a corporation.

The Treasury Regulations for Section 3306(i) and 3401(c) are

substantially the same as the FICA Regulations already reproduced

above and consequently need not be included. So even though

Section 3401(c) does not mention common law employee specifically,

the Section 3401 regulation that defines employee is synonomous

with the other regulations that do define a common law employee

for FICA purposes.

While "employee" has not been defined for income tax
withholding purposes as any particular type of "employee,"
the authorities have merely assumed, sub silentio in
most cases, that the word "employee" as used in the income
tax withholding statutes means "common law employee".
Because of this historical treatment of the income tax
withholding provisions and, further, because the statu-
tory scheme would seem to support such an inference, it
may be inferred that an "employee" for income tax with-
holding purposes means a "common law employ e", as that
phrase is defined in the FICA regulations.'0

Consequently, under the current employment tax provisions,

when a taxpayer, an administrator, or a court is trying to determine

if an employer-employee relationship actually exists, unless

specifically exempted by the statutes, such a determination must

be decided under the common law rules. In litigation, the court

generally consolidates the FICA, FUTA, and income tax withholding

issues into one question and that is whether or not the worker is

an employee of the plaintiff under the common law rules (Treas.

Reg. Section 31.3121(d)-(1)(c)(3)).

Revenue Act of 1978

With the increased enforcement of the employment tax laws

by the IRS, many taxpayers have complained that proposed reclas-

sifications of their workers represent a change in the IRS's
position.05 Some taxpayers have relied on private letter rulings,

technical advice memoranda, and results of prior audits for deter-

mining employment status but nevertheless have found themselves the

subjects of reclassifications by the Service.06 Congress found

it appropriate to provide interim relief to taxpayers involved in

employment tax status conflicts with the IRS until it had adequate
time to resolve the issue. As a result, Section 530 of the

Revenue Act of 1978 was enacted to provide relief for the 1979
tax year. Congress was unable to resolve the employment tax

status issue during 1979, so H.R. 5505 extended the relief pro-
visions of Section 530 until the end of 1980.1

In general, Section 530 accomplishes two primary objectives.

First, Section 530(a)(1) provides that if the taxpayer did not

treat an individual as an employee for any period ending before

January 1, 1980, and all necessary Federal tax returns were cor-

rectly filed in 1979, then the individual will not be treated as

an employee unless there is no reasonable basis for such treatment.

Section 530(a)(2) stipulates that a reasonable basis exists for not

treating a worker as an employee regardless of the circumstances

if the taxpayer has relied on any of the following:

(1) judicial precedent, published rulings, technical
advice with respect to the taxpayer, or a letter
ruling to the taxpayer,

(2) a past Internal Revenue Service audit of the tax-
payer in which there was no assessment attributable
to the treatment (for employment tax purposes)
of the individuals holding positions substantially
similar to the position held by this individual, or

(3) long-standing the recognized practice of a signifi-
cant segment of the industry in which such individual
was engaged.

Second, Section 530(b) prohibits the Treasury Department from

publishing any Regulation or Revenue Ruling after the enactment of

the Revenue Act of 1978 (November 6, 1978) dealing with the employ-

ment status of any individual for purposes of employment taxes.

With the interim relief provided by Section 530 (and extended

by H.R. 5505), Congress has had time to consider many suggestions

as to the remedies for the complex issues that beset the employment

tax area. The next section of this study will briefly introduce

the principal recommendations that have been presented to Congress.

Current Proposed Solutions

General Accounting Office

The General Accounting Office (GAO), at the request of the Joint

Committee on Taxation, conducted a study of the problems with ad-

ministration of the social security tax and the definition of a

common law employee.0 In reviewing the problem of classification

of workers as employees or independent contractors, the GAO con-

cluded that the principal problem involved uncertainty in the

application of the common law control rules. Numerous examples

were discovered where the IRS is inconsistently applying the common

law rules in different geographical areas.ll The GAO report

states that the "major cause of the employee/self-employed contro-

versy involves those cases in which the reclassified workers operate

a business separate from the one that the IRS considers to be the


The primary recommendation of the GAO is that a clear cut test

needs to be devised to introduce a greater degree of certainty

into the employment tax area for both the taxpayer and the IRS.

The approach taken by the GAO is to use four basic tests in deter-

mining whether a true separate business entity actually exists.

If a worker can satisfy the following four tests, the IRS will

be prohibited from reclassifying the worker as an employee. The

individual must:

(1) Have a principal place of business other than that
furnished by the person or persons for whom he or
she performs or furnishes services;

(2) Maintain a separate set of books and records that
reflect all items of income and expense of his or
her trade or business;

(3) Bear the risk of suffering a loss and the oppor-
tunity of making a profit; and

(4) Hold himself or herself out in his or her own name
as self-employed and/or makes his or her services
generally available to the public.

The report argues that the four tests are "more precise, easier to

understand, and can be applied more accurately and consistently

than the common law rules."3 However, failure to meet all four

criteria will not result in automatic employee status. Instead,

if the worker satisfies three of the four criteria this will still

be a possible indication of self-employment and such a situation

will revert to the regular common law rules. If only two of the

four criteria are satisfied, then the worker will be presumed to

be an employee. The GAO concludes that the number of cases that

will require litigation to determine common law employee status will

be greatly reduced by this type of an approach.

In addition to the tests, the GAO proposal prohibits retro-

active determinations (in absence of fraud) if a business (1) obtains

annually from the individual whom the business classifies as self-

employed a signed certificate stating that the individual meets

all the separate business entity tests, and (2) annually provides

the IRS with the name and employer identification number or social

security number of each such certificate signer. To increase the

effectiveness of these criteria the report also proposes that the

taxpayer should sign the certificate under penalty of perjury.

Another problem perceived in the GAO study is the problem of

double collection of taxes on the same income as mentioned in the

introduction of this study. The GAO report proposes that the IRS

amend Section 6521 to allow an offset against the employees' por-

tion of the FICA tax by the appropriate portion of the SECA tax

already paid by the worker.114

H.R. 3245; Safe Harbor Remedy

A similar approach to the GAO proposal was introduced by
Representative Gephardt on March 27, 1979, as H.R. 3245. The

overriding purpose of this bill is to preserve the independent


contractor status of workers in industries that have traditionally

enjoyed such status and are currently being reclassified by the
IRS. This bill, like the GAO proposal, does not replace the

common law rules. Those workers who can not satisfy the five

"safe harbor" criteria for independent contractor status will

then come under the common law rules.

The five safe harbor rules are similar to several of those

proposed by the GAO.

(1) An independent contractor must control the hours he
works. This rule implies a two pronged test. The
worker must control not only the aggregate number of
hours actually worked, but he also must control
substantially all the scheduling of the hours worked.

(2) Independent contractors provide their own place of
business. Renting from the person for whom the
worker provides services would not be prohibited
as long as the rent is reasonable.

(3) An independent contractor experiences investment
or income fluctuations. His compensation is neither
fixed nor guaranteed. Substantial investments
in assets introduce the risk of business failure
and again this is a characteristic of self-employment.

(4) The worker, as an independent contractor, must
perform services pursuant to a written contract
that spell out the employment status and the tax
consequences that result. This test is fairly
mechanical, but it alerts both parties to their
relationship for both business and tax purposes.

(5) The person for whom the services are provided must
file the required tax returns. The worker must re-
ceive the necessary information to file his tax
returns and the IRS must receive the necessary
information to permit collection of the taxes due.

The satisfaction of the five safe-harbor criteria by a worker

would result in automatic independent contractor status. If the

criteria could not be satisfied then the worker would fall under the

usual common law rules. This notion is corroborated by Rep. Gcphardt

in the following summary of the purpose and application of H.R.


This bill creates a statutory scheme that promises to
end the confusion and uncertainty created by IRS enforce-
ment practices that have characterized employment tax
status determinations for nearly a decade. It is re-
cognized, however, that the tests cannot govern all
cases. Therefore, if any one of the tests is not met,
the common law test will be applied to determine the
worker's status as an independent contractor or an
employee. 117

Department of the Treasury

The Treasury's principal arguments against the GAO and

Gephardt proposals are that

(1) the taxpayer will be able to manipulate the tests
simply by changing the form of the business relation-
ship without changing the substance,

(2) the tests are unclear and difficult to administer,

(3) the proposals would continue the need for the use
of the common law rules in many situations, and

(4) the Service does not feel that the proposals will
deter the large number of independent contractors
who willfully fail to comply with the employment tax
provisions. 118

However, the solutions offered by the Treasury take an entirely

different approach to the situation because they view the primary
problem as one of noncompliance.9 This assessment of the problem

is largely due to a recent study conducted by the IRS where they

concluded that 47 percent of the workers treated as independent

contractors failed to declare any of their compensation for income
tax purposes and 62 percent paid none of the social security tax due.

Since the Treasury considers noncompliance of independent

contractors as the most serious problem, their solutions have nothing

to do with the definitional aspects of the common law rules.

Instead, the Treasury supports a flat 10 percent withholding on

compensation paid to independent contractors. This aids in the

collection process for the IRS and also provides more information

with which they can monitor independent contractors and the taxes

they should be paying. In addition to the 10 percent withholding,

the Treasury Department has proposed that instead of a one dollar

penalty per information return not filed (with a maximum penalty

of $1,00), that the penalty should be increased to 5 percent of

payments not reported (with a $50 minimum penalty).121

An interesting note to the Treasury proposal is that the

taxpayer who is paying a worker must still determine if he is an

employee and subject to the graduated withholding requirements

or if he is an independent contractor and subject to the flat

10 percent withholding requirements. The issue of noncompliance

is obviously an important concern, but the fundamental problem that

still remains is the need to differentiate between an independent

contractor and an employee.

H.R. 5460

The fact that both noncompliance and the lack of certainty

with the employee definition are important problems is manifest

in the compromise bill, H.R. 5460, that was submitted to the
House Ways and Means Committee shortly before the end of 1979.1

Briefly, the compromise bill incorporated the five safe harbor

criteria that are contained in H.R. 3245 and the flat 10 percent

withholding from compensation paid to independent contractors

as proposed by the IRS. The only exceptions to the 10 percent

withholding requirements are that no withholding need occur from

a person who (1) performs similar services for five or more

unrelated service-recipients; or (2) certifies that withholding

would be excessive; or (3) makes direct sales for a supplier who

provides no renumeration other than a volume sales bonus.123

Therefore, unless a person qualifies under one of the above excep-

tions, regardless of a person's employment status some sort of

withholding will be applied to any compensation received. Until

this or similar legislation is enacted, the relief provisions of

Section 530 of the Revenue Act of 1978 will continue to be in force

awaiting Congressional enactment of permanent legislation in the

employment tax area.





4Social Security Act of 1935, ch. 531, 49 Stat. 620 (1935).

5U.S. v. Silk, 67 S.Ct. 1463 (1947).

R. COMPTON, supra note 3, at 129.

7Who Are Employees, Title 26 C.F.R. Sec 401.3 (1939) and
Employed Individuals, Title C.F.R. Sec. 400.205 (1939).


9R. COMPTON, supra note 3, at 130.

213 (1915).

C. KINNANE, ANGLO-AMERICAN LAW 284 (2nd edition, 1952).

I2d. at 281.



1Id. at 471.
1 Id.



20Id. at 281.

p. 528 (1911).

22Singer Manufacturing Co. v. Rohn, 132 U.S. 518 (1899).

Id. at 521.

24Id at 518.

2d. at 524.

2615 Wall. 649, 656 as cited in Singer Manufacturing Co.,
supra note 22, at 523.

27Metcalf & Eddy v. Mitchell, 269 U.S. 514 (1925).

2Id. at 521.

See fn. 18 in J. HUGHES, supra note 1, at 48.

30Hearings Relative to the Social Security Act Amendments of
1939 Before the Committee on Ways and Means, 76th Cong., 1st Sess.
8, 11 (1939) (statement of Arthur J. Altmeyer).

2SH.R. NO. 728, 76th Cong., 1st Sess. 61-62 (1939).

33Id. at 74.

34S.REP. NO. 734, 76th Cong., st Sess. 75 (1939).
S.REP. NO. 734, 76th Cong., Ist Sess. 75 (1939).

3Sections 1400-1432 (Subchapter A), Chapter 9, Internal Revenue
Code of 1939.
3Sections 1600-1611 (Subchapter C), Chapter 9, Internal Revenue
Code of 1939.

37Smith, Independent Contractor or Employee?--That is the Ques-

38S.REP. NO. 1631, 77th Cong., 2d Sess. (1942).

I3d. at 8.

40Hearings on Revenue Revision of 1942 Before the Committee on
Ways and Means, 77th Cong., 2d Sess. 81 (1942) (statement of Randolph

41H.R. NO. 2333, 77th Cong., 2d Sess. 14-15 (1942).
Id. at 125.
43Id. at 127.

44Id. at 127-128.

45S.REP. NO. 1631, supra note II, at 165.

46H.R. NO. 2586, 77th Cong., 2d Sess. 56 (1942).

47H.R. NO 510, 78th Cong., Ist Sess. 30 (1943); Current Tax
Payment Act of 1943, ch. 120, par. 2, 57 Stat. 126 (1943).

4U.S. v. Silk, 67 S.Ct. 1463 (1947); Harrison v. Greyvan
Lines, Inc., 67 S.Ct. 1463 (1947); and Bartels v. Birmingham,
67 S.Ct. 1547 (1947).

49U.S. v. Silk, supra note 5, at 1465.






Id. at 1466.

56Id. at 1470


5Id. at 1471.



See previous discussion dealing with the Social Security
Act Amendments of 1939 and the introduction to the income tax
withholding provisions.

62U.S. v. Silk, supra note 5, at 1467,1472.

63d. at 1469.


667 S.Ct. 1547 (1947).

66Id. at 1548.

Id. at 1551.



72d. at 1550.


74322 U.S. Ill (1944).


76Id. at 124,129.

7U.S. v. Silk, supra note 5, at 1468.
712 Fed. Reg. 7966-69 (1947) as cited in Smith, supra note
37, at 584.



8H.R. NO. 1319, 80th Cong., 2d Sess. 3 (1948).

82Id. at 304.

83Act of June 1, 1948, Pub. L. No. 80-642, ch. 469, 62 Stat.

84S.REP. NO. 1255, 80th Cong., 2d. Sess. 11 (1948).

85Act of June 1, 1948, supra note 83, at 438.

86North, The Employment Tax Morass, 11 CREIGHTON LAW REVIEW
784 (1978).

87See fn. 2 in Bonney Motor Express v. U.S., 10 AFTR 2d 5233
(E.D. Va. 1962).

88Hearings on H.R. 2893 Before the Committee on Ways and
Means, 81st Cong., Ist Sess. 1087-1088 (1949).

8H.R. NO. 1300, 81st Cong., Ist Sess. 14-15 (1949).

Id. at 81.

91S.REP. NO. 1669. 81st Cong., 2d Sess. 95-97 (1950).

92Social Security Act Amendments of 1950, Pub. L. No. 81-734,
ch. 809, Sections 104(a) and 205(a), 64 Stat. 500,536 (1950).

93Id., Sections 211-213, at 502.

9426 U.S.C. Sections 480-482, pp. 3556-3558 (1952).

95Id., Section 480, at 3557.

961d., Section 481(b), at 3557-3558.

97Id., Section 481(c), at 3558.

981d., Section 23(a)(1)(A), at 3295.

99Id., Section 481(c)(3), at 3558.

100Compare the language of Sections 1401-1403 of the 1954
Code with Sections 480-482 of the 1939 Code.
1010utside of the employment tax area, the notion of employee
can become equally confusing. For example, the benefits of deferred
taxation of income were extended to self-employed individuals
through the Keogh or H.R. 10 plans. For purposes of qualified
pension, profit-sharing, or stock bonus plans, a shareholder-
employee of a Subchapter-S corporation is interestingly not treated
as an employee, but rather is subject to the limitations imposed
on the self-employed retirement plans Section 401(a)(17) On
the other hand, partners who are treated as self-employed persons
for purposes of retirement benefits may be treated as employees
for purposes of Section 119 (exclusion from gross income for meals

and lodging provided to an employee for the convenience of the
employer) according to Armstrong v. Phinney, 394 F. 2d 661
(5th Cir. 1968).

02Marmoll, 'Employee Defined', TAX MNGM'T (BNA) No. 391,
p. A-3 (1979).
0For an example of the numerous cases litigated in this
area see Marmoll, supra note 102, at C-6 through C-10.
0Marmoll, supra note 102, at A-5.

5S.REP. NO. 1263, 95th Cong., 2d Sess. 210 (1978).


S.REP. NO. 1263, supra note 105.

0Revenue Act of 1978, Pub. L. No. 95-600, Sec. 530, 92
Stat. 2885 (1978).
0Act of December 29, 1979, Pub. L. No. 96-167, 93 Stat.


IIId. at 9.
1Id. at 19.

SId. at 21.

4Id. at 45.

15H.R. NO. 3245, 96th Cong., 1st Sess., 125 CONG. REC. E1342
(daily ed. March 27, 1979) (remarks of Rep. Gephardt).
1125 CONG. REC. H2140 (daily ed. April 9, 1979) (remarks
of Rep. Gephardt).

117Id. at H2142.

Hearings on H.R. NO. 3245 Before the Subcommittee on Select
Revenue Measures, 96th Cong., Ist Sess. 5 (1979) (statement of
Donald Lubick).

19Id. at 7.

10d. at 14.


Id. at 12.

H.R. NO. 5460, 96th Cong., Ist Sess., 125 CONG. REC. H8769
(daily ed. September 28, 1979) (remarks of Rep. Rostenkowski).
23Id. at H8774.



Research Question 1

Variable Identification

The purpose of Research Question 1 is to identify those factors

or variables that are relevant in determining whether or not a

worker is a common law employee. Once these factors are identified,

the court cases can be examined to determine which factors were

mentioned by judges in their written opinions. These data will then

be used to build the models needed to answer the remaining three

research questions.

The first source of relevant factors was contributed by the

appropriate statutory authority. To supplement the limited

statutory guidelines a literature review was conducted. The most

significant work in the common law employee area as far as identify-

ing relevant definitional factors was a BNA Tax Management port-

folio.2 The Tax Management portfolio heavily cited both the IRS

audit manual3 and the Restatement of Agency (hereinafter referred

to as the Restatement). Consequently, these two sources were

studied in detail and are relied on heavily in the subsequent ex-

planation and definition of the variables.


Operational Definition of Variables.

The following is a list of the variables that were obtained

from the above mentioned sources. Each of these eleven variables

is discussed in detail in the pages that follow.

1. Supervision.

2. Integration.

3. Right to delegate.

4. Continuing relationship.

5. Set hours of work.

6. Having control over the place of work.

7. Independent trade.

8. Method of payment.

9. Payment of business and/or travel expenses.

10. Furnishing of tools and materials.

11. Realization of profit or loss.

1. Supervision. Supervision as defined in this study,

centers on the ability of a would be employer to control "how"

a worker accomplishes his assignment. Even though it does not use

the term supervision, Treasury Regulation Section 31.3121(d)-l(c)(2)

states that a common law employee relationship generally "exists

when the person for whom services are performed has 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"

(Emphasis added).

The IRS audit manual discusses supervision in terms of three

separate criteria. The first criterion is referred to as

instructions and is defined as--

A person who is required to comply with instructions
about when, where, and how he is to work is ordinarily
an employee. Some employees may work without receiving
instructions because they are highly proficient and
conscientious workers. The instructions which show how
to reach the desired result may be oral or written.5

The IRS definition of instructions closely parallels the earlier

definition of supervision taken from the Treasury Regulations. Both

sources refer to the notion that an employer is concerned with

more than simply the end results of a job. Instead,an employer

generally desires to control how the job is to be performed. The

IRS definition also relates the need for supervision to the amount

of skill the worker possesses. This same point is made in Ben v. U.S.6

where the District Court stated that "the element of freedom from

control in the manner of the performance of the work, emphasized

in some decisions, loses much of the significance when the skill

of the worker is relied upon in the accomplishment of the par-

ticular task."

The second criterion is referred to by the IRS as training and

is defined as--

Training a person by an experienced employee working with
him, by correspondence, by required attendance at meet-
ings, and by other methods indicates that the employer
wants the services performed in a particular method or
manner. This is especially true if the training is given
periodically or at frequent intervals. An independent
contractor ordinarily uses his own methods and receives
no training from the purchaser of his services. In fact,
it is usually his methods which bring him to the attention
of the purchaser.8

If the employer requires an individual to attend meetings or work

with an experienced employee, this is further evidence of a desire

to control how the work is to be accomplished. In McCombs v. U.S.,

salaried supervisors were employed to observe workers who had

contracted to apply aluminum siding to residential housing. The

purpose of the supervisor was to "instruct the workers in certain

techniques and procedures" and "train people who had no previous

experience. The Court of Claims held that implicit in this find-

ing is the desire of the plaintiff to control not only the result

but also the manner of achieving it."l0

The ability to "direct the order or sequence in which the work

must be done" is the third criterion used by the IRS that relates

directly to the supervision factor. This criterion is defined

in the IRS audit manual as--

If a person must perform services in the order or sequence
set for him by the employer, it shows that the worker
is not free to follow his own pattern of work but must
follow the established routines and schedules of the em-
ployer. Often, because of the nature of an occupation,
the employer either does not set the order of the services
or sets them infrequently. It is sufficient to show
control, however, if he retains the right to do so.11

Again, the reasoning is that if a purchaser of someone's services

is able to control the order or sequence that must be followed by

the worker, then such an individual is controlling the details of

how the job is to be accomplished and is assuming an employer role.

The home improvement industry is an example of how the super-

vision factor has been applied in deciding employee versus indepen-

dent contractor cases. A firm hires salesmen to solicit home

repair jobs. As the jobs are acquired, an "applicator" is given

the job of affixing the roofing or siding materials. The question

is the applicator's employment status. The home improvement


company generally has supervisors to keep track of the applicators

progress and make sure the customers are satisfied with the com-

pleted job. The court has the task of determining the degree of

control these supervisors have exercised over the applicators.

In certain situations the supervisor only appears at the job site

to verify progress and offer advice if it is solicited.1 In

these cases, the courts have held that the lack of supervision

tends to support an independent contractor finding.13 On the other

hand, some courts have held that the supervisors had significant

control over the applicators and through considerable training and

instruction by the supervisors these workers become competent
applicators. In such cases, the courts held that the presence

of supervision supported an employee finding.15 Security Roofing and

Construction Co. v. U.S.16 discounted the notion that supervision

is an important factor when the work is largely routine.

Although it is true that the applicator is normally
unsupervised, he is checked on from time to time . .
If he needs instruction, as, for instance, in how to
conserve material, he receives it. After this, the
work being largely routine, supervision is unnecessary.
I do not regard its absence of controlling significance.
One can be an employee even though he supervises himself
as to the details.17 (Emphasis added)

The presence or absence of supervision is a determination of fact

that must be made by the trier of fact and is often a difficult

distinction to make.

The Restatement defines the overall test that should be

applied in determining a master-servant relationship is whether

"a person employed to perform services in the affairs of another and

who with respect to the physical conduct in the performance of the

services is subject to the other's control or right to control."l8

However, the Restatement then lists "the extent of control which,

by agreement, the master may exercise over the details of the work"

as one of the criteria to be used in applying the above described

test.19 It appears that the Restatement considers control of the

physical conduct of the worker as the overall test to be used in

determining employment status while it also considers control over

the details of the work to simply be one of the factors to be

looked at in applying the overall test. This apparent dual role

is somewhat confusing and is reasonably similar to the question
that surrounded the economic reality test.20 The economic reality

test attempted to relegate control from the overall test that should

be applied in determining a common law employee to a lesser role

as simply a single factor out of many that would be used in de-

fining employment status.

2. Integration. Whether the services performed by a worker

are an integral part of the business is closely related to the

independent-trade factor, variable number seven, to be discussed

later. However, the IRS audit manual treats integration as a

unique factor--

Integration of the person's services into the business
operations generally shows that he is subject to direction
and control. In applying the integration test, first
determine the scope and function of the business and
then whether the services of the individual are merged
into it. When the success or continuation of a business
depends to an appreciable degree upon the performance
of certain services, the people who perform those services
must necessarily be subject to a certain amount of control
by the owner of the business.21

A worker is considered to be a integral part of the taxpayer's

business if the services performed by the worker have "been molded

into he taxpayer's s overall business as one integrated operation
into the taxpayer's overall business as one integrated operation.


A contra example to the notion of being integrated into the business
is found in Aparacor v. U.S.23 which is a case dealing with the

employment status of commission salespersons or distributors.

Aparacor was a large corporation in the business of designing

and selling women's apparel which contracted with various indivi-

duals to distribute and sell its products at retail prices. The

distributors furnished their own office facilities, hired their

own assistants, and were free to engage in other work or the sale

of other products. They were neither reimbursed for expenses nor

trained by Aparacor. The Court further held that the retail dis-

tribution performed by the salespersons was not part of Aparacor's

"regular business of designing and supplying merchandise."24

Aparacor was distinguished from the cases relied on by the IRS

because the court held that those cases involved "typical (albeit

temporary) master servant relationships, that is, the performance

of relatively simple labor, in the course of and as an integral

part of the employer's business."25

Entertainers are an example of individuals that have been held

to be an integral part of the business for which they perform their

services.26 One Court relied on the fact that before certain belly

dancers were featured as part of the lounge show entertainment, the
business had been losing money.27 After the belly dancers and

Greek music were added the establishment became very profitable.

In a similar case, another Court held that go-go dancers were an

integral part of the business.28

The Court finds that the evidence does not support the tax-
payer's contention that the entertainment provided by
these individuals was merely ancillary and subordinate to
the main business. On the contrary, we must conclude that
the go-go dancers were an integral part of the business.29

In some situations, integration is considered an important

factor in employment status cases. However, in the 139 cases

(since several of the cases had multiple verdicts, the total

number of decisions rendered was 148) used in this study, inte-

gration was not explicitly mentioned in 120 of the decisions.

In twenty-six decisions integration was specifically mentioned

in favor of an employee finding and in only two decisions was the

lack of integration mentioned in favor of an independent contractor

finding. It appears that generally the integration factor either

does not apply to the situation or it is a difficult factor to

apply. A businessman is generally not going to hire a worker

to perform services that are unnecessary to the successful run-

ning of his business. To determine if workers are an integral

part of the business is a fact judgment that must be made by the

court. Only where a court explicitly mentions integration in a

written opinion is it considered as evidence supporting either

an employee or independent contractor finding for purposes of this


3. Right to Delegate. If a worker is able to hire, pay, and

fire his own helpers this evidences a certain degree of freedom

characteristic of an independent contractor. On the other hand,

an employer-employee relationship is generally indicated if a

worker is unable to delegate work to another person, or if the

purchaser of his services controls the hiring and firing of as-


The IRS audit manual defines the "right to delegate" in terms

of the freedom to "employ assistants." The right to delegate is

defined in the manual as--

If the services must be rendered personally, presumably
the employer is interested in the methods as well as
the results. He is interested in not only the result
but also the worker.30

The ability of a worker to employ his own assistants is

defined in the IRS audit manual as--

Hiring, supervising, and paying assistants by the employer
generally shows control over the men on the job. Some-
times one worker may hire, supervise, and pay the other
workmen. He may do so as the result of a contract
under which he is responsible for only the attainment
of a result. In this case he is an independent contrac-
tor. On the other hand, if he hires, supervises, and pays
workmen at the direction of the employer, he may be
an employee acting in the capacity of a foreman for or
representative of the employer.31

The Internal Revenue Code is not specific about what consti-

tutes a common law employee. For FICA and FUTA purposes, Section

3121(d) states that an individual is an employee under the usual

common law rules if the contract of service contemplated that sub-

stantially all of such services are to be performed personally

by such individual. This "if" clause seems to imply that it is not

enough for a person to be adjudged a common law employee, but

in addition the contract must contemplate that the services be

performed personally by the worker in question. Thus, according

to this statutory construction, the FICA withholding and payment

requirements cannot be applied to a common law employee unless

the right-to-delegate factor is first satisfied. It is interesting

to note that even though this statutory construction exists no

argument was ever made in the 139 cases included in this study to

avoid the FICA requirements due to the fact that the contract

involved contemplated personal performance of the services. Marmoll

concludes that "there has been a tendency in the authorities to

de-emphasize--primarily through silence--the statutory exceptions

set forth in Section 3121(d)."32

The presence or absence of the right-to-delegate factor was

a factor that was reasonably easy to elicit from the cases read.

Of the 148 judgements made by the District Courts and Court of

Claims, ninety-three decisions incorporated the ability to delegate

by the worker as a factor in favor of an independent contractor

finding. An additional fifteen decisions determined that the worker

did not have the freedom to delegate work or hire his own assis-

tants which tended to indicate an employer-employee relationship.

In the remaining forty decisions the right-to-delegate factor

was not relevant, or its effect was not determinable by the courts.

4. Continuing Relationship. In general, this factor supports

an employer-employee finding if the relationship between the

prospective employer and the worker is found to be of a permanent

nature. Exactly what factors must be present to constitute a

permanent relationship is not easy to pinpoint from the statutory

law or cases.

The Restatement's explanation of this factor is rather cursory.

"If the time of employment is short, the worker is less apt to

subject himself to control as to details and the job is more

likely to be considered his job than the job of the one employing

him."33 The problem with this definition is that it does not give

adequate guidance as to what should be considered permanent em-

ployment. If a worker performs services on a sporadic job-by-job

basis with no one job lasting over a few days, is this then

considered a non-permanent relationship? If this sporadic type

of relationship continues for several years does this then indi-

cate a continuing relationship? If the relationship is contractual

by nature, how long must the contract extend for a permanent rela-

tionship to exist? These are all questions that can arise when

attempting to use the continuing-relationship factor to aid in

determining an employee versus independent contractor case.

The IRS audit manual defines this factor as--

A continuing relationship between an individual and the
person for whom he performs services is a factor which
indicates that an employer-employee relationship exists.
Continuing services may include work performed at fre-
quently recurring though somewhat irregular intervals
either on call of the employer or whenever the work
is available. If the arrangement contemplates continuing
or recurring work, the relationship is considered per-
manent even if the services are part-time, seasonal,or
of short duration.34

The IRS is fairly clear in its interpretation of how to handle

sporadic employment that lasts for a reasonable length of time.

Their view is upheld in Tapager v. Birmingham35 where the District

Court held that even though certain salespersons were part-time

workers because their relationship was regularly recurrent this

was an indication of an employer-employee relationship. The Court

defined the continuing-relationship factor as--

The relationship of an independent contractor generally
contemplates the obtaining of an agreed end and usually
contemplates the obtaining of that end within a stipu-
lated period of time. The relationship of employment
generally contemplates a continuous and indefinite
rendering of services which relationship is terminable
either at the option of the employer or employee without
contractual liability.36

This definition implies that if a definiteness as to the time of

the termination of the relationship exists, then a non-continuing

relationship exists and we have an independent contractor finding.

On the other hand, a continuing relationship or employee finding

is indicated by an indefiniteness as to the time of the termination

of the relationship.

A somewhat contrary finding to Tapager was indicated in
Silver v. U.S. This case involved the home improvement industry

and the classification of an applicator of roofing and siding

materials as an employee or independent contractor. The applicator

in question had performed several jobs during the three year period

under question. The Court held that "permanency of relationship

can hardly be said to exist or be a weighty element when each

obligation was of comparatively short duration and the worker was

free to accept or reject the offer of a new or similar obligation."38

Therefore, when services are performed sporadically, but over a

reasonable length of time, it is not completely clear how a court

will interpret this situation in terms of the continuing-relationship


It is interesting to note that while the continuing-relationship

factor is mentioned in various sources (Restatement, IRS audit

manual, and court cases), that none of these sources refer to any

statutory support for this factor. The continuing-relationship

factor is listed in Section 3121(d) as an exception to the ap-

plication of the FICA provisions to a common law employee. Para-

graph (d) states that if a person is adjudged a common law employee

and satisfies the "if clause" discussed in conjunction with factor

three (right to delegate), then such a common law employee will be

considered an employee for the FICA provisions "except . if the

services are in the nature of a single transaction not part of

a continuing relationship with the person for whom the services

are performed" (Emphasis added). The statute quite clearly

provides that a worker who is classified as a common law employee,

but whose services are not part of a continuing relationship is

excepted from the FICA withholding and payment requirements which

for all intents and purposes treats the worker as an independent

contractor. As was mentioned previously, the exceptions of Section

3121 have not been argued in the cases included in this study

and appear to be substantially ignored in the application of the

common law employee rules for FICA purposes.

For purposes of this study, the continuing-relationship

factor was fairly prevalent in the written opinions of the cases

read. In forty-seven decisions the absence of a continuing rela-

tionship was indicated which favored an independent contractor

finding. In an additional sixty-eight decisions the presence of

a continuing relationship was found to exist which favored an

employee finding. In the remaining thirty-three decisions the

courts did not mention the continuing-relationship factor in their

written opinions.

5. Set Hours of Work. The ability of a worker to set the

aggregate number of hours he will work and also determine when he

will work those hours is usually an indication of the independence

possessed by a self-employed person. Whether a person can control

the hours he works is generally a readily determinable fact. This

is somewhat evidenced by the fact that of the 148 decisions con-

sidered in this study, only eight times did the court fail to

consider setting the hours of work as a relevant factor in their

written opinion. In the other 140 decisions ninety-nine times

the ability to set one's hours of work was mentioned in favor

of an independent contractor finding while in the other forty-one

decisions the ability of the prospective employer to control the

hours worked was considered to favor a finding of employee status.

In regards to the ability to control the hours an individual

works, the IRS audit manual provides that--

The establishment of set hours of work by the employer is
a factor indicating control. This condition bars the
worker from being master of his own time, which is the
right of the independent contractor. If the nature of
the occupation makes fixed hours impractical, a require-
ment that the worker work at certain times is an element
of control.39
In H.R. 3245 as proposed by Representative Gephardt, the first

of the "safe-harbor" provisions is controlling the hours worked.

In hearings before the subcommittee on Select Revenue Measures,

Representative Gephardt proposed that this factor contain a two-

prong attack.41 First, in order to satisfy the safe-harbor pro-

visions, a worker must be able to control the aggregate hours he

works. Second, the worker must also be able to control the

schedule upon which he works these hours. If a worker meets these

two requirements then a reasonable degree of freedom appears to

exist favoring an independent contractor finding.

The real crux of this factor that has been mentioned by both

the IRS audit manual and H.R. 3245 is that: if a worker can control

how much, when, and how hard he works, then this is a strong indi-

cation of self-employment. If on the other hand, a person has to

work a 9 to 5 job due to his employer's desire, then the worker

is not master of his own time.

6. Having Control Over the Place of Work. The general

premise of this factor is that independent contractors generally

provide their own place of business while an employee is provided

a place to work by his employer. This general distinction, however,

is somewhat of an oversimplification. There are certain kinds of

work that must be done on the employer's premises, but such work

need not be done by an employee. For example, an electrician

must come to the employer's place of business, but by no means

necessitates that the electrician is an employee.

The IRS audit manual defines controlling-the-place-of-work

factor as--

Doing the work on the employer's premises in itself is not
control. However, it does imply that the employer has
control, especially when the work is the kind that could
be done elsewhere. A person working in the employer's
place of business is physically within the employer's
direction and supervision. The use of desk space and
telephone and stenographic services provided by an em-
ployer places the worker within the employer's direction
and supervision.42

According to this definition, the Service's position seems to be

that a fairly strong indication of an employer-employee relation-

ship exists if a worker performs his services on an individual's

business premises. However, Marmoll suggests that the Service's

current position is that "furnishing a place of work and of

supplies--while factors to be considered in determining an employer-

employee relationship--are not alone sufficient to establish the


Controlling the place of work is a factor included in both

the GAO proposal and H.R. 3245. In the GAO proposal, the second

of the four basic tests which must be met to be guaranteed

self-employment status requires the worker to have a "principal

place of business other than that furnished by the persons for

whom he or she performs or furnishes services."44 As stated, this

test seems to eliminate anyone being automatically considered an

independent contractor if they happen to work on the employer's

premises. However, in further explanation of this test, the GAO

proposal states that the principal place of business can be rented

from the would be employer if the rent if fair and reasonable4 5

While the ability to rent from the individual to whom the services

are rendered seems to provide more flexibility, the GAO proposal

states clearly that using a person's own residence for the princi-
pal place of work will not satisfy this test.4

Providing one's own place of business is also the second

requirement of the safe-harbor criteria suggested in H.R. 3245.

However, the bill does recognize that certain individuals, by the

very nature of the services they perform, do not have places of

business and should not be held to this requirement.47 For example,

insurance agents, door-to-door salesmen, real estate agents, truckers,

and loggers do not perform their services at a single location.48

The notion of salesmen and truckers introduces another element

into controlling the place of work. It is possible that a salesman

may be required to work in a certain area and that truckers may be

required to drive certain routes. According to the IRS audit manual,

this type of situation is also evidence of controlling the place of
work. The IRS audit manual states that--

Control over the place of work is indicated when the
employer has the right to compel a person to travel a
designated route, to canvass a territory within a certain

time or to work at specific places as required. In
some occupations services must be performed away from
the premises of the employer, for example, employees
of construction contractors or taxicab drivers.5

In most situations, the place-of-work factor is fairly easy

to determine. This partially explains why it was chosen by both

the GAO and Representative Gephardt in drafting proposals that

would hopefully add certainty to the common law employee definition.

In the cases included in this study, the employer controlling the

place of work was mentioned seventy-seven times in favor of an

employee finding. In another forty-nine decisions, the worker

was determined to control the place of work which favored an inde-

pendent contractor finding. In only twenty-six decisions did the

courts consider the place-of-work factor irrelevant.

7. Independent Trade. Whether or not a worker is engaged

in an independent trade or business from the person for whom he

is providing services is a very fundamental element of the common

law control test used in defining employment status. The Restate-

ment lists as one of the facts to be determined in establishing

whether a worker is an independent contractor or employee "whether

or not the one employed is engaged in a distinct occupation or


In discussing common law employees, the Treasury Regulations

state that individuals performing services as independent contrac-
tors are not common law employees.52 As an example of these types

of individuals, the Regulation lists "physicians, lawyers, dentists,

veterinarians, construction contractors, public stenographers,

and auctioneers, engaged in the pursuit of an independent trade,

business, or profession . ."53 (Emphasis added). The entire idea

of an independent contractor is closely tied to the existence of

a separate or independent trade or business.

The GAO, in their report to the Joint Committee on Taxation

discussed in Chapter II, directed the employment status test at

determining whether a true separate business entity actually
exists.54 From this study, the GAO concluded that the major prob-

lem centered around those situations where the worker had a sep-

arate trade or business from the prospective employer, but the IRS
still reclassified the worker as an employee. Because of the

GAO's belief that many of these separate businesses should indeed

by treated as independent contractors, their proposal was structured

such that a trade or business not only had to exist, but that trade

or business had to satisfy four basic tests to be considered as

a self-employed entity.56

The IRS audit manual provides substantial detail in how to

determine if a worker is engaged in a separate trade or business.

The manual divides the independent-trade factor into the following

three separate categories:

(a) Can the individual providing the services work for
a number of firms at the same time?

(b) Does the individual make his services available to
the general public?

(c) Is the individual required to devote his full time
to the person for whom he performs the services?

The audit manual defines the separate categories as--

Working for more than one firm at a time. A person
who works for a number of persons or firms at the same
time is generally an independent contractor because he
is usually free from control by any of the firms. It

is possible, however, for a person to work for a number
of people or firms and be an employee of one or all of
Making service available to general public. The
fact that a person makes his services available to the
general public usually indicates an independent contrac-
tor relationship. An individual may hold his services
out to the public in a number of ways; he may have his
own office and assistants; he may hang out a "shingle"
in front of his home or office; he may hold business
licenses; he may be listed in business directories or
maintain business listings in telephone directories;
or he may advertise in newspapers, trade journals, maga-
zines, etc.
Full time required. If the worker must devote his
full time to the business of the employer, the employer
has control over the amount of time the worker spends
working and impliedly restricts him from doing other
gainful work. An independent contractor, on the other
hand, is free to work when and for whom he chooses.
Full time does not necessarily mean an 8-hour day or a
5- or 6-day week. Its meaning may vary with the intent
of the parties, the nature of the occupation, and customs
in the locality. These conditions should be considered
in defining "full time."
Full-time services may be required even though not
specified in writing or orally. For example, to produce
a required minimum volume of business may compel a person
to devote all of his working time to that business; or
he may not be permitted to work for anyone else, and to
earn a living he necessarily must work full time.58

It is very difficult to identify the distinction between working

for more than one firm at a time and having to devote one's full time

to one employer. Simply stated, if a worker works for other emp-

loyers and is not required to answer to just one boss, a certain

degree of independence is shown which is consistent with being

self-employed. For example, this type of independence is charac-

teristic of a worker known as a "gypsy chaser." A gypsy chaser

is an individual who contracts with a truck driver to unload his

truck which may contain furniture, fruit, etc. Gypsy chasers

generally frequent truck stops and attempt to solicit jobs as

truckers enter the stop. Generally, a gypsy chaser is engaged by

many different truck lines in a single day and is not considered

to work full time for any one firm.59 The courts have generally

interpreted this as significant evidence in favor of an indepen-

dent contractor finding.6

The occupation of a telephone solicitor is an example of a

different situation where a worker performs services for one per-

son and is required to work a set number of hours per day. In

Lieb v. U.S., telephone solicitiors who worked for an exterminator

company were classified as employees by the IRS. Among other fac-

tors discussed by the Court was the fact that the solicitiors were

required to work their entire shift in the employer's office for

five or six days a week.62 Such a finding was evidence that the

basic relationship between the telephone solicitors and Lieb was

that of an employer-employee.

The distinction between working for more that one firm at

a time, or offering services to the general public, is also very

slight. The nature of the services performed by a worker apparently

determines whether an individual can provide his services to the

public at large, or whether he can provide his services to a number

of different firms, and thus whether an employer-employee relation-

ship exists. For example, a steel consultant's services are of

fairly limited application to the general public and would there-

fore probably be limited to certain engineering or steel-related

industrial firms. In contrast, an insurance salesman's services

are of the nature that are more applicable to the general public.

It is this type of service that the IRS audit manual is referring

to when it states that a worker may advertise in newspapers,

magazines, or be listed in the telephone directory. In reading

the court cases that comprise the data for this study, it was found

that working for more than one firm and working for the general

public measured the same basic factor, but simply applied in dif-

ferent factual situations.

The independent-trade factor was considered present in the

cases read for this study if it was manifest in any of the three

separate categories as defined by the IRS. In the majority of the

decisions (ninety-four), an independent trade or business was deter-

mined to exist. In twenty-five decisions the courts held that the

worker was not involved in a separate independent trade or bus-

iness. In the remaining twenty-nine decisions, whether or not

an independent trade existed was not a relevant factor according

to the court's written opinion or if it was relevant it was inde-

terminable whether or not it favored an independent contractor

versus an employee finding.

8. Method of Payment. The method of payment is the seventh

fact that the Restatement mentions should be considered in determining

whether "one acting for another is a servant or an independent con-

tractor."63 The Restatement fails to elaborate on what methods of

payment distinguish an independent contractor finding from an em-

ployee finding. The IRS audit manual's definition, however, is

quite helpful in adding some substance to this factor. The IRS

audit manual defines the method of payment as--

Payment by the hour, week or month generally points to
an employer-employee relationship, provided that this

method of payment if not just a convenient way of paying
a lump sum agreed upon as the cost of doing a job. The
payment by a firm of regular amounts at stated intervals
to a worker strongly indicated an employer-employee
relationship. The firm assumes the hazard that the
services of the worker will be proportionate to the
regular payments. This action warrants the assumption
that, to protect its investment, the firm has the right
to direct and control the performance of the worker.
It is also assumed in absence of evidence to the con-
trary that the worker, by accepting payment upon such
basis, has agreed that the firm shall have such right
of control. Obviously, the firm expects the worker to
give a day's work for a day's pay. Generally, a person
is an employee if he is guaranteed a minimum salary or
is given a drawing account of a specified amount at
stated intervals and is not required to repay any excess
drawn over commissions earned.
Payment made by the job or on a straight commission
generally indicated that the person is an independent
contractor. Payment by the job includes a lump sum
computed by the number of hours required to do the job
at a fixed rate per hour. Such a payment should not
be confused with payment by the hour.64

The explanation of the method-of-payment factor provided by the

IRS indicates that the basic distinction is that employees are

paid regular amounts at stated intervals regardless of the employee's

output, whereas an independent contractor is paid on a lump-sum

or per-job basis and his compensation does depend on his completion

of certain requirements.

This basic distinction makes sense when one assumes that if a

worker is to be paid by the hour his employer is interested in

the worker completing the task in the shortest reasonable amount

of time. Since the employer must pay such a worker by the hour,

he likely will provide more detailed instructions and supervision

to ensure the quickest possible completion of the job.

On the other hand, if the worker is paid by the job in a lump

sum payment, this tends to indicate that the purchaser of the

services is only interested in the final results to be accomplished.

The amount of time to complete the job is irrelevant in this type

of situation as long as the results are those that both parties

agreed upon. In fact, it would be incumbent upon the worker to

determine the quickest method to complete a job because his com-

pensation is directly related to the number of jobs that he can

successfully complete. Also, the fact that a worker may receive

payment in several installments before the job is completed is

not an indication of employer-employee relationship. According

to the IRS audit manual, if the receipt of intermittent payments

is merely a convenient method to disperse a lump sum, then such

an arrangement still favors an independent contractor finding.65

The rule that is being applied throughout the entire analysis of

this factor is whether the worker's compensation is contingent on

his performance of certain requirements (meaning no guarantee of

profit) or simply the number of hours he works.

In general, the determination of how a worker is paid is

rather straightforward. In the cases included in this study,

128 times the judge determined that the worker was being paid in

a method that indicated an independent contractor finding. In an

additional seventeen cases, the judges felt the method of payment

seemed to indicate an employer-employee relationship. In only

three cases was the method-of-payment factor not considered in the

judge's written opinion. From this it is evident that the method-

of-payment factor has been applied in most of the cases included

in this study and the information needed to apply this factor in

actual court case situations is usually readily available.

9. Payment of Business and/or Traveling Expenses. The

reimbursement of expenses is concerned in general with the

method-of-payment factor as discussed above, but is unique enough

to be considered a separate factor. Reimbursement of expenses has

a similar advantage to the method-of-payment factor; namely, it is

a reasonably simple factor to apply. Either a worker is being re-

imbursed for his business expenses or he is not. This is not

particularly consistent with the fact that in fifty-seven of the

decisions analyzed in this study, the court did not appear to

consider reimbursement of expenses in their written opinions.

This is most likely attributable to the fact that a reimbursement

of expenses was not mentioned specifically in the Restatement or

in one of the landmark cases as was the method-of-payment factor.66

This may result in the situation where reimbursement of expenses

is simply considered jointly with the method-of-payment factor as

does Marmoll in the Tax Management portfolio.67

This study takes the same approach as the IRS audit manual

by treating reimbursement of expenses as a separate factor. The

audit manual defines reimbursement of expenses as--

If the employer pays the person's business and/or traveling
expenses, the person is ordinarily an employee. The
employer, to be able to control expenses, must retain
the right to regulate and direct the person's business
Conversely, a person who is paid on a job basis and
who has to take care of all incidental expenses is
generally an independent contractor. Since he is account-
able only to himself for his expenses, he is free to work
according to his own methods and means.68

The audit manual implies that a worker who has to depend on an

employer for reimbursement of expenses is more subject to that

employer's control than is a worker who pays his own expenses.

In other words, reimbursement of a worker's expenses is simply

another method of controlling that worker's business activities.

An employer-employee relationship tends to be indicated when a

purchaser of services pays for the worker's business licences,

meals, transportation, or allows the worker to use the company's

charge account.

The Service's position as discussed above is somewhat inflex-

ible. Marmoll states that--

The Service's position, as set forth in the manual, on
the payment of business or travel expenses ignores the
possibility of a cost plus fixed fee contract as well
as the modern day custom of charging itemized expenses
to the customer or client in addition to the fee for the
work done. The clients of lawyers and accountants, for
example, are customarily charged for the attorney's or
the accountant's travel expenses and, yet, the client
does not control the business activities of the attorney
or accountant, the relationship clearly being one of
client and independent contractor.69

The lawyer or accountant example above appears to suggest that the

reimbursement-of-expenses factor needs to be considered in terms

of the overall compensation agreement. If the reimbursement of

expenses is in addition to an agreed upon lump sum fee, then Mar-

moll seems to suggest that the lump sum payment which supports

an independent contractor finding somehow overrides the fact that

expenses are reimbursed which of course favors an employee finding.

While it is true that the method-of-payment factor may carry more

weight than the reimbursement-of-expenses factor when they have

conflicting results, the fact still remains that reimbursement

of expenses by the employer still favors an employee finding.

In the cases included in this study, judges were able to apply

the reimbursement-of-expenses factor on its own merits in ninety-

one decisions. In seventy-four of these decisions the factor

favored an independent contractor finding while in the other

seventeen decisions the factor favored an employee finding.

10. Furnishing of Tools and Materials. The more substantial

the investment in tools and materials by a worker, the more likely

the worker is to be considered an independent contractor. If the

employer furnishes the tools and materials necessary for the

accomplishment of the worker's assignments, then this tends to

indicate an employer-employee relationship. There are certain

kinds of jobs for which the tools needed to perform the assigned

task are inconsequential. For example, a gypsy chaser70 who unloads

trucks needs practically no tools to perform his services. Since

the work is primarily manual, the furnishing of tools would not

be a particularly significant factor in a case involving the

employment status of a gypsy chaser. On the other hand, an appli-

cator of siding and roofing materials must have a rather complete

set of hand tools, ladders, scaffolding, etc. and the furnishing

of tools would be a much more significant factor in this type of


Both Treasury Regulation Section 31.3121(d)-l(c)(2) and the

Restatement include the furnishing of tools as a factor that should

be included in the definition of a common law employee. The Restate-

ment further states that if the tools are provided by the employer

and are of substantial value, it is understood that the worker will

follow the directions of the owner in their use and this indicates

the owner is master.71 The IRS audit manual provides additional

detail as to how the furnishing-of-tools-and-materials factor

should be interpreted.72 The audit manual describes this factor


The fact that an employer furnishes tools, materials,
etc., tends to show the existence of an employer-emp-
loyee relationship. Such an employer can determine
which tools the person is to use and to some extent,
in what order and how they shall be used.
An independent contractor ordinarily furnishes his
own tools. However, in some occupational fields, e.g.,
skilled workmen, workers customarily furnish their own
tools. They are usually small hand tools. Such a prac-
tice does not necessarily indicate a lack of control over
the services of the worker.73

Application of the furnishing-of-tools-and-materials factor

is relatively straightforward which is evidenced by the fact that

in 131 out of 148 decisions included in this study the judges men-

tioned this factor in their written opinions. In eighty of those

decisions, the courts held that the worker provided his own tools

and/or materials which favored an independent contractor finding.

In another fifty-one decisions the courts held that the employer

provided the tools and/or materials which favored an employee finding.

In only seventeen decisions did the judges fail to discuss the fur-

nishing-of-tools-and-materials factor as part of their written


11. Realization of Profit or Loss. The worker who can realize

a profit or sustain a loss is generally an independent contractor

and the worker who is prevented from earning a profit in excess

of his stated compensation or is insulated against sustaining

losses, is generally considered an employee. For example, in
Nevin Inc. v. Rothensies the court held that a lessee of a drug-

store was an independent contractor. In this case, the parties

involved established a separate (though not a fully independent)

business where the lessee had a considerable personal financial

stake in the business.

He could make or lose money in the business. The pos-
sibility of profits could be enhanced by efficiency,
economy and skill. He took the risk of considerable per-
sonal loss in case the business was not successful a
risk which involved a good deal more than the mere
possibility of loss of position. He obtained complete
freedom in connection with his own time, working hours,
etc., and an opportunity to increase his income not only
by sales records (as in the case of a commission salesman)
but by business judgment in most of the matters which
are in the province of any independent retailer.75

Consequently, the lessee could affect the amount of profits he was

able to earn through his own managerial efficiency and skill.

The IRS audit manual also discusses the importance of managerial

skill in the realization of profits and avoidance of losses.76

The manual states that "whether a profit is realized or loss

suffered generally depends upon management decisions; that is,

the one responsible for a profit or loss can use his own ingenuity,

initiative, and judgment in conducting his business or enterprise."77

Another important component of the realization-of-profit-or-

loss factor is determining whether the worker has a significant

capital investment in the business. The IRS audit manual provides

that for a significant investment to exist, the investment must

be real, essential, and adequate.78 Such an investment is made

generally in equipment, furniture, or real property necessary to run

the business.

The question of whether an investment in equipment is real

seems to be concerned with whether the worker really has an equity

investment, or is the worker simply buying the equipment on time

from the person for whom he is providing services. The audit manual

illustrates this point in the following illustration.

Little weight can be accorded to a worker's investment . .
if the worker purchases equipment from his employer
on a time basis but the employer retains title to the
equipment, has the option of retaining legal ownership
by paying the worker the amount of his equity in the
equipment at any time before the equipment is fully paid
for, requires its exclusive use in the operation of
his business, and directs the worker in its use. Such
investments are not "real".79

To be essential the investment must be in equipment or facil-

ities necessary for the performance of the worker's services.

The example given in the IRS audit manual concerns a model who has

a large investment in her wardrobe, but poses for a photographer

that ordinarily provides the wardrobe and strictly as a matter

of indulgence the photographer allows the model to use her own

clothes. Such an investment in clothes is not essential to the

services that she performs. "The photographer hires her only for

her photogenic qualities and her ability to pose; it is not required

that she furnish her own wardrobe."80

The critical test suggested by the IRS audit manual in deter-

mining if an investment is adequate is to compare the value of the

investment of the worker to the total value of all the facilities

needed to perform the work.

An investment in facilities is not adequate if the
worker must rely appreciably on the facilities of others
to perform the services. For instance, an individual
who is engaged to perform a machine operation on his own
premises and who furnishes his own equipment of sub-
stantial value may be a self-employed contractor instead
of an employee of the manufacturer.81

The realization-or-profit-or-loss factor is not only a major

part of the IRS audit guidelines, but it is also a factor included

in both the GAO proposal and H.R. 3245. In the GAO proposal,

"the risk of suffering a loss and opportunity of making a profit"

is one of the four basic tests used to determine if an independent

contractor engaged in a trade or business should be considered

self-employed.82 The only explanation of the factor provided by

the proposal is that there should be a "real possibility that

expenses directly related to the business will exceed business


On the other hand, H.R. 3245 provides considerable detail in

describing its third safe-harbor criteria which it calls "invest-

ment or income fluctuation."84 The bill proposes that a worker who

has a substantial investment or who risks income fluctuations should

satisfy this safe-harbor criteria.85 It treats investment and

income fluctuations as two separate components of an overall test

which can be satisfied by the presence of either a substantial

investment or risk of income fluctuation.

The income fluctuation test is satisfied if the income level

is neither fixed nor guaranteed, but rather directly depends on

the out-put of the worker. This can be exemplified by a salesman

who can make several sales presentations and not make a single sale.

This is not the same as an employee who is basically assured that

if he works a certain number of hours at a reasonably acceptable

level, he will receive a specified amount of compensation.8

Application of the substantial-investment-in-assets test is

similar to the income fluctuation test. The percent of the in-

vestment is not considered an important criterion despite the IRS

audit manual, but rather the worker must "invest a significant

amount of money or his time as in the income fluctuation test

with no assurance of success."87
with no assurance of success.


With the importance placed on the realization-of-profit-or-

loss factor by the IRS and the inclusion of the factor in both

the GAO proposal and H.R. 3245, it is not surprising that the

factor was discussed by judges in 119 of the 148 decisions included

in this study. In only twenty-nine decisions did the courts

fail to consider the realization-of-profit-or-loss factor in their

written opinions.

Before discussing the methods employed in the coding of the

variables, those factors that were deleted from the study due to

their infrequent occurrence in the written opinions will be pre-

sented. The following is a list of those seven factors discovered

in the literature review, but not included in the analysis of this


(1) Did the worker possess a special skill?

(2) Was the taxpayer's claim consistent with industry

(3) If required, who supplied special uniforms?

(4) What was the intent of the employer and worker?

(5) Did the worker receive any fringe benefits?

(6) Was the worker required to submit written or oral

(7) Can the worker terminate his relationship with the
employer at any time he wishes without incurring

Since none of these factors were included in more than 10 percent

of the court cases, this was interpreted as evidence that these

factors were not particularly relevant in determining what consti-

tutes a common law employee.

The only other factor that was discovered in the search for

relevant variables, but not used in this study was the "right to

discharge." Treasury Regulation Section 31.3121(d)-I(c)(2) mentions

the right to discharge as "an important factor indicating that the

person possessing that right is an employer." The IRS audit manual

discusses the right to discharge in the following manner--

The right to discharge is an important factor in indicating
that the person possessing the right is an employer. He
exercises control through the ever-present threat of dis-
missal, which causes the worker to obey his instructions.
An independent contractor, on the other hand, cannot be
fired so long as he produces a result which meets his
contract specifications.88

The IRS audit manual's definition, simply stated, is that an employee

can be fired anytime, but an independent contractor cannot be dis-

charged except under the terms of his contract. This rather sim-

plistic approach ignores the presence of union contracts that can

often limit the possibility of discharge of an employee. This

argument is supported by Marmoll as follows--

Since the law has developed in such a manner that most
employees have some protection against an arbitrary right
of discharge, and since many contractually agree with
their employers to give a certain amount of notice before
terminating the employment relationship, the restate-
ment's explanation of who is a "servant" or "employee"
does not mention the right to discharge. Moreover,
there are courts which, while considering the factor
of right to discharge or right to terminate, have placed
the factor in perspective, not allowing it to govern
the case despite the exaggerated importance given to the
factor in the regulations.89

One District Court has held that simply because the taxpayer

had the right to discharge the worker if his services were not

satisfactory in "no way" meant that an employer-employee relation-

ship existed.90


This same right exists in every contractor who had
employed a subcontractor when the latter's performance
falls below standard. An applicator who did not like a
particular assignment was free to refuse it and in such
a case the plaintiff would attempt to give him another

This same position is taken again by another District Court in a

similar case.

While it is true that he could terminate an applicator's
work before the completion of a particular job if the
desired result was not being accomplished, this power
was no different than that of a general contractor to
declare a breach of his contract had been committed by
a sub-contractor.92

What makes this factor even more difficult to understand in

this type of study is that the written opinions of the judges

ordinarily fail to provide enough information to adequately

determine if this so-called right-to-discharge factor is really

being applied to an independent contractor relationship or an

employer-employee relationship. Because of the inability to

ascertain when the right-to-discharge factor was present in the

written opinions, it was decided to delete this factor from the


With the selection of the eleven factors completed, the

mathematical models necessary to answer Research Question 2 can

be constructed. Before developing the methodology to be used in

studying Research Question 2, it is first necessary to discuss the

coding procedures used in the analysis of the data.

Coding of the Variables

Each of the eleven variables previously defined was treated

as a trichotomous random variable when collecting the data from

the court cases. There are alternate methods of coding tricho-

tomous independent variables in building mathematical models.

To obtain the maximum amount of information contained in this

type of data, each variable should be represented by two dummy

variables. For example, factor 8, method of payment, would be

coded as follows: (1) if the worker was paid by the job, variable

XI would be coded as a 1 and 0 otherwise; (2) if the worker was

paid by the hour, variable X2 would be coded as a I and 0 other-

wise; and (3) if the method-of-payment factor was not mentioned

by the court, then both XI and X2 would be equal to zero.

This simple model could be expressed as

Y = B + BIXI + B22 + U, (3.1)


Y is the probability of a worker being classified
as an employee,

U is the error term,

B's are the independent variable coefficients.

Taking the expected values of this model results in

E(Y1IXI = 0, X2 = 0) = B0 + BI

E(Y IXI = 0, X2 = 1) = B + B2

E(YIIXI = 0, X2 = 0) = B .

The interpretation of these coefficients would be that B0 equals

the "probability of an employee finding" (hereafter referred to

as Y) if the method-of-payment factor was not mentioned in the

case. If BI is added to BO, this represents Y when a worker is

paid by the job while B0 + B2 equals Y if the work is paid by the

hour. The difference in Y according to whether a worker is paid

by the hour or by the job is

B + BI (B + B2 = BI B2.

A different approach using a trichotomous independent variable

in building a mathematical model would be to simply represent

the method-of-payment factor with three values. For example,

0 could represent the worker being paid by the job, I could re-

present the method-of-payment factor not being mentioned, and 2

could represent a worker being paid by the hour. This simple model

could be represented as

Y = B0 + BIXI + U. (3.2)

Taking the expected value would give

E(YIXI = 0) = BO,

E(YIXI = 1) = B0 + BI,

E(YIX1 = 2) = B0 + 2B2.

At first glance the only difference in the expected values for

model 3.2 and those calculated for model 3.1 would be the expected

values of Y given the worker is being paid by the hour. However,

a more important difference is that the expected values for model

3.2 imply that the difference in Y when the method-of-payment factor

is not mentioned and when the worker is paid by the job is

(B0 + BI) B0 = BI

while the difference in Y when the method-of-payment factor is not

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