Section 530 relief for worker classification controversies.

• Author: Nash, Claire Y.

The IRS continues to be concerned about the appropriateness of taxpayers' classifications of workers as independent contractors. IRS estimates show that the underpayment of federal income taxes on self-employment income and the underpayment of self-employment taxes contribute $122 billion and $57 billion, respectively, to the "tax gap." (1) To reduce underreporting of these taxes and narrow this portion of the tax gap, (2) the IRS will generally scrutinize the classification of workers as independent contractors, rather than employees, during income tax audits of firms, and assess taxpayers for the underpayment of employment taxes.

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In an effort to increase tax compliance and provide certainty for taxpayers, in September 2011 the IRS announced a new voluntary classification settlement program (VCSP). The VCSP provides partial relief from retroactive federal employment tax assessments for eligible taxpayers that agree to prospectively treat their workers, or a class or group of their workers, as employees. (3) To be eligible for the VCSP, a taxpayer must have consistently treated the workers in question as nonemployees and must have filed all required Forms 1099 for the workers for the previous three years. Taxpayers must apply for admission to the program. At the time of application, the taxpayer cannot be under audit by the IRS or, concerning the classification of its workers, by the U.S. Department of Labor or a state government agency.4 for the workers for the previous three years. Taxpayers must apply for admission to the program. At the time of application, the taxpayer cannot be under audit by the IRS or, concerning the classification of its workers, by the U.S. Department of Labor or a state government agency. (4)

By design, the initial cost to participate in the VCSP is relatively small. Consequently, the IRS retains discretion whether to admit a taxpayer into the program. Taxpayers admitted into the program must pay 10% of the employment tax liability that might have been due on compensation paid to the workers reclassified as employees for the most recent tax year, determined under the reduced rates of Sec. 3509(a). Participants will not be liable for any interest and penalties on the reduced employment tax amount, and the IRS will not challenge the prior classification of the workers reclassified under the VCSP. However, taxpayers with more than one class of workers should be aware that participation in the program will not prevent an IRS challenge to the classification of workers not covered under the VCSP. Additionally, for the first three years following admission to the program, participants must agree to an extended sixyear statute of limitation on employment taxes for the workers involved. After careful analysis of the VCSP, taxpayers might find that, even though the initial cost to participate in the program is relatively small, the future costs (i.e., the future employment taxes and future employee benefit costs associated with the prospective reclassification of workers as employees) may be too high and untenable for the certainty it provides. Under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), taxpayers must pay Social Security, Medicare, and By design, the initial cost to participate in the VCSP is relatively small. Consequently, the IRS retains discretion whether to admit a taxpayer into the program. Taxpayers admitted into the program must pay 10% of the employment tax liability that might have been due on compensation paid to the workers reclassified as employees for the most recent tax year, determined under the reduced rates of Sec. 3509(a). Participants will not be liable for any interest and penalties on the reduced employment tax amount, and the IRS will not challenge the prior classification of the workers reclassified under the VCSP.

However, taxpayers with more than one class of workers should be aware that participation in the program will not prevent an IRS challenge to the classification of workers not covered under the VCSP. Additionally, for the first three years following admission to the program, participants must agree to an extended six-year statute of limitation on employment taxes for the workers involved.

After careful analysis of the VCSP, taxpayers might find that, even though the initial cost to participate in the program is relatively small, the future costs (i.e., the future employment taxes and future employee benefit costs associated with the prospective reclassification of workers as employees) may be too high and untenable for the certainty it provides. Under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), taxpayers must pay Social Security, Medicare, and unemployment taxes (5) for the benefit of workers classified as employees and withhold and remit amounts from employees' wages for the employees' share of Social Security and Medicare taxes.

FICA and FUTA taxes are significant costs of employing workers. The current FICA tax rate paid by an employer is 7.65%. (Employees pay 5.65% for 2012 because of temporary legislation cutting the rate by 2 percentage points.) A taxpayer with employees must contribute 6.2% of a worker's earnings for Social Security and 1.45% for Medicare. (6) The maximum earnings to which the Social Security rate is applied are adjusted annually; however, there is no maximum level of earnings to which the 1.45% Medicare rate is applied. For 2012, the maximum earnings subject to the Social Security tax are $110,100 per worker. (7) Taxpayers are also required to pay a 6% FUTA tax on the first $7,000 of earnings for each employee annually. (8)

Taxpayers that treat workers as independent contractors not only avoid the costs of employment taxes, but they also avoid the administrative costs associated with calculating and withholding taxes from workers' earnings; depositing employment taxes with the Treasury; and reporting employment tax withholdings, contributions, and deposits on the appropriate forms during the year. In addition, they avoid employee benefit costs for workers' compensation insurance, health and welfare benefits, and retiree plans. However, if upon audit, the IRS determines that a taxpayer should have classified its workers as employees, the retroactive employment tax assessments could be large and potentially financially devastating.

Taxpayers that choose to continue to treat their workers as independent contractors can still prevail in an IRS challenge to their worker classifications and avoid retroactive employment tax assessments if they qualify for relief under Section 530 of the Revenue Act of 1978. (9) Section 530 provides relief for taxpayers who reasonably, but erroneously, classify workers as independent contractors instead of employees. Recent court decisions show that, consistent with Congress's intent to protect taxpayers that exercised good faith in determining that their workers were not employees, the courts continue to liberally construe the "reasonable basis" requirement in the law in favor of taxpayers.

Taxpayers that meet the consistency requirements (described below) and have a reasonable basis for not treating workers as employees can still prevail in the application of the Section 530 safe-harbor provisions to the facts and circumstances of their respective working relationships. This article reviews the common law principles and authoritative guidance available to distinguish when workers are employees and the Section 530 safe-harbor provisions. This article also discusses how taxpayers have met the statutory standards for the safe harbor and prevailed in IRS challenges to classifications of workers as independent contractors.

Common Law Employee or Independent Contractor

The extent to which a worker is subject to the control of the taxpayer is the crucial test in determining the nature of the working relationship. However, whether a worker is an employee is predicated not only on whether the worker is subject to the taxpayer's control, but also on whether the taxpayer has the right to control the worker. Regs. Sec. 31.3121(d)-1 defines the common law employer-employee relationship as follows:

Generally such relationship exists when the person for whom services are performed has the right to control Generally such relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done.(10) Control or the Right to Control

Early court decisions establish that the right to control and direct the specific manner in which an individual works toward the desired end work product is just as fundamental as control in defining the employer-employee relationship. In Capital Life 6-Health Ins. Co., (11) the taxpayer failed to show that the commissioned salesmen it treated as independent contractors were free from the control of the company. The taxpayer provided regular training to the salesmen, did not have a written contract with the salesmen, could terminate the relationship at will, and issued a guidebook of rules governing the salesmen's conduct. Following the termination of their relationship with the company, the salesmen retained no economic interest in the insurance policies they wrote. When considered collectively, all of the elements of the working relationship showed that the salesmen were not free of the company's control.

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