I am studying a contract submitted to me by a recruiting agency. I
have my own S-Corp of which I am the sole owner/employee. My S-Corp is
the "consultant", the agency is the "Company". What do you think of
this clause ? It is new to me. Do you feel it is reasonable or
unreasonable ? Have you seen similar clauses like it in corp-to-corp
consulting contracts ? How should I respond ?

Consultant is aware that the Congress of the United States has 
promulgated and enacted Section #1706 (a) of the Tax Reform Act of
1986 which has a direct effect on computer consulting companies, their
clients, and the independence of the personnel assigned.

In that context, Consultant has been advised that the Internal Revenue Service may 
successfully assert that the Consultant is in fact NOT independent,
but is an employee of either Company or its client. Consultant hereby
warrants that it will indemnify and hold harmless Company and/or its
client, against any monetary claims which may be asserted by the
Internal Revenue Service, the State or Federal Unemployment Insurance
Division, and/or the Social Security Administration or a Sub-division
thereof against either Company or its client, (including the
imposition of interest and penalties assessed thereon, as well as
legal fees) seeking to enforce compliance with the Aforementioned
Internal Revenue Code, SectionH1706(a).

Hello and thank you for your question.

Here is how one source characterizes the issue:
In a nutshell, "Section 1706"  made it so that the default presumption
for computer consultants was that they were employees, unless proved
otherwise.

For businesses known as "technical services firms" who provide
technical services to their customers (including computer
consultants), Section 1706 removed so-called "Section 530 employment
tax safe havens" that otherwise apply to all other types of businesses
using independent contractors. As a result, if a technical services
firm hires a high-tech worker to perform services for that firm's
customers as an independent contractor, then the firm must prove to
the IRS that this worker is an independent contractor under the
centuries-old "common law" employment test. Even if the firm shows a
strong reason for hiring the worker as an independent contractor --
for example, the IRS approved the firm's practices in a prior audit,
or the treatment conforms to industry practice or a court ruling, all
of which are "safe havens" under Section 530 -- Section 1706 makes
these reasons irrelevant for technical services firms.

The harm to high-tech firms and workers caused by Section 1706 is more
than theoretical. Technical services firms which use independent
contractors -- even if they act in good faith -- can be severely
penalized by the IRS and forced to pay "unpaid" employment taxes
although the contractors have already paid these same taxes in full!  
In fact, some IRS auditors use Section 1706 to claim "incorporated"
high-tech independent contractors are not legitimate. Left with only
the common law employment test to prove a worker's status to the IRS,
many high-tech firms will not hire any independent contractors. They
do not want to "attract" an almost-certain IRS audit because the time
and expenses to fight the IRS means that even "winning" the audit is
really a "losing" situation.
What is "Section 1706"?
http://timelord01.home.sprynet.com/accm/faq.htm#8.2

So the concern is that the Company or its client (really the client --
i.e. the company that you'll be providing services to) might be
accused by the IRS of having you as its employee.  The main tax cost
to your being an employee is they would have failed to pay social
security and Medicare tax on your 'wages.'

The social security and medicare tax is 7.65% of the first $94,200
that they pay you, and 1.45% of any excess.
http://www.ssa.gov/pubs/10003.html

They also could be accused of failing to do the other tax compliance
items that employers must take care of - - giving you the tax
withholding form to fill out, withholding income tax from your 'wages'
and the rest.

Asking them to delete that clause, if they're gong to treat you as an
independent contractor, would be asking them to assume those risks
which they're not likely to do.  Nor can you expect them to want to
agree to take you on as an employee - - because there are probably
employee benefits (401k, medical insurance, etc) that they'd have to
pay if they did hire you as an employee and they're not part of the
deal.

Which is also why they probably won't agree to submit the question to
the IRS on Form SS-8 for determination.
http://www.irs.gov/pub/irs-pdf/fss8.pdf

I'd suggest you consider the actual circumstances of how you're going
to be working, and decide if it's a risk you're willing to take.
Here's the general test:
http://www.irs.gov/taxtopics/tc762.html

And here's the sort of facts the IRS would like to see if you're going
to really be an independent contractor (scroll down to "computer
industry":
http://www.twc.state.tx.us/ui/tax/manuals/audit/aud_ch3_4.html

Good luck and thanks for letting us help.

Search terms used:
independent contractor employment tax audit
"section 1706" withholding

---

Request for Answer Clarification by newyorkconsultant-ga on 22 Nov 2006 22:26 PST

I should have clarified in my original question that I pay myself a
salary out of which I deduct payroll taxes, ss, medicare and
unemployment tax. My company will gross $200,000 out of which I will
pay myself a salary of $120,000 with all pertinent taxes etc.

The motivation as I understand it for the IRS to seek to re-classify a
contract employee is to regain lost payroll taxes from when the
contract employee paying self-employment tax but working for one
"client" for six months. This is where the IRS gets the feeling
someone is trying to avoid paying taxes.

However, in my situation where I am my own employee and pay regular
payroll taxes out of my own salary, then I think the IRS would relax
because taxes are getting paid and nobody is trying to pull a fast
one.

And what would they gain by re-classifying me ? It would simply switch
the burden to my client from me, as I could re-file and get the
payroll taxes I paid returned to me.

So perhaps that puts my question in a better light. Care to share
additional comments on my clarified situation ?

---

Clarification of Answer by richard-ga on 23 Nov 2006 17:50 PST

As you note, a self-employed person pays the combined employer and
employee payroll tax rate, 2 * 7.65 = 15.3% so the IRS would be
breaking even, <if> your S-corp were to pay the entire sum to you.

Thanks so much for the kind words and tip!

Google Answers Researcher
Richard-ga

This is a complex issue as it involves not only the legalize of the
contract in question but also the varied circumstances of the work
conditions, so it is difficult to address thoroughly without
professional knowledge in both the tax and legal arenas.

However, the answer you gave was very detailed and beyond what I had
accomplished in my googling on this matter. I see that you googled
'"section 1706" withholding' - a good pick. And the link you came up
with, http://www.twc.state.tx.us/ui/tax/manuals/audit/aud_ch3_4.html,
was a real fine as it clarifies the situation from the view of an IRS
auditor.

Also the link "http://timelord01.home.sprynet.com/accm/faq.htm#8.2"
was a great find as well.

Not only did I find more information on this issue from your answer
but I learned how to use google more effectively.

Excellent research !

Thank you.