Q: One of our longtime independent contractors (IC) has been engaging in a bizarre practice: When a client pays by credit card for a cruise, tour or all-inclusive resort, the IC charges it to the IC's credit-card merchant account, and then the IC pays the supplier using the IC's own credit card. This behavior appears counterproductive, as the IC must absorb the approximately 3% merchant fee. Have you ever heard of this practice? Why would an IC engage in it? Does it raise risks for our agency, and if so, should we prohibit it? Wouldn't prohibiting the practice be a kind of control that would risk IRS reclassification of the IC to an employee?
A: I have heard of this practice a few times, and each time it has been part of an embezzlement or fraud perpetrated by an IC.
I recommend that you consider prohibiting the practice and requiring the IC to process the client's charge using only the supplier's or your agency's merchant account.
An IC who decided to use his or her own merchant account might do so for any or all of three reasons. Their benefits all potentially outweigh the 3% cost of the merchant fee.
First, there will be an enormous cash-flow benefit for a cash-strapped IC. The client's money gets deposited into the IC's account in a few days, but after the IC pays the supplier using his own card, the IC does not need to pay his credit card bill for months or even years, except for the minimum monthly payment.
Second, as you probably can guess, an IC may use his own credit card in order to obtain frequent flyer or loyalty program points on his own card. Depending on the program and the cardholder's program status, it may well pay to absorb a 3% loss in order to obtain the program benefits that the IC seeks.
Finally, by having the client pay the IC by credit card, the IC might be able to mark up the cruise, tour or all-inclusive without having the client ever become aware of the lower price paid by the IC. Marking up a travel service is perfectly legal, unless it is prohibited by the particular supplier's agreement with the IC or your agency.
Allowing an IC to use his own merchant account creates a big risk for your agency.
It is the same risk that your agency runs when it allows the IC to deposit client funds: the risk that the IC will not pay the supplier at all, but will instead spend the client's money on more pressing needs or leave town with the money.
Regardless of your legal liability to the client or supplier for the IC's acts, your agency will probably make good in order to preserve its reputation.
To avoid such a disaster, it may make sense to require that ICs process charges the same way that your employees do.
While requiring the IC to process sales in a specified way is a form of behavioral control, it is important to remember that no single factor is determinative to the IRS.
So, if the IC is otherwise free to sell when, where and to whom he wishes, I would not worry about the risk of reclassification.
Mark Pestronk is a Washington-based lawyer specializing in travel law. To submit a question for Legal Briefs, email him at [email protected].