Testimony of Kristie L. Darien, Director of Government Affairs
The National Association for the Self-Employed

House Small Business Committee
Subcommittee on Regulatory Reform and Oversight

"Federal Agency Treatment of Small Business"
May 15, 2003

I would like to express my appreciation to Chairman Ed Schrock, Ranking Member Robert Brady and the members of this Subcommittee for the opportunity to participate today in this hearing. I am here to testify on behalf of the National Association for the Self-Employed and our 250,000 member businesses, representing over 600,000 owners and employees nationwide.

The National Association for the Self-Employed is the nation’s leading resource for the self-employed and micro-businesses, businesses with ten or less employees. Today, this vital segment of the small-business population within our nation numbers more than 18 million. Micro-businesses are the drivers of America’s economic engine, creating well over a third of all new jobs to the economy between 1998 and 1999. The last U.S. Census reported that these firms employ more than 12.3 million workers with a total annual payroll of more than $309 billion. Beyond these tangible contributions, it is also important to note that according to an August 2002 poll by USA Today, CNN and Gallup, Americans rate people who own and operate small businesses as the second most trustworthy group in the nation, right behind teachers.

Often, the chief speed bump faced by micro-business owners on the road to their success is a collective $800 billion dollar bill called federal government regulation. And because big successes usually have small beginnings, these costs loom large to micro-businesses, which are capitalized chiefly on dreams and ideas.

A report sponsored by the U.S. Small Business Administration entitled “The Impact of Regulatory Costs on Small Firms,” cited that firms employing fewer than 20 employees face an annual regulatory burden of $6,975 per employee. This same report cited that environmental regulations and tax compliance issues are particularly burdensome to small business.

The NASE membership is from a diverse array of industry sectors; from consultants to manufacturers to farmers. Yet with each of the industries we represent, the chief agency they interact with on a continuous basis is the Internal Revenue Service.


Internal Revenue Service

The NASE has been very pleased with the recent efforts made by the Internal Revenue Service to become small-business friendly. However, the self-employed and micro-business communities still face an overwhelming regulatory burden in complying with IRS regulations and enforcement of various rules. Vague and complex rules can mean the demise of their businesses. According to a study by the Tax Foundation, in 2002 businesses bore the majority of the tax compliance cost with 52.8 percent of the total cost, or $102.5 billion. The Office of Management and Budget estimated that in 1995 businesses spent 2.4 billion hours on tax compliance efforts.

One specific IRS regulation that is exceedingly burdensome to the micro-business and self-employed communities is the employee vs. independent contractor classification. Many NASE Members either utilize independent contractors or are themselves independent contractors. Disputes about who is an employee and who is an independent contractor have cost small businesses more than three-quarters of a billion dollars in IRS penalties and back-taxes during the past 10 years.

The IRS has a complicated 20-point checklist the can be used as a guideline in determining whether or not an individual is an employee or an independent contractor. Yet, using this checklist does not guarantee that a person is correctly classified. Other IRS materials published to assist in classification are equally as convoluted. NASE Members have indicated when utilizing the I.R.S.’s tax assistance help line on this issue, they have gotten different answers from different agents on this same issue. A large issue is that there is no one, single, homogenous definition of the term "employee." Thus, there is no clear and concise manner for a self-employed individual or micro-business owner to easily determine when an individual should be classified as an independent contractor or an employee.

Also, if a micro-business owner has been selected for an audit, the IRS is supposed to provide employers with relief from potential IRS reclassification of a firm’s independent contractors as employees, by prohibiting the IRS from reclassifying such workers if the employer has met various relief requirements as laid out by Section 530 of the Revenue Act of 1978. Section 530 was enacted in response to complaints regarding increased enforcement and aggressive application of the employment tax laws by the IRS. Section 530 requires small-business owners to meet the following relief requirements:

1. A “reasonable basis” for treating the workers as independent contractors rather than employees. A “reasonable basis” includes reliance on:

   1. Judicial precedent or IRS rulings;

   2. A past IRS audit in which there was no assessment attributable to employment taxes; and

   3. A long-standing industry practice of treating the workers as independent contractors.

2. Substantive Consistency: must have treated similar workers equally in regards to classification.

3. Reporting Consistency: must have filed Form 1099-MISC for each worker, unless the worker earned less than $600.

Over the years, the IRS has chipped away at many of these supposed “safe harbors” for reclassification. A micro-business owner is typically an owner whose office occupies the corner of their bedroom, whose warehouse is their garage, whose CIO and CFO and CEO and janitorial staff share the same desk and business card. Is it “reasonable” to believe they would have the ability and time to research IRS rulings and judicial precedent to make certain they have a “reasonable basis” for classifying someone as an independent contractor?

With more and more individuals conducting a business out of their home as "independent contractors" and the economic incentive to employers to use independent contractors rather than employees, the issue of worker reclassification continues to be a key area for the recovery of revenue by the IRS despite its recent efforts to become more small-business friendly. Due to the regulations’ vagueness and complexity it is very easy for the IRS to arbitrarily reclassify workers and thus, require micro-business owners to pay enormous sums of back taxes and penalties, which ultimately force them to go out of business. Reclassification of 10 independent contractors to the classification of employee, with taxes, penalties and interest can net 100 times more revenue than auditing an individual. (Willingham & Coté, 2001)

Solutions

The NASE strongly feels that the IRS regulation must be updated to provide straightforward rules for classifying workers and relief from reclassification. We strongly support the reintroduction of last years’ Independent Contractor Determination Act, which clearly defined the rules for classification of workers, provided certainty for businesses that enter into independent-contractor relationships, and minimized the risk of huge tax bills for back taxes, interest, and penalties if a worker is misclassified after the parties have entered into an independent-contractor relationship in good faith.

The NASE also feels that a continued push towards tax simplification and paperwork reduction would greatly alleviate the IRS regulatory burden on small business and minimize enforcement issues. Due to their size, micro-businesses are responsible for managing every aspect of their business. Every second spent contending with burdensome record keeping and tax preparation takes away from the time they expend running and growing their businesses. Tax simplification and paperwork reduction would have numerous positive affects. First, easy to understand tax rules would reduce the compliance costs of the self-employed and micro-business owners, allowing them to reinvest that time and money in the success of their businesses. Second, a simpler tax code would raise compliance rates and lessen mistakes made in tax filings, thus reducing the administrative burden of both the taxpayer and the IRS. Most importantly, clarifying tax regulations allows those preparing their own taxes to more readily understand the law and their responsibility of complying, lessening the need for enforcement.


Conclusion

The ultimate hardship that is faced by the self-employed and micro-businesses when dealing with federal agencies is the complexity and vagueness of regulations they issue. The simple difficulty of understanding and then complying with any and all regulations affecting their business is overwhelming for a micro-business owner. This burden imposed on micro-business is disproportionate to that of larger businesses because smaller firms cannot spread the overhead costs associated with hiring accountants and attorneys, and the general cost of paperwork burdens and staff needed to try and comply with the maze of federal regulations.

Small business in general do not feel comfortable with calling the various federal agencies to ask questions and seek compliance assistance. The NASE feels that agencies need to do a better job of giving small-business owners better access to plain-English compliance assistance materials via their Web sites or local offices. The majority of micro-business owners, while not fond of the regulations imposed on them, want to do what is right and comply with the regulations. The NASE was greatly pleased to see the passage of H.R. 205, the National Small Business Regulatory Assistance Act, which expands the SBA-sponsored Small Business Development Center Program to provide, as one of their services, regulatory compliance assistance. We believe that no written guidebook, online or phone compliance assistance can outweigh the benefits of the one-on-one assistance micro-business owners and self-employed individuals receive at their local Small Business Development Centers.

The National Association of the Self-Employed would again like to thank this Subcommittee for the opportunity to express the concerns of America’s micro-business owners. We hope you will continue your valuable efforts to alleviate the regulatory burden on America’s micro-business and self-employed communities. The members of the NASE who hope to turn the American dream into an American success story depend upon your vigilance on our behalf.