During this current economic slowdown, your company may decide to outsource certain projects that have traditionally been performed by in-house workers. Consider all the implications.

Case in point: Because your company is using independent contractors as opposed to employees, it is not responsible for payroll taxes and income tax withholding on the amounts paid to these workers. Similarly, you do not have to cover independent contractors under your qualified retirement plan and health insurance program.

However, the difference between independent contractors and employees is not always clear-cut. The IRS often investigates these determinations. If it reclassifies some of the workers as employees, which is a common practice, your company could be hit with hefty payments for back taxes, plus penalties and interest.

Saving grace: Fortunately, you may be able to rely on "Section 530" relief in a pinch. This special tax rule, legislated into law in Section 530 of the 1978 Revenue Act, enables you to claim independent contractor status for workers if certain requirements are met. Specifically, your company is exempt from employment tax liability under Section 530 if you satisfy these rules:

• The company has not treated the worker as an employee for any period of time and does not treat workers in similar positions as employees.
• All federal returns required to be filed by the company (including information returns) consistently treat the worker as an independent contractor.
• The company has a reasonable basis for not treating the worker as an employee.

How do you show a "reasonable basis" for treating a worker as an independent contractor? Any one of the following four methods may suffice.

1. The classification is a long-standing practice of a significant segment of your industry or profession. For this purpose, "long-standing" can mean less than 10 years, while a "significant segment" may be less than 25%.
2. The classification has survived an IRS audit. If your business was audited after 1996 regarding the employment tax treatment of workers and the classification was allowed to stand, you qualify under this exception. For audits started prior to 1997, it does not matter if the audit involved any worker classification issues; there is no problem as long as the treatment of the workers has not changed.
3. You can provide adequate precedent. If there is an authoritative court decision or IRS ruling that supports your position, you may meet the reasonableness test.
4. You can show that your determination for independent contractor status is based on the sound reasoning of a paid tax professional.

Note that you cannot qualify for Section 530 relief for a prior tax year if you failed to issue Form 1099s for independent contractors in that particular year. This is a critical aspect for avoiding tax liability. The lesson is clear: Coordinate these activities with your tax advisers.