IRS Worker Classification Audits—Risks and Relief Options

The battle between the Internal Revenue Service (IRS) and taxpayers continues over independent contractor treatment. The Wall Street Journal recently reported that the IRS has been making its rounds to small businesses, checking in to see if they have classified their workers correctly.

Congress’s and the IRS’s perception is that the use of independent contractors has led to an ever-widening “tax gap” in lost payroll tax revenues from misclassified workers. In 2010, the IRS began a national research project that involved the examination of 6,000 taxpayers, with a focus on whether they were complying with the employment tax reporting and withholding rules. One of the examination areas was worker classification issues. The taxpayers were randomly selected and included large, mid-sized, and small business employers and nonprofit organizations. Not surprisingly, a majority of the audits were of small businesses (because smaller businesses comprise a majority of the taxpayer community). An IRS representative recently confirmed that the IRS is finishing up the last of the national research project audits now and that they should have information soon about areas of noncompliance.

Worker classification initiatives are also a high priority for the U.S. Department of Labor (DOL), state attorneys general, and state agencies. Over the last few years, there have been numerous federal and state legislative and administrative proposals relating to independent contractors. Most recently, the DOL proposed commissioning a survey to explore the extent and nature of independent contractor misclassification as part of its ongoing misclassification initiative. The proposed survey would involve interviews of more than 10,000 workers from various industries over the next two years. Without a doubt, the process and results of that survey will likely spur questions from affected workers and additional independent contractor misclassification litigation and enforcement actions.

Given the current fiscal situation in the United States and the increased scrutiny on independent contractor relationships at the federal and state levels, independent contractor disputes are not going away any time soon.

Advantages of Engaging Workers as Independent Contractors

In a recent article, The Wall Street Journal reported that “[d]espite the threat of a payroll tax audit, more small employers are finding that independent contractors are essential to remaining competitive.” That is because it is significantly less expensive to hire independent contractors since they do not require employers:

• to pay federal and state employment taxes (including Federal Insurance Contributions Act (FICA) tax), federal and state unemployment insurance taxes, or workers’ compensation premiums;
• to provide employee benefits (health coverage, retirement plan, vacation pay); or
• to pay for the costs of office space, materials or equipment for the workers.

Furthermore, employers can hire an independent contractor when, and as, they need them.

Classification Criteria:  Independent Contractor or Employee? 

Unfortunately, there is neither a single nor a simple test used to determine whether a worker is an independent contractor or an employee. The tests applied are complex, factually based, and highly subjective, and they differ depending on the law at issue. Further, because the test used by the IRS differs from the DOL’s test, which also differs from the test(s) applied by many states, it is quite possible that the IRS could determine that a worker is an independent contractor while another government agency treats the worker as an employee (or vice versa).

Under present law, the determination of whether a worker is an employee or an independent contractor for federal employment tax purposes is generally based on a facts and circumstances test that seeks to determine whether the worker is subject to the control and direction of the service recipient, not only as to the result but also the details and means by which that result is accomplished. In 1987, based on an examination of cases and rulings, the IRS developed a list of 20 factors that may be examined in determining whether an employee-employer relationship exists. The IRS also looks at any other information that helps determine the degree of control and degree of independence. The IRS generally groups evidence regarding the right to control into three primary categories: (1) behavioral control; (2) financial control; and (3) relationship of the parties. The importance of each category and factor will vary depending on the type of work being done and the factual context. The IRS’s view of which factors are relevant in any given circumstance may be very different from the taxpayer’s. Given the highly subjective nature of the analysis, it wouldn’t be surprising or unusual for a tax auditor or worker to look at the same facts as the employer and reach an entirely different conclusion.

Risks of Misclassification

Misclassification of a worker as an independent contractor poses many significant risks, including liability for federal employment taxes for all open tax years, plus interest and penalties. For example, assuming that a company does not qualify for any of the relief provisions or settlement programs described below, the company’s liability for federal employment taxes for one year for one misclassified independent contractor earning $50,000 is approximately $20,000 (i.e., 40% of $50,000), plus interest and penalties. (The 40% rate used in this example is the full statutory rate, which assumes a 25% federal income tax withholding rate and 15.3% rate for the combined employer and employee portions of FICA). This liability can be eliminated entirely if the independent contractor arrangement qualifies for the safe harbor provided by Section 530 of the Revenue Act of 1978. Those taxpayers who do not qualify for the Section 530 safe harbor may qualify for reduced tax rates under Section 3509 or the IRS Classification Settlement Program, the IRS Voluntary Classification Settlement Program (VCSP) or the Temporary Expanded VCSP (Temporary VCSP). The IRS Classification Settlement Program is a voluntary settlement program for taxpayers who are under audit. The VCSP and the Temporary VCSP are both voluntary settlement programs for taxpayers who are not under audit. Each of these relief provisions and settlement programs are described further below.

In addition to federal taxes, wrongfully classifying workers as independent contractors can subject employers to liability for failure to withhold state taxes, failure to pay for or provide state unemployment insurance and state workers’ compensation coverage, failure to pay minimum wages or overtime, failure to provide employee benefits (and the potential disqualification of employee benefit plans) and other state law violations. In addition, when the so-called employer mandate provisions of Code Section 4980H become effective on January 1, 2014, the cost of misclassifying a worker may increase, in some cases dramatically. If a worker provides an employer 30 or more hours of service per week on average during a calendar month, and if the worker is determined to have been the employer’s common law employee, the employer may have been required to offer the worker and his or her dependents the opportunity to enroll for coverage in an employer-sponsored health plan as a condition of immunizing itself from federal excise taxes under Section 4980H(a). If the federal excise tax is triggered, the amount for a month can be calculated by multiplying $167 times the employer’s entire full-time workforce (minus the first 30 full-time employees), not just for the misclassified worker. Depending on the total number of company employees, that could be a significant liability.

Protecting Yourself from Federal Tax Liability

Many employers succeed in creating legitimate independent contractor relationships while avoiding the risks associated with misclassification. There are a number of steps that employers can take when creating and maintaining an independent contractor relationship that will help them avoid or substantively reduce their potential exposure in an employment tax audit.

Understand the IRS Tests and Relief Provisions

Employers should be careful to structure and manage independent contractor relationships with the IRS’s control test factors in mind. To assist with this, the IRS has published a training guide called “Independent Contractor or Employee? Training Materials” that its auditors use as audit guidelines. Employers can also use IRS Publication 1779, “Independent Contractor or Employee?” and IRS Fact Sheet, FS-2007-27 (2007), Employment Taxes and Classifying Workers as resources.  In addition, employers should understand the statutory provisions and settlement programs available that provide relief from liability for federal employment taxes.

Section 530 Safe Harbor

The Section 530 safe harbor eliminates all (past and future) federal employment tax exposure for qualifying independent contractor arrangements. Under the Section 530 safe harbor, an employer is not responsible for past employment taxes for workers who the IRS determines have been misclassified. Nor is it required to prospectively reclassify such workers. Rather, employers can continue to treat workers that the IRS determines have been misclassified as independent contractors for federal employment tax purposes provided that the employer has a reasonable basis for such treatment (and otherwise satisfies the other requirements of the safe harbor). Given the magnitude of the relief, employers should be mindful of the Section 530 safe harbor requirements and position themselves to qualify for that relief.

To qualify for the Section 530 safe harbor:

• The taxpayer must have filed all Forms 1099 for the independent contractors.
• Each group of workers that holds similar positions must be treated consistently (e.g., the employer cannot treat any worker holding a substantially similar position as a W-2 employee).
• The taxpayer must have a reasonable basis for its treatment of its workers as independent contractors.

For this purpose, “reasonable basis” includes reliance on court cases, published rulings, a ruling the taxpayer received from the IRS, a past IRS audit in which there was no assessment with respect to the class of workers at issue or by showing that a significant segment of the taxpayer’s industry treat similar workers as independent contractors, or other reasonable basis. More information on the Section 530 requirements can be found at the IRS’s Publication 1976, Do You Qualify for Relief Under Section 530?

Note, the Section 530 safe harbor is not available to all taxpayers and it only provides relief for federal employment taxes. It does not apply with respect to certain services provided by technical services personnel (engineer, designer, drafter, computer programmer, or skilled workers in a similar line of work), and test proctors. In addition, it possibly may not provide relief from the Section 4980H(a) excise tax described above if workers covered by the Section 530 safe harbor would be classified as common law employees, the employer does not offer such workers the opportunity to enroll in an employer-sponsored health plan, and the worker obtains health insurance from an exchange.

Not surprisingly given the magnitude of the employment tax relief available under the Section 530 safe harbor, several legislative proposals have been introduced in the past few years that would greatly weaken the availability of the Section 530 safe harbor, if enacted. To date, those legislative attempts have not been successful. If an employer is relying on the Section 530 safe harbor for employment tax protection, it should track legislative developments that may adversely restrict future reliance on Section 530.

Section 3509 Relief

Section 3509 relief, like the Section 530 safe harbor and settlement programs described below, highlights the importance of issuing Form 1099s to independent contractors. This is because, as a general rule, if the employer issues Form 1099s, then its liability for federal income tax withholding is limited to 1.5% of the total wages paid to the worker and its liability for the employee’s portion of FICA taxes is limited to 20% of the employee’s FICA taxes that would otherwise be imposed. Note, Section 3509 does not provide any relief with respect to the employer’s portion of FICA taxes or Federal Unemployment Tax Act (FUTA) taxes. For 2012, the effective tax rate under Section 3509 is 10.28% (for compensation up to the Social Security wage base) and 3.24% (for compensation above the Social Security wage base).

If the employer fails to issue Forms 1099 and the employer cannot establish reasonable cause for such failure, the special 1.5% withholding rate is raised to 3% and the special 20% FICA tax rate is raised to 40%. Section 3509 relief does not apply if the employer intentionally disregards the law in treating an employee as an independent contractor.

IRS Classification Settlement Program

The Classification Settlement Program is an optional settlement program for taxpayers who are under a federal employment tax audit. Under the Classification Settlement Program (CSP), two graduated settlement offers are available if the taxpayer will agree to classify its workers as employees prospectively. Under the CSP, if an employer has filed all required Form 1099s and has a colorable claim to the Section 530 safe harbor, the CSP offer is 25% of the employment tax liability for such workers for the most recent year under audit, calculated under the reduced rates of Section 3509. Alternatively, if an employer has filed all required Form 1099s but does not have a colorable claim to the Section 530 safe harbor, the CSP offer is a full employment tax assessment under the reduced Section 3509 rates.

IRS Voluntary Classification Settlement Program and the Temporary VCSP

Employers may also be eligible for federal employment tax relief by voluntarily reclassifying workers under the VCSP or the Temporary VCSP. The VCSP was established in 2011 and was subsequently revised in December of 2012 to enable more companies to participate. The Temporary VCSP was established in December of 2012 and is available only through June 30, 2013. These programs allow employers to voluntarily reclassify workers who were treated as independent contractors prospectively in exchange for immunity for the past. In exchange for federal employment tax audit protection for the employer and the reclassified worker, employers pay 10% (under the VCSP) or 25% (under the Temporary VCSP) of the employment tax liability for such workers for one year, calculated under the reduced rates of Section 3509(a) or (b), respectively. For the VCSP applications filed in 2013, the most recently closed tax year will be 2012, and therefore the 2012 rates will apply. For 2012, the effective tax rate under Section 3509(a) is 10.28% (for compensation up to the Social Security wage base) and 3.24% (for compensation above the Social Security wage base). The rates under Section 3509(b) are higher. Interest and penalties are waived (except that under the Temporary VCSP, described below, the employer must pay a reduced penalty for unfiled Forms 1099 for the previous three years.)

To be eligible to participate in the VCSP (as revised in December of 2012), an employer must: (1) have consistently treated the workers that it seeks to voluntarily reclassify as employees as nonemployees in the past; (2) have filed all required Form1099s for each of the workers for the previous three years; (3) apply to participate in the VCSP; and (4) enter into a closing agreement with the IRS. In addition, the employer must not currently be under an employment tax audit by the IRS, current worker classification audit by the DOL or any state government, or contesting the classification of workers from prior audits with the IRS or DOL in court. A prior audit does not disqualify a taxpayer that complied with the results of the prior audit. Employers no longer are required to extend the period of limitations for employment taxes as part of the VCSP closing agreement with the IRS.

The Temporary VCSP is available to employers that failed to file required Form 1099s for workers it seeks to reclassify, but otherwise meet the remaining requirements of the VCSP (described above). Employers that wish to participate in the Temporary VCSP must submit an application on or before June 30, 2013. The VCSP continues to be available after June 30, 2013 for employers that have timely filed Form 1099s for workers they seek to reclassify.

Note, participation in the VCSP or the Temporary VCSP may expose employers to a host of other worker and state consequences because these programs are limited to federal employment taxes and do not address retirement and health care benefits, state taxes, or other employment law misclassification concerns. For that reason and because there may be alternatives to the VCSP or the Temporary VCSP to reduce or eliminate federal employment tax exposure, employers must weigh carefully all the pros and cons of participating in either program.

Conclusion

Needless to say, this is a very complex area of law. Employers that are concerned about their existing workforce classifications, that take the position that any of their workers are independent contractors, or that decide to participate in the VCSP or Temporary VCSP, should contact their tax advisor.