The IRS sees Kevin Gallagher's free-spirited bike messengers as employees; he swears they're independent contractors. The IRS means to make Gallagher an example. He's perilously close to making himself a martyr. Either way, he loses

Kevin Gallagher is battling tax auditors. And although he's enlisted the support of lawyers and accountants, of his local and national industry associations, and of legislators at the statehouse and in Washington, D.C., he's probably going to lose.

The auditors want Gallagher to reclassify his workers. His company, Quicksilver Messenger Service, in Chicago, pays its drivers and cyclists as independent contractors -- autonomous businesses providing services for a fee. Straight commission, no benefits. But the Illinois Department of Employment Security (IDES) and the Internal Revenue Service say they should be employees -- that, in fact, they are, and that Gallagher, Quicksilver's chief executive, should have been withholding income taxes and Social Security all along.

The first battle won't finish Gallagher off. He'll lose to state auditors, but there's a limit to the penalty they can impose -- in Gallagher's case, almost $15,000. Next, he'll lose to the IRS, which has estimated that he owes more than $80,000 in unpaid taxes. That's more than any annual profit that Quicksilver has ever made. But then comes the Labor Department, which will tally up all the overtime Gallagher owes to those retroactive employees, and the sky's the limit. If he reclassifies his workers, benefits will whittle away at what there is of his margins, and if some sort of national health-care bill passes, that could finish him off, he says. Oh yes, and one more thing: once his drivers are employees, they'll be easier to unionize, which the teamsters would like to do.

The same battle is going on in dozens of industries, over roofers and manicurists, accountants and exotic dancers. And although it's not the first time combat has been joined, it's more intense than ever before. Partly, it's about revenues. Independent contractors -- especially 20-year-old bicycle messengers -- don't pay their taxes as reliably as employees who have them withheld. And it's easier for auditors to track down one established company than 100 footloose kids.

But the battle is also about competing ideas of employment -- the government's, the owners', and the workers' themselves. The number of contractors is growing as workers demand greater independence and flexibility and as companies in a competitive marketplace rush to outsource unessential operations, to dodge workplace litigation, and to shrug off the growing cost of benefits. Looking at the new class of workers, it's difficult to say whether they're victimized or self-actualized. Ask them, and they're not sure themselves about what they are or what they want to be. Or what they're owed.

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Quicksilver's offices look like a dorm without the intellectual implications -- scuffed white walls, threadbare carpet, secondhand furniture, and food wrappers. Bicycles, intact or in pieces, obstruct the entrance to one lobby, where someone snoozes in front of a television. Through the next door, past a beer-company poster of a healthy young woman, and over the noise of another TV, George Hraha, the company's co-owner, president, and dispatcher, is cussing out a recalcitrant biker. More bikers wander in to pick up deliveries. Some look hearty, hip, and sportive, as if they live every office drone's freedom fantasy; others look desperate. Twenty yards beyond the window rumble the elevated trains that define Chicago's downtown, the Loop.

In his office the CEO is explaining his fight against reclassification and how it became a crusade to save his industry. Gallagher, 39, is immediately likable -- down-to-earth and gregarious, with thick graying hair and a luxuriant mustache. He eagerly pulls file after file from a cabinet he's dedicated to the campaign, talking obsessively and wincing every time he uses the wrong word, a giveaway word. Describing the two partners' division of labor, he says, "George handles everyday operations: dispatching, hiring -- ach! I mean contracting! Oh God, this has got me punchy! But he gets the contractors. I'm more involved with customer relations, sales, accounting."

And increasingly, with litigation and legislation. Gallagher estimates he easily spends 20% of his time on the reclassification face-off. There are weeks when that's almost all he does. "If I were going into the business today, I would use employees, only because of the time that I spend on this issue."

Gallagher further concedes, "Employees would make my life a little bit easier, to be honest with you. With contractors, the day after a Grateful Dead concert, you may be down 10 drivers. They just didn't feel like coming in. And that's their prerogative. With employees, I'd have more control." Then, too, he'd have a little more control over, um, presentation. Gallagher laughs. "Personal hygiene, and everything that goes along with that."

That wouldn't be Quicksilver's style, though. Gallagher and Hraha enjoy the free spirits, oddballs, and ex-cons who answer their help-wanted ads, like the guy who lived under the highway. ("He was always available for early deliveries," Gallagher says.) And they prefer the no-frills motivation style. "If they want to do it, they do it," Hraha says. "If they don't, I get somebody else, simple as that."

Ten years ago, when the partners got into the business, using contractors was standard operating procedure. In fact, it might have been impossible to survive if Quicksilver had assumed the overhead associated with employees. Contractors gave Quicksilver more flexibility, and the company grew. At first the company handled only prescheduled deliveries by car; then it added on-demand deliveries. Bike couriers came next. Bikers can pick up a package downtown, carry it quickly past traffic, and hand it off to a driver to take to the suburbs. That's when sales took off. In 1992 the company made a 5% pretax profit on $1.2 million in sales, using about 30 drivers and 15 bikers at any time, all contractors.

Now, Gallagher says, it would be almost impossible to reclassify. "I don't know how high my workers' comp would go, and that's a huge expense in our industry," he says. "That's not to mention what would happen to my unemployment-contribution rate. It would drastically affect our bottom line." There would be benefits to pay, too. Gallagher could charge clients more, but they'd probably shop elsewhere. Or he could pay couriers less, but they'd leave, too. The auditors pick off companies one at a time and put those businesses at a competitive disadvantage.

Gallagher and Hraha started as contractors themselves. They had been working for a title-insurance company. "I was in the judgment department," Gallagher explains. "The company purchased a computer database and basically eliminated my job." The company needed deliveries made, but cheaply. So the insurance agents asked Gallagher if he wanted to make deliveries as an independent contractor, and they set him up with Hraha, whom they'd employed as a delivery driver.

Stripped of benefits and job security, the pair began making night deliveries by car and meeting in the wee hours to take a break and plan their growth. While dropping off deliveries for the title company, they found they could pick up others and grow a real business. Their instincts were dead-on: after a few years they couldn't handle all the deliveries alone. A lawyer told them -- correctly at the time -- that the industry's employment standard was to use independent contractors. So they used contractors.

That was long before the IRS and the IDES began their new round of crackdowns. The trouble started in 1989, after Quicksilver's laid-off office manager applied for unemployment benefits. He'd been an employee -- one of the few there -- but the words courier service on his application sent up a red flag. Later Gallagher received notice that the state would be auditing Quicksilver, first for the tax years 1987 and 1988, then for 1989 and 1990. He's spent the five years since tangled up in two chains of audits, hearings, and appeals at the state and federal levels.

The auditor, Gallagher says, was surprisingly polite. "He's a foot soldier, very unbiased, just there to collect numbers." The hearing that followed his audit was more contentious. Gallagher showed up at the offices of the state Department of Employment Security at 9:30 a.m. with his lawyer, his accountant, and a consultant who had worked for the department.

In nine hours of testimony, Gallagher tried to prove that the service his couriers performed was outside the usual course of Quicksilver's business -- that his company was a "brokerage" that referred customers who needed deliveries made to independent contractors who made those deliveries. The IDES wasn't buying. (Would you?) The official decision stated: "The customer believes an account with Quicksilver is an account with that messenger company alone, and that the messengers are merely agents or representatives of Quicksilver." The IDES assessed $15,000 in back taxes and penalties. Getting that one scalding decision cost Gallagher $25,000 in professional fees.

Now Gallagher has taken the state audit to the second level of appeal. But no courier service has yet won a worker-classification case in Illinois, and it doesn't look as if Quicksilver will make history. "We'll take it as far as I can financially afford to take it," he says.

It gets worse. The state audit automatically triggered a letter of liability from the IRS, which presumes guilt and sends a bill, which a company can contest. Quicksilver lost the IRS audit, which found that the courier owed $80,729 in back taxes. Gallagher is appealing that decision, too. He doesn't expect to win in court, though; his lawyers tell him his only chance is to win an exemption for the entire industry from the state legislature .

So Gallagher has become a reluctant crusader for his competitors, too. "I backed into this," he insists. "But every day you get more involved." As he nears the audit endgame his reluctance grows. He knows that when he loses the last audit battle, he'll have to cut a deal if he wants to avoid bankrupting his business. Commonly, the IRS tells a company it will forgive past debts if the owner agrees to reclassify its workers as employees. But if he cuts a deal, he's a poor crusader.

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The IRS uses a notorious set of 20 common-law guidelines to determine a worker's status. For instance, the more training a worker receives, the more he looks like an employee. If a worker's services are integral to business operations, she looks like an employee. Workers who furnish their own tools look more like independent contractors.

There is some brutal justice in the IRS's guidelines. They tell owners and workers that they can't have the best of both worlds. But the guidelines are vague and arbitrary. Not all of them apply in every case, and they aren't weighted, so you might pass all but one test and still fail.

The recent crackdown isn't the first; the IRS aggressively pursued misclassification of workers in the mid-1970s. But companies complained so bitterly that Congress passed a safe-harbor provision, Section 530, allowing continued and unending use of independent contractors without penalty if businesses could qualify on three counts: first, they had to have filed their 1099 forms faithfully; second, they had to prove "consistent use" (in other words, all workers had to be contractors -- there could be no mix of employees and contractors); and third, they had to prove "reasonable basis" (that is, that they were relying on industry practice or a long-standing precedent). Intended as a stopgap, the statute was extended indefinitely.

The IRS laid off for a while. Meanwhile, use of contractors rose. In 1985 nearly 12 million taxpayers filed returns as sole proprietors, a group that includes independent contractors; by 1990 the number had grown by 3 million.

Of course, much of the increase was legitimate -- part of a watershed in the way America works. But some of it wasn't. Faced with a tough business climate, some companies decided that reclassifying employees as contractors was a cheap way to get the same work done. Workers were in no position to argue.

In 1985 the feds test-audited independent contractors in seven districts and found widespread misclassification and unpaid taxes -- lots. Since then, the IRS has been sowing mines all over Section 530's safe harbor. Assisted by computerized processing of tax returns and information shared with state agencies, the IRS has stepped up its audits of companies that use independent contractors. Congress originally instructed the IRS to interpret Section 530 liberally. Businesses say that lately it's easier for a camel to pass through the eye of a needle than for them to gain safe harbor.

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The IRS makes a convenient bad guy. but the agency says it's just doing its job, trying to recover some of the $2 billion a year in lost revenues it attributes to misclassification -- money that should have been paid in income taxes, Medicare, Social Security, and state and federal unemployment insurance, debt that the rest of us have to cover. "There's a side to it that company owners ignore," says Tony Warcholak, former director of employment-tax administration for the IRS. "Contractors aren't covered by unemployment insurance, and they become an additional cost to the state if they end up on welfare."

States hard hit by the recession have also stepped up their efforts to reclassify contractors, to recoup some of the money paid out in unemployment benefits. Illinois is one of the toughest, in a class with California, Georgia, Michigan, New York, and Texas. Most states, including Illinois, use the "ABC" test to differentiate between contractors and employees. Even vaguer than Section 530, it comprises three broad criteria, all of which a company must meet: (a) Does the company exercise control over the worker? (b) Does the worker perform services at the company's place of business or in its course of business? (c) Does the individual work in an independently established trade? It's an easy test to fail, especially when "control" can be as simple as dispatching a driver, and "place of business" is extended to include anyplace a driver picks up a package.

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Kris Guse makes about $400 a week driving for Quicksilver Messenger Service -- enough to cover his dirt-cheap rent and slacker expenses. One week, when the Grateful Dead was in town, he made just half that. He gets no salary, no hourly wage -- just a 55% commission on every delivery he makes, whether it's a $5.40 deferred delivery to Meigs Field three miles away or a $65.90 emergency delivery 68 miles to Hebron. Drivers who really push, he says, can make $1,000 a week.

Before this job, Guse worked in a furniture shop. "We made beautiful stuff, and I loved the work, but the boss and I disagreed," he says. "I told him, 'If our results are the same, what does it matter whether I do it your way or mine?"

Guse rolls in at 9:30 a.m., hours after hungrier drivers have left for their first deliveries. He gets a package going out to Hoffman Estates, an office park in Chicago's northwest suburbs. When he gets there he parks illegally in front of a wheelchair ramp, trots into the office to deliver an envelope, returns, and radios the dispatcher at Quicksilver's downtown office. A good dispatcher is the key to a courier service's success, keeping both customers and drivers happy. Hraha knits together a series of short hauls for Guse that bring him back downtown in stages, making money all the way. "With this job, I take whatever route I want. They don't argue with me." Guse sets his own hours, too. In the summer he keeps a fishing rod in the backseat, and, he says, on particularly slow days -- or particularly nice days -- "I'll tell them, 'Let me go, I've got other things to do."

Does Guse fit the IRS's definition of an employee? Or the state's? Or any reasonable person's? He's certainly integral to Quicksilver's business -- if the couriers aren't employees at a courier service, who is? And the company tells him where to pick up and drop off deliveries. But he's free to refuse a delivery, he decides how to get there, and he can come and go as he pleases. He's free to work for other services, but he doesn't. The car is an investment but not a big one.

Gallagher's couriers would look more like by-the-book contractors if he could get a business card, a piece of letterhead, any advertising the courier has placed, or even an invoice from each one. His lawyer Nancy Jeorg tells him this. Gallagher is incredulous: "A biker that has business cards?! Who advertises?!" Jeorg knows it's unrealistic. "It's an outdated idea of the independent contractor. It hasn't kept up with the times," she says.

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Lots of people have tried to bring the definition up-to-date; even the IRS admits that the fuzzy semantics are a problem. Periodically, Congress holds hearings. Accountants, lawyers, business owners, and labor groups give testimony. Nothing happens. Each interested industry has its political action committee working on Congress, too. Gallagher belongs to the Expedited Package Independent Contractors Council (EPICC), which is trying to win an exemption for the industry at the federal level. Joe Morris, the EPICC's executive director, sees no prospects for a solution anytime soon. "No one in Congress has adopted this fight as his own," he says. "We're in a wait-and-see period."

Powerful interests oppose any solution that would make fewer people employees. Independent contractors are harder to unionize, so labor is opposed. Employees fit more neatly into Clinton's national health-care dreams, so the current administration is opposed. The president's proposal would give the IRS permission to eliminate the Section 530 safe harbor.

As long as the definition of an employee remains hazy, there's always some hope of interpreting the rules favorably. So some industries have focused not on finding an overall solution but on winning exemptions for themselves from Congress. Some, such as real estate agents, have succeeded. Although real estate agents work exclusively for one company, from its office, using its equipment and even training at its expense, they're classified as contractors. The IRS can't touch them.

Courier-industry folks point to real estate agents with outrage -- how can they be contractors if we're not? But they're envious, and they hope to mimic the real estate agents' success, with the help of people like Kevin Gallagher.

Gallagher began his efforts to win a state exemption at the end of 1992. With help from his lawyer Jeorg and Joe Berrios, a lobbyist and former state representative, he wrote and filed House Bill 179, which would exempt Illinois couriers from any penalties for using independent contractors.

It cost Quicksilver $3,500 to hire the lobbyist for four months and to get things this far. To push the bill further, Gallagher needed more money. "We couldn't do this through the local association, the Messenger Service Association of Illinois, because some members use employees," he explains. "So we formed a group outside the association." That group raised $20,000 for the lobbyist. If the bill passes, the lobbyist will get another $20,000 from the group.

When he goes to the capital in Springfield to testify before the House, Gallagher is in his element. "That's the only satisfaction I've gotten out of this whole thing -- the education in the legislative process."

Weirdly, he doesn't sound disillusioned. But his state-level campaign may prove a hard lesson. In Illinois all interested parties must sign off on a bill before it goes to a vote. The IDES has signed off on Bill 179, and so has the industry. The holdouts? The unions. "It boils down to a negotiated settlement," Jeorg says. "No one knows what it will take to get labor to settle."

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Gallagher sees the wall up ahead. He thinks he can pursue the appeals process for another five months before the money runs out. If his bill doesn't pass by then, he'll have to decide whether to reclassify. "It would come down to, Do I cut off my nose to spite my face? My partner and I, we both have families, and a lot of other families depend on Quicksilver. If it came down to closing the business on principle or paying, converting, and trying to survive, I'd probably have to . . . I'd just have to wait and see what happens. As the standard-bearer for this legislative battle, I wouldn't want to let anyone down." But later he admits, "If it means retaining the company, there's no contest. Which upsets me, because I believe they're independents."

But beliefs don't keep bread on the table. In fact, Gallagher has planned for reclassification. He and others figure that as more companies are forced to reclassify workers, the industry will consolidate. Only big companies that can spread out personnel overhead will survive. Gallagher wants to make Quicksilver too big to swallow, and with that in mind he recently acquired another courier for $10,000. That's money he won't spend on his crusade, so it appears he's made his decision. If he can grow to $5 million within a few years, he figures, he'll be safe.

Can Quicksilver make money with employees? Other courier companies do, like Arrow Messenger Service, which is owned by Phyllis Apelbaum, president of the Messenger Service Association of Illinois. In the 20 years since its founding, Arrow has grown steadily to revenues of more than $6 million. Yet its 200 drivers and bikers are all employees, with paid holidays and vacations, benefits, and Christmas bonuses. Apelbaum withholds taxes, FICA, the whole deal. "I believe that, in my company, the couriers are employees," says Apelbaum. "Direction and control are important to me. It's part of the service to the customer." Also, when she started Arrow it was more common to use employees.

Apelbaum's customers pay for her principles; Arrow charges 25% more than the regional average. "Have we lost business because of it? Absolutely. Would I have it any other way? No sir." Her customers pay more, she says, because, like her, "they don't expect couriers to work below a living wage."

Those principles also make it harder for Apelbaum to recruit couriers. "Some think if you're withholding taxes, you're taking their money. If they go to work for a contractor company, their checks will be bigger. Our personnel people tell them up front that we use employees. Sixty percent leave right then." The ones that stay, she says, stay longer than contractors would, even though Apelbaum makes demands of them that she could never make of contractors. Arrow's drivers can't drop out for a week to follow the Grateful Dead. And they wear uniforms.

Lisa Vilchis would have no part of that. She's been working as a Quicksilver bike courier on and off for about two years. Bored with her part-time job in a mortgage-lending bank, Vilchis got three tattoos and a courier job. She's 28 and looks like Jodie Foster. She's biked for three services but has stayed with Quicksilver the longest. "I won't work for some services. Arrow makes you wear a bow tie. I'm not going to wear a yellow shirt and a black bow tie."

Lisa says she keeps good records and pays her taxes. That's unusually conscientious. Many bikers laugh at their colleagues who pay. Vilchis does without health insurance for now -- a situation that displeases her mother. "She tells me I'll wind up in Cook County Hospital."

Vilchis says she lives for the moment; Bill Clinton frets about her future. What will she retire on? How will she pay if she does wind up in Cook County Hospital? And does she pay her taxes regularly? You can't blame the government for worrying -- that's part of its job. It would be so much simpler if Lisa Vilchis were an employee.


Workers are generally considered employees if they --

1. Must comply with the employer's instructions about the work

2. Receive training from or at the direction of the employer

3. Provide services that are integrated into the business

4. Provide services that must be rendered personally

5. Are aided by assistants who are hired, supervised, and paid by the employer

6. Have a continuing working relationship with the employer

7. Must follow set hours of work

8. Work full-time for an employer

9. Do their work on the employer's premises

10. Must do their work in a sequence set by the employer

11. Must submit regular reports to the employer

12. Receive payments of regular amounts at set intervals

13. Receive payments for business or traveling expenses

14. Rely on the employer to furnish tools and materials

15. Lack a major investment in the facilities or equipment used to perform the services

16. Cannot make a profit or suffer a loss from their services

17. Work for one employer at a time

18. Do not offer their services to the general public

19. Can be fired by the employer

20. May quit work at any time without incurring liability

Source: The IRS. n

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