RAYMOND KANE owns a travel agency in New York. Like many travel agents, for years he has rented space to independent agents who work for themselves but pay him a percentage of their commissions. His agency issues 1099 forms reporting to the Internal Revenue Service the amount it pays the independent contractors after deducting their rent and the commission percentage.
In 1991, Mr. Kane got notice from the IRS that the firm would be audited for the year 1989. An IRS auditor spent six months at the agency scrutinizing the contracts between it and the independent contractors. After the audit, the IRS issued a ''no change'' finding, meaning that Kane's firm was in compliance with IRS regulations, including those governing independent contractors.
Imagine Kane's surprise, then, when two years later the IRS told him that the agents were no longer independent contractors but were, and had always been, employees for whom his agency should have been deducting and paying taxes. Even though the agents had paid their own taxes, the IRS is demanding $274,000 in penalties from Kane's company for 1992-94.
More than 5 million Americans work as independent contractors, but no law defines who qualifies as one. Over the years, the IRS has evolved a 20-point common-law test for determining who is independent and who is an employee. But interpretations vary from office to office. According to Sen. Christopher Bond (R) of Missouri, who chaired hearings last week on tax issues affecting small businesses, the IRS has in recent years forced the reclassification of some 400,000 independent contractors as employees,
and is currently forcing the conversion of almost 2,000 a week. Sen. Don Nickels (R) of Oklahoma calls it an IRS ''war'' on independent contractors, ''the heart and soul of small business.''
The IRS is legitimately concerned about the number of self-employed people who underreport their income or don't pay taxes. But forcing them to convert to employee status to make it easier for the IRS to ensure payment is not the answer.
The answer is for Congress to write a definition of independent contractor that everyone can understand and implement. Small businesses need to know that they are acting legally and are not going to have problems with the IRS two, three, or four years down the road. Such a definition should require that independent contractors invest capital and personal training in their business, have contracts with more than one client, advertise independently of clients, provide service under a registered business n ame, and have a place of business or pay fair-market rent to work out of a client's location.
Another suggestion that makes sense would have clients such as Kane's travel agency deduct 5 percent of contractors' pay and turn it over to the IRS as a down payment on taxes. This would help the IRS identify contractors, ensure that some money is paid, and create incentives for contractors to pay Uncle Sam what they owe.
Some of these ideas are contained in House bill HR 1972, which has more than 130 co-sponsors. Senator Nickles plans to introduce a Senate version soon.
Small business is one of the most important sources of new-job creation in the American economy. It shows every sign of being even more important in the future. It's essential that Congress ensure that this fragile sector flourish by removing or amending unnecessary and unhelpful tax policies.
Among other proposals before the Senate Small Business Committee are these:
* To exclude family-owned businesses from the estate tax. One bipartisan bill would exempt up to $1.5 million of a family-owned business.
* To lower the capital-gains tax.
* To create incentives for small-business owners to contribute to employee retirement-savings plans. Senate majority leader Bob Dole suggests allowing small-business employees to contribute up to $6,000 yearly to a retirement plan, with the employer contributing the same amount for a total of $12,000.
* To allow the self-employed to deduct the full cost of their health-insurance premiums, giving them the same benefit employees have.
It's essential that Congress help the crucial small-business sector by removing or amending unnecessary and unhelpful tax policies.