Independent Contractor Employee Audits

 

By: Robert E. McKenzie, Esq. ©2009

  1. INDEPENDENT CONTRACTOR  CONTRACTOR 

  1.10  Beginning in the mid mid 1980's the IRS began test programs in several Districts Districts auditing employers employers who

allegedly misclassified their employees as "independent contractors." This program, called the Special Compliance Employment Tax Examination Program, began in 1984 in seven districts. It was later expanded to 26 Districts. Districts. The Internal Revenue Service reported in 1988 that t hat in the first year 92% of the t he taxpayers examined examined on the issue of worker classification were confronted with additional tax assessments. As a result of the large revenues generated by the IRS's test program, it has now expanded its employment tax examination program to include all districts. The program was originally called the Employment Tax Examination Program or ETEP. Later, the t he Internal Revenue Service Service changed the name of the program to the Office of Employment Employment Tax and Compliance (OETAC).   1970's 1.20  During the 1970's, the Internal Inter nal Revenue Service Service also stepped steppe d up its efforts in Employment Tax Tax Audits. As

a result of complaints by taxpayers, however, Congress sought to rein the IRS in by passing IRC § 530 of the

 

Revenue Act of 1978. That provision sought to provide relief for companies that were the subject of IRS Employment Employm ent Tax examinations. e xaminations. As As a result of the passage of IRC § 530, the IRS suspended suspended most of its Employment Employm ent Tax examination e xamination efforts from 1978 to 1984. Section 530 was intended to be temporary t emporary to allow a llow Congress to pass specific definitions of employees, but as a result of conflict among a mong various industries, industries, Congress Congress was unable to come up with a definition. Therefore, Therefore, as of 1988, the IRS resumed resumed its aggressive aggressive Employment Tax Examination Program. That That program continues up through the date of this publication publication even eve n though the IRS has a classification classi fication settlement program which is discussed later in this Section. Section 530 was also amended by the Small Business Jobs Protection Act which is also discussed later in this Section.  

Effect of Reclassification Reclassification financial impact of IRS reclassification reclassification of independent independent contractors contra ctors can be di disastrous. sastrous. The stakes stakes are 1.30  The financial very high, in excess of 43% of payments to t o independent contractors. contract ors. The IRS mig might ht also seek to impose impose personal liability liabi lity pursuant to IRC § 6672 on corporate officers. Reclassification Reclassification also leads to requirements that employees  be included under state tax programs and under employee benefit programs. programs.  

Potential Liability withholdi ithholding ng which which would would result in in deficiencies 1.40  IRC § 3509 provides for assumed rates for FICA and w  between about 11% and an d 14% of a company's reclassifi reclassified ed payroll. Section Section 3509 rates apply if the company did not intentionally disregard worker classification classification rules. Absent application of IRC § 3509 rates, ra tes, the IRS assumes assumes a rate for withholding withholding of 28% of payments pa yments to reclassi rec lassified fied workers. It also imposes liabili liability ty for both employee and employer FICA and Medicare for a total of 15.3% of payments. The employer also becomes liable for FU FUTA. TA. A redetermination for the th e three thre e past years will normally normally destroy most labor intensive service businesses.

  2. COMMON-LAW TEST

  2.10  For purposes of the Federal Insurance Insurance Contributions Act (FICA), (FICA), the Federal Unemployment Unemployment Tax Act Act (FUTA), (FU TA), and income tax withholding, withholding, the term te rm "employee" includes any individual individual who, under the usual common-law common-l aw rules for determini det ermining ng the employer/empl e mployer/employee oyee relationshi relationship, p, has the t he status stat us of an employee. [See IRC 4§ 3121 (d), 3306(i), 3401 (c)]

 Control and Direction 2.20  Under the common-law common-law rules, rules, a worker worker is an employee when when the person for whom services are performed has the right right to control and direct the individual who performs the service. This control must reach n not ot only the result to be accomplished, but also the details and means by which the results are to be accomplished. The employer need not actually exercise control. It is sufficient that the right to do so exists. It is the substance of  each particular relationship that governs; therefore, the employers may not simply contract away their  employment tax liabilities.

 

Employees for FICA Purposes

 

2.30  The IRC §3508 also provides that certain individual individual occupation occupat ion groups, groups, who who may not be employees employees under  common-law common-l aw rules, will will be treated tre ated as employees for FICA purposes only. This category was origi originally nally referred to to

as "Statutory Employees" and identified under IRC § 3121 (d)(4) aass agent drivers, traveling or city salesm salesmen, en, full-time fulltime life life insurance salesmen and homeworkers. It also a lso includes includes corporate officers who receive remuneration remunerat ion for services as corporate officers.   3. TWENTY TWENTY COMMON-LAW COMM ON-LAW FACTORS

  common-law factors have been identified by the IRS for determining determining whether a worker is in fact 3.10  Twenty common-law an employee. [See Rev Rul 87-41, 1987-1 CB 296] Unfortunately the degree of importance of each of these factors varies from case to case. Some factors do not apply to certain occupations and therefore, should not be given given any weight. weight. Although 11 of the 20 factors may indicate employee status, this does not ne necessarily cessarily mean an employer/employee relationship exists. Some of the factors may be inappropriate under the circumstances and some may be more significant than others. The weight to be given and degree of importance of each factor varies depending on the occupation and the reasons for its existence.  

Factors following ng 20 common-law factors are used by the IRS. IRS. These factors are the basis of Form SS-8, SS-8, 3.20  The followi which is used by the IRS to analyze the employee/independent contractor question:   (1)  Compliance with instructions. A person who is required to comply with instructions about when, where, and how to work is ordinarily ordinarily an employee. The control factor fact or is present if the employer has the right to instruct, whether or not he in fact does so.  

(2)  Training. Training of a person by an experienced employer, by correspondence, by required attendance at meetings, and by other methods indicates control because it shows that the employer wants the services performed in a particular method or manner. This is especiall especially y true if the training t raining is is given  periodically  periodicall y or at frequent intervals. Independent ccontract ontractors ors ordinarily ordinarily rely rely upon their own resources for  training and receive no training t raining from from the purchasers purcha sers of their services.   (3)  Integration with business. Integration of the person's services services in the business operations generally generally shows that the person p erson is subject subject to t o direction and control. In determini dete rmining ng whether integration exists, it is necessary to determine the scope and function of the business and whether the services of the individual are merged into it.   (4)  Personal rendition of service. If services must be rendered personally, it indicates that the employer is interested in the methods as well as the results. The employer is iinterested nterested not only in getting a desired result, but also in who does the job. Lack of "employer"-type control may be indicated when an individual indivi dual has the right right to hire a substitute without the employer's knowledge. knowledge.

 

  (5)  Hiring, supervising and payment of assistants. Hiring  Hiring,, supervising, supervising, and payment of assistants assistants by the employer generally shows control over the workers on the job. Sometimes Sometimes one worker may hire, supervise, and pay the other workers. This may result from a contract under which the worker provides materials and labor and is responsible responsible only for the attainment of a result. In this case, the worker is an independent contractor. On the other hand, if the worker hires, supervises, and pays other workers at the

direction of the employer, the worker may be acting as an employee in the capacity of a supervisor or  representative of the employer.   (6)  The existence of a continuing relationship. The existence of a continuing relationship between an individual indivi dual and the person for whom the individual performs performs services is a factor ttending ending to indicate the existence of an employer-empl e mployer-employee oyee relationship. Continui Continuing ng services may include work performed at frequently recurring rec urring,, though somewhat irregular, intervals. If the aarrangement rrangement contemplates conte mplates continuing or  recurring work, the relationship is considered permanent, even if the services are rendered on a part-time  basis, or the person actually actua lly works works only a short short time.   t he employer is a fact factor or indicative of  (7)  Set hours of work. The establishment of set hours of work by the control. This condition bars the worker from being master of her own time, which is a right of the independent contractor. Of course, an independent contractor often must work when facilities are open to her and a nd must complete an entire e ntire job within a certain period of time. t ime. However, However, it is the flexibility flexibility within within these necessary time restraints that separates the independent contractor from the employee. Where fixed hours are not practical because of the nature of the occupation, a requirement that the worker work  at certain times is an element of control.   (8)  Exclusive full-time work. If the worker must devote full time to the business of the employer, the employer has control over ove r the amount of time t ime the worker spends working. working. This implici implicitly tly restricts the worker from doing other gainful work. An independent contractor, on the other hand, may choose for  whom and when to work.   Full-time does not necessarily Full-time nec essarily mean mean an a n eight-hour day or a five or six-day week. Its meaning may vary with the intent of the parties, the nature of the occupation, and the customs of the locality.

  t he employer' e mployer'ss premises is not control in itself; (9)  Work on employer's premises. Doing the work on the however, it does imply that the employer has control, especially where the work is of such a nature that it could be done elsewhere. e lsewhere. A person working in in the employer's place of business is physically physically within the employer's direction and supervision. The use of desk space and of telephone and stenographic services  provided by an employer places places the worker within the employer's direction and supervisi supervision, on, unless the worker has the option as to whether to use these facilities.   Work done off the premises does indicate some freedom from control; however, it does not by itself mean that the worker is not an employee.

 

  (10) 

Sequence of work done. If a person must perform services in the order or sequence set by the employer, it shows that the worker may be subject to ccontrol ontrol as the worker is not free fre e to follow his own  pattern of work, but must follow follow the established routines and sschedules chedules of the employer. This This is true if  the employer retains the right to do so even if in fact he does not.

(11) 

Reports recruited. If regular oral or written reports must be submitted submitted to the employer, it indicate indicatess control in that the workers are compelled to account for her actions.

 

(12)  Payment by hour, week, or month. An employee is usually paid by the hour, week, or month, whereas payment on a commission commission or job basis is is customary where the worker is an independent contractor. Payment by the job includes a lump sum, which is computed by the number of hours required to do the job at a fixed rate per hour.   The guarantee of a minimum minimum salary or the granting of a drawing account aatt stated state d intervals with no requirement for repayment of the excess over earnings indicates the existence of an employer-employee relationship.   (13) 

Expense account. Payment by the employer of the worker's business and/or traveling expenses is a factor indicating control over the worker. Conversely, a lack of control is indicated where the worker is  paid on a job basis basis and has to take ca care re of all iincidental ncidental expenses.

  (14) 

materials, etc., etc ., by the employer is indicative of  Tools and materials supplied. The furnishing of tools, materials, control over the worker. Where the worker furnishes the tools, materials, etc., it indicates a lack of  control; but in some occupational fields, it it is customary for employees to use their own hand tools.

  (15) 

Facilities-furnished.  A significant significant investment in facili fa cilities ties by the person performing the services tends te nds to show an independent status. On the other hand, the furnishing of all necessary facili fac ilities ties by the "employer" tends to indicate the absence of an independent status on the part of the worker.

  Facilities generally include equipment or premises necessary for the work, but not tools, instruments, Facilities instruments, clothing, etc., that are provided by employees as a common practice in their particular trade.

  (16) 

who are in a position to realize a profit or suffer a loss as a result of their  Risk of loss. Individuals who services are generally independent contract contractors, ors, while while individuals who who are employees are not in such a  position.

  (17) 

firms at the same time it usually Number Num ber of "emp "e mployers." loyers."   If a person works for a number of persons or firms

 

indicates an independent status because in such cases the worker is usually free from control by any of  the firms. It is possible, possible, however, that a person may work for a number of people or firms and still be an employee of one or all of them.   (18) 

Availability to general public. Workers who make their the ir services available to the general public public are usually independent contractors.

  (19) 

indicating that the person pe rson possessing possessing the Power to fire. The right to discharge is an important factor it: indicating right right is an employer. The employer exerc exercises ises control through the ever-present threat of dismissal dismissal that causes the worker to obey instructions. Independent contractors, on the other hand, cannot be fired as long as they produce results that measure up to their contract specifications.

  Sometimes Som etimes an employer's right right to discharge d ischarge is restricted restricted because bec ause of the employer's contract with a labor union u nion or 

through increasingly more liberal judicial decisions in favor of employees. Such restrictions do not weigh unfavorably against the existence of an employm e mployment ent relationshi relat ionship. p.   (20) 

Termination damages. An employee has the right to end the relationship with the employer at any time the employee e mployee wishes wishes without incurring liability. liability. An independent cont contractor ractor usually agrees to complete a specific job and is responsible responsible for its satisfactory completion or is li liable able for breac breach h of contract. contra ct.

  4. INT INTERPRETAT ERPRETATION ION OF COMMON-LAW TEST TEST

  conflicting nature of the various various tests, they become a weapon weapon in the hands of IRS 4.10  Because of the conflicting employees. The author has found it aalmos lmostt impossible impossible to convince c onvince front-line Revenue Officer Examiners (ROE's) (ROE's) and Revenue Agents (RA's) that a particular group of workers meet the common law test as independent contractors. The Internal Revenue Service appears to have an inherent bias in favor of determining employee/employer relationshi relationship. Only at the Divisi Division on doesare theforced putative employer e mployer havelitigation the potential have a fair consideration of thep.common-l common-law aw Appeals test. Some taxpayers a re to initiate refund suits suits to to finally finall y secure justice in employment employment tax disputes with the IRS. IRS.   Worker Agreement 4.20  One common common misconception misconception that many many people have is is that if there is is a contract signed by the worker  worker  agreeing to independent contractor status, that creates such a relationship. That is not in fact the case. The common-law test controls even if the worker has agreed to be an independent contractor. The Internal Revenue Manual instructs its employees as follows:

 

When an employer-employee employer-employee relationshi relat ionship p exists, it is of no consequence whether the employee is designated designated aass a trustee, agent, independent contractor, or other title. Additionally, signing a contract does not always indicate the

 

worker is self-employed. self-employed. What does doe s govern is the substance of a particular relationship, and consequently employers cannot contract cont ract away a way their employment tax liabilities. liabilities. [IRM 104.6.5.6]   State Tests

is an employee employee pursuant to state state unemployment tax or worker's compensation laws, laws, that 4.30  Even if a worker is does not in fact mean that that worker is a worker for federal purposes. Many states impose a much harsher test, known as the ABC test, for determination of a worker's status. Therefore, a worker might be an independent contractor for common-law test purposes and an employee for worker's compensation and state unemployment tax purposes.  

5. SECT SECTION ION 530 OF REVENUE ACT OF 1978

 

5.10  In the early 1970's, the Internal Revenue Service Service stepped up its enforcement of the employment employment tax laws. As a result, many businesses faced the severe economic consequences of reclassification. Because of pressure from these businesses, Congress Congress passed Section 530 of the Re Revenue venue Act of 1978 as an interim relief relief provision. Section 530 of the Revenue Act of 1978, as amended, is not part of the Internal Revenue Code (IRC). However, some publishers publishers include its text after afte r IRC § 3401(a). Unfortunately, Congress was not able to come c ome up with a definition of employee. employee. In 1982, the Senate Finance Committee proposed a five-factor test te st which, if met, would would  provide safe harbor for independent contractors. contrac tors. The fi five ve factors proposed by the Senate Finance Committee

were:   (1)

Control of hours worked;

(2)

Place of business;

(3)

Investment or income fluctuation;

(4)

Written contract and notice of tax responsibiliti responsibilities; es; and

(5)

Fil Filing ing of required returns.

 

 

 

 

 

 

This legis legislation lation was not passed pa ssed by Congress. Congress Congress was able to t o agree upon passage of IRC §§ 3508 3 508 and 3509, which are discussed later in this material. [See [See Sections 11-8 and 11-9]   Safe Harbor of § 530

provides that "an individual individual shall be deemed not to be an employee for purposes of  5.20  Section 530 provides determining tax liabiliti liabilities, es, unless the taxpayer t axpayer had no reasonable basis ba sis for treating such individual individual as an an employee." [Revenue Act of 1978 § 530(a)(1)] Section 530 further provides three statutory safe havens and one general safe haven for meeting the reasonable basis requirement. Under Section 530, a taxpayer is deemed to have a reasonable basis forreliance not treating anof individual as an: employee where the taxpayer's treatment of the worker was in reasonable on any a ny the following following:   (1)  Judicial precedents, published IRS rulings, rulings, technical advice memorandum, or private lette letterr ruling or  determination letter ruling directed to the taxpayer;   (2)  A prior IRS audit of the taxpayer, taxpaye r, not necessaril nec essarily y for employment tax purposes, in which there was no assessment attributable to the taxpayer's employment tax treatment of the class of workers whose present status is at issue. The Small Small Busi Business ness Jobs Protection Act of 1996 removes this protection protec tion for tax returns re turns filed for years after 1996;   (3)  A long-standing, long-standing, recognized recognized practice prac tice of a significant significant segment of the t he industry in which the taxpayer taxpaye r is engaged; and

  (4)  A general safe haven (any other reasonable basis). In addition to the three statutory methods set forth above, the statute allows the taxpayer to demonstrate "reasonable basis" for its treatment of workers in some other manner.   Additional Requirements 5.30  Even though the taxpayer has satisfied satisfied one of the designated designated statutory safe havens, Section Section 530 relief relief will will  be denied where the taxpayer ta xpayer fails to meet meet two additional requirements:

  (1)  The taxpayer must not have previously treated the individuals in question as an employee; and   (2)  The taxpayer taxpaye r must have timely filed all required information information returns for ea each ch worker consistent with classification as an independent contractor (i.e., Form 1099).  

 

Burden of Proof 

5.35  The Small Small Business Jobs Protection Protec tion Act provides provides that for post-1996 post-1996 periods if a taxpayer establishes a  prima facie Section Section 530 case, the burden of proof shifts to Internal Revenue Service.

  Consistency Provisions

"consistency provisions" provisions" [Revenue Act Act of 1978 § 530(a)(3)] relief is unavailable to the 5.40  Under the "consistency taxpayer if the taxpayer (or predecessor) has treated any individual after December 31, 1977, holding a substantially substantiall y similar similar position as an employee e mployee for eemploym mployment ent tax purposes. Under this section, relief would also  be denied in the successor taxpayer's business. business. The author defended a cclient lient who met met at least two of the Safe Harbors of Section 530, but the IRS claimed that there is inconsistent treatment. The taxpayer employed union truck drivers to drive company-owned trucks and contracted with independent drivers who owned their own trucks to provide additional trucking resources. The Internal Revenue Service used the term "truck driver" to describe both categories (union drivers and owner operators). Because both categories are truck drivers, the IRS refused to grant Section 530 relief based upon its determination that there was inconsistent treatment. The author   believes such cases indicate indicate bad faith of the IRS when negoti negotiating ating the use of S Section ection 530 Safe Harbors. The case was settled in Appeals after three years of dispute with a full concession by the IRS, but to gain that victory the taxpayer spent thousands of dollars for legal and accounting fees.   Treatment as Employee

published guideli guidelines nes in Revenue Procedure Proce dure 85-18 for purposes of interpreting "treat." In 5.50  The IRS has published general the word "treat" "tre at" includes the following following::   (1)  The withholding of income tax or FICA tax from an individual's wage; or   

(2)  The filing filing of employment tax returns (i.e., Form 940, 941 or W-2).   [Rev Proc 85-18, 1985-1 CB 518]   Effect of Section 530 Relief  5.60  The IRS IRS takes the position position that a successful Section 530 defense does not change the status of an employee to independent independe nt contractor contra ctor for other ot her purposes. The IRS Manual [IRM 104.6.5.5] provi provides des as follows follows::

  (1)  It is important to remember that even if an employer is entitled to relief under Section 530, the employees remain employees for other purposes of the Code. Section 530 only terminates the liability liability of  the employer for the employment taxes but has no effect on the employee's status. It does not convert workers from the status of employee to the status of self-employed (independent contractor). The Section 530 employee is still considered an employee e mployee for income tax and qualified benefit plan eligibili eligibility ty

 

 purposes. Therefore, Therefore, the employer e mployer must must consider the Section 530 employees employees as employees iin n determining whether its pension, profit-sharing, or stock-bonus plan satisfies the qualification requirements of Section 401 (a).    

(2) received. The Section employeeshare remains liableisfor liable the employee share of Uncollected FICA tax with respect to all wages wag The530 e mployee's employee's of FICA reported reported on Form 8919, Social Security andes

Medicare Tax on Wages,, by substituting the word "wages" for the word "tips." Revenue Procedure 85-18, Section 3.08; Section 31.3102-1 (c). See also Revenue Ruling Ruling 86-111, 1986-2 CB 176.

  (3)  Where Section 530 employees have filed and paid their tax under the Self Employment Tax Contributions Act Act (SECA), they may file a claim for refund for the difference between be tween SECA tax and the employee share of FICA.   (4)  As an employee, the worker generally cannot deduct unreimbursed business expenses above the line on Schedule C, but must deduct de duct them, t hem, if at all, as miscellaneous miscellaneous itemized deductions on Schedule A, Form 1040, subject to t o the two percent perce nt limitation limitation of IRC § 67. This This sometimes results results in liability liability for the alternative minimum tax. Further, the t he worker cannot ca nnot adopt or maintain a self-employment self-employment retirement ret irement  plan. Finally, Finally, certain benefits provided provided by the business to a worker as an empl employee oyee may be excludable from income by the employee due to specific IRC exclusions provided only to employees (e.g., employer  employer   provided accident and health hea lth insurance. insurance.   Judicial Jud icial Interpretation Interpretation 5.70  In Lambert Nursery Nursery and Landscaping, Landscaping, Inc. v, United States, States, the United United States Court of Appeals ruled that the nature na ture of the th e relationship and not the t he services performed, is a critical fact factor or in determining iiff two groups of  workers hold substantially substantially similar similar positions. positions. The Lambert Nursery test appears appe ars to be correct because it is clear  that attorneys, accountants and doctors and other persons who are historically independent contractors may be employees even though the services they perform as either employees or independent contractors are identical. Therefore, the position requirement should be interpreted to relate to the relationship between the worker and the business, not the nature of services performed. Once the consistent treatment requirement is met for the worker or group of workers, it should not be forfeited for that period. It may, however, be forfeited for future  periods if if inconsistent inconsistent treatment treat ment is not maintained. maintained.

  6. REASONABLE BASIS FOR INDUSTRY PRACTICE

  6.10  Unfortunately for taxpayers, taxpaye rs, despite the direction direction of Section Section 530, the IRS has not liberally liberally construed the industry practice safe haven, In Technical Advisory Memorandum 8733004, the Service denied Section 530 relief even though the taxpayers established that 60% of the companies providing associate dentists to dental

clinics in therestated geographic area have treated theof associate In TAM 8749001, the Service the narrow interpretation industrydentists practiceasasindependent set forth in contractors. TAM 8733004. Moreover, the Service indicated that the safe harbor is wholly unavailable in the case of a new industry which did not exist at the time of Section 530's enactment.

 

  Impact of Small Business Jobs Protection Act

Small Business Jobs Protection Protec tion Act provides provides specific specific guidance guidance on the industry practice safe harbor. A 6.15  The Small significant sig nificant segment does not require a showing showing of more than 25% of the industry. The committee committee reports say this rule is a ceiling only and a lower percentage perc entage may constitute a significant significant segment. The practice need not have continued for more than 10 years, as the IRS has argued in some cases.   Geographical Definition

most courts have rejected the Internal Revenue Service Service s narrow interpretation of industry 6.20  Fortunately, most  practice. In General Investment Corp. v. United United State States, s, the 9th Circuit held the determi dete rmination nation of what constitutes a relevant industry practice should be liberally construed in favor of the taxpayer in light of the remedial character of such since Section 530. Before the 9th Circuit, the government argued that in order to rely upon the industry practice standard, General Investment Corporation should be required to prove the industry standard for  mining mini ng companies throughout the United States, or at least for small mining mining companies companies throughout the United United States which process and extract ore. The 9th Circuit soundly rejected both arguments. It found that "Congress intended to protect employers who exercise good faith in determini determining ng that workers were eemploy mployees ees or  independent contractors." The Court cited the legislative history of Section 530, which stated that "reasonable  basis" is is to be construed liberally liberally for the taxpayers. taxpaye rs.

 

  Industry Cooperation 6.30  Historically, Historically, it has been very difficult difficult for taxpayers taxpaye rs to provide sufficient sufficient proof of relevant industry industry  practice, particularly because competitors, out of fear of an IRS audit, refuse to cooperate. Although understandable, an industry as a whole is generally both served and protected by cooperation in this regard.

Application of Section 530 Relief  6.40  The Small Small Business Jobs Protection Act reversed the IRS' IRS' position position that there must be a determination that the worker is an employer under common law standards before the taxpayer may use Section 530 safe harbors.

The Act also that forRevenue post-1996 periods if a taxpayer wished a prima facie Section 530 case, the burden of proof shiftsprovides to the Internal Service.

  7. SUBSECTION D

  Section 530 with with respect to "technical service 7.10  Section 1706 of the Tax Reform Act of 1986, amended Section specials" by adding Subsection Subsection D. Subsection D provides that the relief re lief under Section 530 is not available with respect to t o individuals individuals referred to "Technical Service Specialists" Specialists" whose whose services are engaged by a broker. Subsection Subs ection D only applies a pplies to three party transactions t ransactions involving, involving, the worker (Technical Service Specialists), Specialists), the  broker firm and the client who uses the service of the worker.   8. IRC § 3508

  8.10  IRC § 3508 provides specific relief relief for certain industries industries from worker reclassification. reclassification. Qualified Qualified real estate agents will be relieved from redetermination if the person is a licensed real estate agent and receives all of  her remuneration based upon sales or other output, rather than hours worked, pursuant to a written contract. Direct sellers will will be relieved of recharacterization recharac terization if they are a re engaged in a trade or business of selling selling consumer   products (i.e., Avon, Amway) Amway) and receive rece ive substantially substantially all of their remuneration based upon sales or other  output, rather than hours worked, pursuant to a written contract.

  9. IRC § 3509

  9.10  Congress passed IRC § 3509 in in 1982 to provide for reduced employment tax liabili liability ty to employers employers for  certain retroactive recharacterization of workers. The Act provided that if Forms 1099 were filed with respect to

the workers, then t hen the following following rates would apply:  

 

(1)  1.5% of liability liability of total t otal payments for income tax withholding withholding;; and   (2)  The employers share of FICA plus plus 20% of the employees share of FICA. If no 1099's were fil filed ed with respect to the workers, then the liability would be:   (3)  3% liability for income tax withholding; and   (4)  The employer's share of FICA plus 40% of the employee's share.   FUTA Liability 9.20  IRC § 3509 is not applicable for FUT FUTA A tax liabili liability, ty, and no adjustment adjustment is available available under IRC § 6205 with with respect to interest and penalties. The lower tax rates provided under IRC § 3509 do not apply where the employer intentionally disregards disregards reporting requirements. [See L Ltr tr Rul 8415010]

  10. INTEREST FREE ADJUSTMENTS — IRC § 6205

 

10.10  A special interest free adjustment is provided provided with respect to certa certain in under-payments of FICA FICA and withholding withhol ding tax liability. liability. This rule rule does not apply with respect to FUTA FUTA taxes. The underpaid underpa id FICA and/or  withholding withhol ding tax liability liability must must be paid at the t he time that "error is ascertained." An error is ascertained when the employer has sufficient knowledge of the error to be able to correct it. [See Rev Rul 75-465, 1975-2 CB 474 for  special rules]

  11. SPECIAL ABATEMENT ABATEMENT RULES — IRC §§ 3402(D), 6511(D)(7) AND 6521   11.10  IRC § 3402(d)(1) provides provides that an employer has the ability to obtain relief relief from a retroactive assessment of income withholding tax liability if an employer can demonstrate that the worker reported the income covered

 by the assessment on his his Form 1040 return. IRS Form Form 4669 is designed designed for this purpose. purpose. Forms 4669 are transmitted to the IRS with with Form 4670, IRC § 3402(d) relief is unavailable if the special tax ra rates tes of IRC § 350 3509 9 apply.   Mitigation of the Statute of Limitations 11.20  IRC § 6521 provides mitigation mitigation of the effect of the t he Statute of Limitations on obtaining a refund of FICA and SECA taxes in situations involving involving retroactive recha recharacterization racterization of workers. Under IRC § 6521, the employer may obtain credit for her share of FICA taxes if the statute of limitations for the worker obtaining the a SECA refund refund has expired. e xpired. Section Section 6521 relief re lief is unavailable unavailable if the special spec ial tax rates rate s of IRC § 3509 apply.

 

 

Refund Claims by Redetermined Employees 11.30  Under the prior law, the taxpayer was required to file a claim claim for refund of excess self-employm self-employment ent taxes taxe s  paid after redetermi redete rmination nation to be an employee within three years after the due da date te of the return, ret urn, the return is

filed or two years after the tax was paid. The Taxpayer Relief Act of 1997 provided that a redetermined employee, may now file a claim for overpayment of self-employment taxes any time before the last day of the second year yea r after the Tax Court decision becomes final in a Tax Court procee proceeding ding regarding regarding redetermination. In other words, the redetermined red etermined individual individual does not have ha ve to file file a claim until after all proceedings by the putative putat ive employer have concluded before the United States Court.   12. CLASSIFICATION SETTLEMENT PROGRAM

  12.10  The IRS announced in FS-96-5 that it will will be testing procedures under an optional workers classification classification settlement program. The Classification Classification Settlement Settlement Program P rogram (CSP) (CSP) is also intended to ensure e nsure that the taxpayer  t axpayer  relief provisions provisions of Section Section 530 of the Revenue Reve nue Act of 1978 are properly applied. [IRM 104.6.6.1] Since Since announcement the program as a test the IRS has now apparently made the program permanent by incorporating it within the Internal Revenue Manual.

  Training Manual 12.15  As part of its classification classification settlement program, the IRS has issued training materials materials to its employees. Those training materials require a much more liberal view of employm employment ent tax ta x issues. The The authors auth ors have noted note d that in many instances the IRS is much more willi willing ng to discuss the iss issue ue in a manner more favorable to the taxpayer  t axpayer  than prior to the issuance of these training materials. materials. [Training [Training 3320-102 (10-96)]

  Eligibility deve lop the worker classificat classification ion issue, issue, including the business' eligibility eligibility 12.20  Under the CSP, an examiner will develop for relief under Section 530. The examination group manager must then confirm the business' elig eligibil ibility ity for a CSP settlement. If an offer is made and accepted by the business, a standard closing agreement provided by the IRS National National Office will be executed. execute d.

  Graduated Settlement Offers

graduated settlement offers will will be available. If the business meets meets the Section 530 reporting 12.30  A series of graduated consistency requirement but either clearly doesn't meet the Section 530 substantive consistency requirement or  clearly can't satisfy the Section 530 reasonable basis test, the offer will be a full employment employment tax assessment assessment for  the one year under examination, computed using IRC § 3509, if applicable. If the business meets the reporting consistency requirement and has a colorable argument that it meets the substantive consistency requirement and the reasonable rea sonable basis test, the offer will will be an assess a ssessment ment of 25% of the employm e mployment ent tax ta x liability liability for the audit a udit year, computed c omputed under Section 3509, if applicable. The business must agree to prope properly rly classify classify its workers  prospectively. [IRM 104.6.6.13.1 ]  

 

Section 530

12.40  If the requirements of Section 530 are fully met, no assessm assessment ent will be made, and the t he business may may continue to treat its workers as independent contractors. Furthermore, a business that wishes to treat its workers as employees may enter an agreement tto o begin treating its workers as employees currently or at the t he beginning of 

the next ne xt year. If it does so, the business will will not give up its claim to Section 530 relief for prior years.

 

 

13. TAX COURT JURISDICTION

 

13.10  The Taxpayer Relief Relief Act of 1997 allows the taxpayer, taxpa yer, upon filing filing an appropriate pleading, to obtain Tax Court review of an "actual controversy" involving an IRS redetermination as part of an examination, that: (1) one or more individuals performing performing services services for the taxpayer taxpaye r are employees e mployees for employment employment tax ta x purposes [IRC § 7436(a)(1)], or (2) the taxpayer is not entitled to relief under Section 530(a) with respect to such an individual. The Code Section does not define actual controversy but the term is used in the federal court system to mean a real dispute between bet ween adverse adve rse parties involving substantial substantial legal interests.

  Party in Interest 13.20  A pleading before the Tax Court can only be filed by the person for whom the services are performed.

[IRC § 7436(b)(1 )] The taxpayer taxpa yer must file a petition with the Tax Court within within 90 days of the time the IRS issues a certified or registered mail notice to the taxpayer of its determination in an employment tax matter. If  there is a Tax Court proceeding, the change of employment tax treatment of any individual from that of an intended contractor to that of an employee, the treatment as an employee will not be taken into account by the Tax Court. The assessment and collection of taxes ta xes is suspended whil whilee the matter is pending before the United United States Tax Court.   All Case Procedures 13.30  If the amount of the employment tax dispute is $50,000 or less for each calendar calenda r quarter involved, the case may be conducted under the rules of evidence, practice and procedures applicable to small income tax cases. [IRC § 7436(c)(1 )] Decisions Decisions entered under the small tax case c ase rules will not be reviewed re viewed in any other  court and will not be treated as precedent for any other case not involving the same petition and the same determinations. The Tax Court decision, de cision, together with a brief summary of the Court's reasons for its dec decisi ision, on, willl satisfy requirements for reports on Tax Court proceedings wil proce edings,, hearings and determinations. det erminations.

 

Effect of Tax Court Decision in Larger Cases 13.40  The Tax Tax Court determination of an employment tax matter matter will have the same force and effect as a s any other Tax Court decision. It is appealable in the same manner as any other Tax Court proceeding. The Taxpayer  Relief Act of 1997 also amended the prohibition against sui suits ts to restrain assessment and collection c ollection of taxes with respect to t o employment status cases. [IRC § 7421 74 21 (a)] Employment status cases aare re also eligible eligible for awards of  administrative admini strative and liti litigation gation costs pursuant to IRC § 7430.

  Limits of Tax Court Jurisdiction

Court had previously previously held that IRC § 7436, which which granted its jurisdiction jurisdiction to make make certain cert ain 13.50  The Tax Court employment employm ent status stat us determinations, didn't didn't give it juris jurisdiction diction to decide dec ide the proper prope r amount of employment tax and

 

income tax withholding due as a result of its status determination. The Code was amended in 2000 to read rea d as follows: “IRC §7436(a)(2) such person is is not entitled entitled to the treatment under subsection (a) of section 530 of the Revenue Act of 1978 with respect to such an individual, individual, upon the filing filing of an appropriate pleading, pleading, the Tax Court may determine whether such a determination by the Secretary is correct and the proper  amount of employment tax under such determination. Any such redetermination by the Tax Court shall have the force and effect of a decision of the Tax Court and shall be reviewable as such.”   Therefore the Court may determi dete rmine ne liability liability the amounts due as a result of its determination.

  14. TRUST FUND RECOVERY PENALTY — IRC § 6672

  14.10  The liabili liabilities ties imposed imposed under IRC § 6672 are known as the Trust Fund Recovery Penalty Pe nalty (formerly 100% Penalty). There are a re two major tests to determine de termine if someone is subj subject ect to provisions of IRC § 6672. The two issues issues in question may be stated as follows: follows:

  (1)  Whether the party against whom the penalty is proposed had the duty to account for, collect and pay over trust fund taxes; and   (2)  Whether he or she wilfully wilfully failed failed to perform this duty.   Personal Liability of Officers 14.20  In the context of employment employment tax examinations, e xaminations, IRC § 6672 poses a danger danger to officers of a company which is forced to cease operations as a result of a large employment tax deficiency. Although the Internal Revenue Service has a policy of not pursuing officers officers of companies for personal pe rsonal li liability ability in cases where IRC § 3509 rates have ha ve been bee n applied, it has pursued officers of companies when the higher higher assumed rates of li liabili ability ty were imposed. Obviously, Obviously, once aan n assessment is made using the higher assumed rates of 20% for withholding and the employee portion of FICA, a person who controlled the corporate taxpayer has significant risk of  liability pursuant to IRC § 6672. The controlling officer of the corporation would not have the defense that he was not a responsi re sponsible ble person. The sole defense available ava ilable to the officer would be that his conduct was not willful. willful. The word "willfull "willfully," y," as used in IRC § 6672, does d oes not signify signify an act ac t done with a fraudulent or evil ev il purpose, purpose, but merely knowingly knowingly or intentionall intent ionally y disregarding the statutory provisi provision. on. The Seventh Circuit has defined

willfulness will fulness as a s follows:   An act is willf willful ul if it is voluntary, conscience and intent intentional. ional. A responsible responsible person acted ac ted willfully willfully if he knowingly used available funds to prefer other creditors over the Internal Revenue Service.  

 

Personal Fault 14.30  The Supreme Supreme Court has observed that "the fact fa ct that the provision imposes imposes penalty and is violated violated only by willful wil lful failure failure is itself strong evidence that t hat it was not intended intende d to impose impose liability liability without personal pe rsonal fault."

  Lack of Knowledge 14.40  In the case of an Employment Tax Examination, Examination, an officer certainly mig might ht raise the defense tha thatt he was unaware of the liability and therefore, should not be found to have been willful. Unfortunately for the taxpayer  utilizing that defense, in order to use the higher rates, other than IRC § 3509 rates, there must be a finding that the taxpayer ta xpayer intentionall intent ionally y disregarded the rules for employment taxes. Obviously, that standard would relate directly to the willfulnes willfulnesss standard of IRC § 6672. If the original original tax deficiency was never ne ver litig litigated, ated, then the taxpayer retains the right to defend that the corporate entity did not intentionally disregard tax rules and therefore, the potentially p otentially responsible responsible person pe rson was not willful. willful.