Can Executives and Producers Be Employees <i>and</i> Independent Contractors?

Probably the most important tax detriment to being an employee rather than an independent contractor is that business expenses of employees are subject to a variety of tax limitations (for example, they are not deductible for alternative minimum tax purposes) that in many cases result in no tax benefit whatsoever for such expenses. Independent contractors are not subject to those restrictions. Also, the ability to sock away vast sums of tax-advantaged retirement funds is much more limited for employees than for independent contractors. There are other disadvantages, too.

Taking a cue from outside producers, directors and other talent who work as independent contractors, some executives have bifurcated their agreements to reflect the dual nature of their services.

The first agreement is a typical employment agreement, pursuant to which the individual provides services as an executive and is treated as an employee for tax purposes. The second agreement is an independent contractor agreement, pursuant to which the individual, or the individual's loanout corporation, works as a producer and is treated as an independent contractor for tax purposes.

In order for this arrangement to be respected for tax purposes, the IRS must be willing to accept the fact that a worker may simultaneously be treated as an employee and an independent contractor while working for the same company. The IRS recently indicated that such an arrangement is acceptable, in Information Letter 2012-0069 (Dec. 28, 2012) (www.irs.gov/pub/irs-wd/12-0069.pdf).

This Information Letter is a letter from the IRS Office of Chief Counsel to a congressman in response to a question raised by the congressman on behalf of a constituent. The Information Letter states that it “provides only general principles of law. It is intended for informational purposes only and does not constitute a ruling.” The Information Letter thus may not carry much weight in the context of a tax audit, but it is nevertheless helpful because it reveals how the IRS is likely to analyze a bifurcated work arrangement.

The congressman asked “whether a person can be an employee and an independent contractor simultaneously, for the same company, when working as a professional consultant on two separate consulting projects.” The IRS answered yes. Getting to that “yes” is not easy, though.

'Employee' Test

The key to planning for this dual treatment is found in the definition of “employee” for tax purposes. Tax regulations indicate that an employer-employee relationship exists when the person for whom the services are performed (for ease I'll refer to this service recipient simply as “company”) has the right to direct and control the individual who performs the services, not only as to the result to be accomplished, but also as to the details and means by which that result is accomplished.

In practice, this test is difficult to apply. Most company-worker relationships allow the company some degree of direction and control over the worker. It may not be easy to tell whether the controls are strict enough for the worker to be treated as an employee. The fact that a worker provides services through a loanout corporation, while optically moving the needle in the direction of independent contractor characterization, is not viewed as a determining factor by the IRS.

The Information Letter provides a neat summary of the way the IRS thinks about worker classification. It divides relevant facts into three different categories: behavioral controls, financial controls and the relationship of the parties.

“Behavioral controls” refers to whether the company has a right to direct or control how the worker performs specific tasks. Relevant factors include training, instruction and evaluations. The more behavioral controls, the more likely the worker will be treated as an employee.

“Financial controls” refers to whether the company has the right to direct or control the financial aspects of the worker's activities. Relevant factors include method of payment, ability for the worker to achieve profit or loss, and whether the worker has made a significant investment, incurred unreimbursed expenses, or otherwise made services available to the “relevant market.” Again, the more behavioral controls, the more likely the worker will be treated as an employee.

“Relationship of the parties” refers to the parties' agreements and actions, both between themselves and vis-'-vis the rest of the world. Relevant factors include the provision (or not) of employee benefits, the right of the parties to terminate the relationship, the permanency of the relationship and whether the services performed are part of the company's regular business activities.

How It Works

How does this framework apply to the individual who is both an executive and a producer (the latter perhaps through the individual's loanout corporation)? It is usually pretty clear that an executive is an employee, regardless of the industry. Entertainment industry executives often have written contracts that spell out in detail what the executive is to do and how and where he or she is to do it. Executives frequently receive vacation time, health insurance, employee benefits and other items that generally point to employee status. Note that the absence of one or more of these facts does not necessarily lead to the conclusion that the executive is an independent contractor.

Now suppose the executive is also to work as a producer for the same company, providing such services in addition to those of being an executive. The Information Letter indicates that the individual may be treated as an independent contractor in respect of his or her production services if the applicable tests are satisfied. The three categories referred to in the Information Letter ' behavioral controls, financial controls and the relationship of the parties ' should be analyzed carefully to see if the parties can get comfortable shoe-horning the producer activities into an independent contractor relationship.

The challenge is that the IRS's image of a typical independent contractor does not necessarily square with the executive/producer duality. The IRS seems to view an independent contractor as fitting the mold of, say, your local electrician. An electrician may have a business name (such as “Westside Electricians”) and advertises his services to prospective clients. The electrician may work for numerous different customers in any given year. He may be licensed, is presumably trained and skilled, and has made an investment in his own tools. Because of the expenses of running his business, the electrician might realize a loss from his business.

The producer who is also an executive typically fits a different profile. He or she may work for only one company during any given year, not advertise his or her services, and run virtually no risk of operating at a loss. The producer provides services that are essential to and part of the company's business, as contrasted with the electrician whose services involve matters that are ancillary to the company's business. And so on.

Nevertheless, given the right facts and the right structure, there is no reason why an executive may not also be treated as an independent contractor when also providing services as a producer. Here are some suggestions:

• At the very least, the agreements should be reflected in writing, ideally in two separate contracts. The contract for executive services should include all of the typical employment agreement terms and conditions, including such items as vacations, health insurance, reimbursement of expenses, pension plan, etc., as applicable. The contract for producing services should not include any of these items.
• The two contracts should be completely independent, possibly even entered into with different, even though affiliated, company entities. Each agreement should stand on its own as a completely separate agreement. The existence and terms of one agreement should not depend at all on the existence and terms of the other. The contracts should not be connected; for example, a breach of one should not constitute a breach of the other. Compensation in one should not be tied to compensation in the other.
• In practice, the connection of the two arrangements can prove to be the biggest obstacle to clean planning, particularly in cases where the parties do not truly believe that the work assignments are separate. For example, the company may want the ability to terminate both relationships if the executive/producer breaches one of the contracts. Or the company may want to limit the individual's overall compensation in a manner that requires the producer compensation to be tied to the executive compensation. Each case should be analyzed and structured carefully.

Conclusion

Worker classification is a hot-button issue for the IRS. The IRS has made a public show of warning companies that it will be conducting wide-range audits to assure that employees are not improperly classified as independent contractors. Still, if a worker is truly an independent contractor with respect to his or her producing services, the IRS Information Letter should be viewed as confirming that the arrangement can be structured in a way that works.

Bob Jason is a Managing Director at Nigro, Karlin, Segal and Feldstein, LLP in Los Angeles and a member of this newsletter's Board of Editors. ' 2013 Robert M. Jason. All rights reserved.

What studio executive has not also wanted to be a producer? Many start down the producer road even while continuing to serve as executives. In its own way, the IRS has just made this path a little easier.

Entertainment company executives often provide producing and creative services in addition to their more traditional executive-employee services. As producers, though, they want to be treated the same as outside producers ' as independent contractors, even while as executives, they are treated as employees. This desire comes from the fact that treatment as an employee results in a number of very specific tax consequences that are far worse than those applicable to independent contractors.

Dual Contracts

Probably the most important tax detriment to being an employee rather than an independent contractor is that business expenses of employees are subject to a variety of tax limitations (for example, they are not deductible for alternative minimum tax purposes) that in many cases result in no tax benefit whatsoever for such expenses. Independent contractors are not subject to those restrictions. Also, the ability to sock away vast sums of tax-advantaged retirement funds is much more limited for employees than for independent contractors. There are other disadvantages, too.

Taking a cue from outside producers, directors and other talent who work as independent contractors, some executives have bifurcated their agreements to reflect the dual nature of their services.

The first agreement is a typical employment agreement, pursuant to which the individual provides services as an executive and is treated as an employee for tax purposes. The second agreement is an independent contractor agreement, pursuant to which the individual, or the individual's loanout corporation, works as a producer and is treated as an independent contractor for tax purposes.

In order for this arrangement to be respected for tax purposes, the IRS must be willing to accept the fact that a worker may simultaneously be treated as an employee and an independent contractor while working for the same company. The IRS recently indicated that such an arrangement is acceptable, in Information Letter 2012-0069 (Dec. 28, 2012) (www.irs.gov/pub/irs-wd/12-0069.pdf).

This Information Letter is a letter from the IRS Office of Chief Counsel to a congressman in response to a question raised by the congressman on behalf of a constituent. The Information Letter states that it “provides only general principles of law. It is intended for informational purposes only and does not constitute a ruling.” The Information Letter thus may not carry much weight in the context of a tax audit, but it is nevertheless helpful because it reveals how the IRS is likely to analyze a bifurcated work arrangement.

The congressman asked “whether a person can be an employee and an independent contractor simultaneously, for the same company, when working as a professional consultant on two separate consulting projects.” The IRS answered yes. Getting to that “yes” is not easy, though.

'Employee' Test

The key to planning for this dual treatment is found in the definition of “employee” for tax purposes. Tax regulations indicate that an employer-employee relationship exists when the person for whom the services are performed (for ease I'll refer to this service recipient simply as “company”) has the right to direct and control the individual who performs the services, not only as to the result to be accomplished, but also as to the details and means by which that result is accomplished.

In practice, this test is difficult to apply. Most company-worker relationships allow the company some degree of direction and control over the worker. It may not be easy to tell whether the controls are strict enough for the worker to be treated as an employee. The fact that a worker provides services through a loanout corporation, while optically moving the needle in the direction of independent contractor characterization, is not viewed as a determining factor by the IRS.

The Information Letter provides a neat summary of the way the IRS thinks about worker classification. It divides relevant facts into three different categories: behavioral controls, financial controls and the relationship of the parties.

“Behavioral controls” refers to whether the company has a right to direct or control how the worker performs specific tasks. Relevant factors include training, instruction and evaluations. The more behavioral controls, the more likely the worker will be treated as an employee.

“Financial controls” refers to whether the company has the right to direct or control the financial aspects of the worker's activities. Relevant factors include method of payment, ability for the worker to achieve profit or loss, and whether the worker has made a significant investment, incurred unreimbursed expenses, or otherwise made services available to the “relevant market.” Again, the more behavioral controls, the more likely the worker will be treated as an employee.

“Relationship of the parties” refers to the parties' agreements and actions, both between themselves and vis-'-vis the rest of the world. Relevant factors include the provision (or not) of employee benefits, the right of the parties to terminate the relationship, the permanency of the relationship and whether the services performed are part of the company's regular business activities.

How It Works

How does this framework apply to the individual who is both an executive and a producer (the latter perhaps through the individual's loanout corporation)? It is usually pretty clear that an executive is an employee, regardless of the industry. Entertainment industry executives often have written contracts that spell out in detail what the executive is to do and how and where he or she is to do it. Executives frequently receive vacation time, health insurance, employee benefits and other items that generally point to employee status. Note that the absence of one or more of these facts does not necessarily lead to the conclusion that the executive is an independent contractor.

Now suppose the executive is also to work as a producer for the same company, providing such services in addition to those of being an executive. The Information Letter indicates that the individual may be treated as an independent contractor in respect of his or her production services if the applicable tests are satisfied. The three categories referred to in the Information Letter ' behavioral controls, financial controls and the relationship of the parties ' should be analyzed carefully to see if the parties can get comfortable shoe-horning the producer activities into an independent contractor relationship.

The challenge is that the IRS's image of a typical independent contractor does not necessarily square with the executive/producer duality. The IRS seems to view an independent contractor as fitting the mold of, say, your local electrician. An electrician may have a business name (such as “Westside Electricians”) and advertises his services to prospective clients. The electrician may work for numerous different customers in any given year. He may be licensed, is presumably trained and skilled, and has made an investment in his own tools. Because of the expenses of running his business, the electrician might realize a loss from his business.

The producer who is also an executive typically fits a different profile. He or she may work for only one company during any given year, not advertise his or her services, and run virtually no risk of operating at a loss. The producer provides services that are essential to and part of the company's business, as contrasted with the electrician whose services involve matters that are ancillary to the company's business. And so on.

Nevertheless, given the right facts and the right structure, there is no reason why an executive may not also be treated as an independent contractor when also providing services as a producer. Here are some suggestions:

• At the very least, the agreements should be reflected in writing, ideally in two separate contracts. The contract for executive services should include all of the typical employment agreement terms and conditions, including such items as vacations, health insurance, reimbursement of expenses, pension plan, etc., as applicable. The contract for producing services should not include any of these items.
• The two contracts should be completely independent, possibly even entered into with different, even though affiliated, company entities. Each agreement should stand on its own as a completely separate agreement. The existence and terms of one agreement should not depend at all on the existence and terms of the other. The contracts should not be connected; for example, a breach of one should not constitute a breach of the other. Compensation in one should not be tied to compensation in the other.
• In practice, the connection of the two arrangements can prove to be the biggest obstacle to clean planning, particularly in cases where the parties do not truly believe that the work assignments are separate. For example, the company may want the ability to terminate both relationships if the executive/producer breaches one of the contracts. Or the company may want to limit the individual's overall compensation in a manner that requires the producer compensation to be tied to the executive compensation. Each case should be analyzed and structured carefully.

Conclusion

Worker classification is a hot-button issue for the IRS. The IRS has made a public show of warning companies that it will be conducting wide-range audits to assure that employees are not improperly classified as independent contractors. Still, if a worker is truly an independent contractor with respect to his or her producing services, the IRS Information Letter should be viewed as confirming that the arrangement can be structured in a way that works.

Bob Jason is a Managing Director at Nigro, Karlin, Segal and Feldstein, LLP in Los Angeles and a member of this newsletter's Board of Editors. ' 2013 Robert M. Jason. All rights reserved.