Employee vs. independent contractor status: the section 530 safe harbor.

• Author: Campagne, James M.

Any practitioner who has advised a client on the status of a worker as an employee or an independent contractor under the 20-factor common-law test (now found in Rev. Rul. 87-41) has probably not recovered from the experience. It is difficult to imagine a more frustrating area of tax law; at least one professional described this as subjectivity, uncertainty and exposure all rolled into one. And with the extensive IRS audit efforts in this area, the key word is exposure.

As long ago as 1978, Congress enacted Section 530 of the Revenue Act of 1978 in an effort to relieve the nightmare of the 20-factor common-law test, by providing some objective guidance and protection for taxpayers faced with such a classification issue. Section 530 created a "safe harbor" for taxpayers classifying individuals as independent contractors; if certain requirements are met, an employer may treat an individual as an independent contractor for employment tax purposes without having to resort to an analysis of the 20-factor common-law standard.

As will become apparent, Section 530 provides limited relief for taxpayers; the requirements that need to be satisfied to obtain relief, while not, as nightmarish as the 20-factor test, are nevertheless difficult to apply; they are quite subjective, and are frequently difficult to satisfy. Moreover, Section 530 has no effect on the employee's employment and income tax responsibilities, nor does it address the potential excise tax exposure that may result from misclassification.

Rev. Proc. 85-18 sets forth the current guidelines for applying the provisions of Section 530. In general, if a taxpayer has a "reasonable basis" to treat a category of workers as independent contractors for all periods after 1978, and all employment and other Federal tax returns are properly filed consistent with classifying these workers, as independent contractors, the workers are deemed to be independent contractors for employment tax purposes. In addition, the employer must have treated all individuals holding "substantially similar positions" as independent contractors. If the Section 530 safe harbor rules do not apply, no presumption of employment status is made. Instead, the taxpayer and the Service must apply the 20-factor common-law test to determine whether the workers are employees or independent contractors.

What is a "reasonable basis"?

In enacting Section 530, Congress made it clear that the term "reasonable basis" should be construed...