The other Microsoft case …

What about the other Microsoft case, the one you didn’t hear about in the news? To explain it, we must discuss trends.

Note: Credits to Kelly Murphy of The Avalon Group. Her lectures on the Microsoft precedent and the new IRS rules for consultants and their clients are highly recommended. 503/638-6660.

Trend #1. A major business trend in recent years has been downsizing and outsourcing. This "unbundling of the value chain" is one of the Engines of Prosperity that we write about in our book of the same name.

Recent job growth in the U.S. has come from independent practices and small businesses. The Fortune 500 has been flat in sales and shrinking in jobs for years.

Trend #2. A major political trend is that Congress has abrogated its traditional administrative oversight role. Few in Congress dare anger the soccer moms, or whomever, by "interfering" with the bureaucracies. One result is that the regulators have broken their leashes.

Even the popular but exhaustingly tedious efforts to reform IRS were mostly deflected. Despite the Constitution and recent media reports, the IRS still treats taxpayers as guilty until proven innocent, except when it is taken into court. ("What Taxpayers really gain from IRS reform," Money, September 1998, pg. 152.)

With Congress inactive, only the courts offer much hope of redress. That’s a very expensive and time consuming process. ("Taking Regulators to Court," American Management Association International, July/August 1998, pp. 30-32.)

The bureaucracies now focus more energy on small firms. A lawyer friend says IRS audit manuals actually suggest targeting small firms that can’t afford to defend. All successful predators attack the weak, and the IRS does it well.

Trend 1 (unbundling) + Trend 2 (predatory regulators) = big trouble.

Firms downsize to save money, but they still need to get work done. Hence, a common practice used to be laying off employees and hiring them back as "consultants" at their former wages plus about 30%.

That sounds reasonable to those who have not run businesses, but it's not. It doesn't come close to covering the costs of running a practice. The overhead for even supporting an employee is more like 100%. Doing business has many costs: training, travel, phone, marketing, practice development, services, vacations, equipment, licenses, rent, insurance, supplies, printing, postage, web pages, conferences, professional associations, accountants, bad debts, taxes, fees, lawyers, interest, etc.

When you pay a consultant's fees or buy a shirt from a store, most of the money goes toward covering the cost of doing business. Though established firms bill consultant time at $100 to $500 per hour, the median income for management consultants is low, only $54,400. (Money, September 1998.)

The Case. Microsoft used to have a practice using what the press called "perma temps" or "microserfs" instead of employees, presumably because not paying benefits saved them money. For years, they used large numbers of contract temporary workers to write code.

What happens when contract workers tally their expenses and find that their net income is lower? They pay less tax. The IRS doesn't like that, and they have found ways to turn outsourcing and unbundling into a gold mine.

As strange as it may sound, the IRS can disallow any business expense (receipts or not) just by saying it’s "not ordinary and necessary." Those who disagree can argue at their own cost.

Few realize it, but if you dare to appeal the IRS can examine seven years (!) of your tax returns. They can also extend the statute of limitations indefinitely, by sending a cute little form that says if you don't agree to waive your rights they will simply find against you. IRS also stacked the deck with tough new guidelines (IRS form SS8) for independent contractors.

The good news is that if a contractor has solid practices, good tax attorneys, and solid records, cases where IRS disallows business expenses without just cause are quite winnable in tax court. The bad news is that this process takes years, the contractor's costs will be high, and it is all but impossible to recover one's costs even if judged innocent.

But back to the Microsoft case. Because of clumsy policies, Microsoft was an early, easy, obvious target. The IRS waited a few years for potential interest and penalties to accrue, and then pounced. The microserfs were easy prey. As a bunch of kids who had worked only for Microsoft, few came close to meeting the guidelines for being independent contractors. It was like shooting fish in a barrel or taking candy from babies.

Microsoft quickly chose to settle, agreeing with IRS that its microserfs were employees, not independent contractors. That crushed the microserfs. Disallowance of their business expenses, plus interest, penalties, and the cost of re-filing years of tax returns was devastating. They were in deep trouble.

As it turned out, Microsoft was in worse trouble. It soon learned that agreeing with the IRS was a big mistake. The IRS hit Microsoft, the real target, for its "misclassified employees." They collected, of course, but that wasn't the end for Microsoft. Things quickly got worse, much worse.

Some of Microsoft's contract workers -- now deemed employees, faced with huge tax bills from having their business expenses disallowed, and desperate, hired lawyers. The lawyers smiled. "Why not be Microsoft employees? They will owe you benefits and stock options worth millions."

Microsoft objected, so the workers sued on a class-action basis. Microsoft, having already agreed the microserfs were employees, lost. Microsoft appealed to the 9th circuit court, and lost. They appealed again, and lost. Finally they appealed to the Supreme Court, who refused to hear the case, so Microsoft lost again. Overall, the debacle has cost Microsoft billions, made lawyers rich, and probably gotten some IRS bureaucrats promoted.

Professional independent contractors invest and take great care to protect themselves and their clients from the regulatory bureaucracies in general, and especially from the IRS. That is expensive, and they imbed this cost into their fees. It is a cost of doing business.

The lesson? Get a real independent contractor, a professional. Hiring pseudo-consultants "cheap" can be very expensive, as Microsoft and others have learned.

Incidentally, as a separate and unrelated matter, I myself was dragged through this gauntlet by the IRS, having all my business expenses egregiously disallowed. That started a three-year ordeal, which ended only when I sued the IRS in Federal Tax Court. [Docket No. 16166-98, John D. Trudel, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.] In the end, the court ruled that I owed the IRS nothing for the year in question. None of my clients were ever dragged into the case, or bothered in the slightest.

This article is expanded from The Trudel Group newsletter, Q4 1998.

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