We have been treading the murky waters of wrongly classifying a worker as an independent contractor, when s/he really is an employee. Last week at The Emplawyerologist, we covered the IRS‘s Voluntary Classification Settlement Program (VCSP). Click here for a review.) We now know that the VCSP has a significant downside that businesses need to evaluate. The IRS does provide another possibility, however. Section 530 of the Revenue Act of 1978 may also provide relief to businesses. What type of relief does it provide, how does a business become eligible, and what, if any, downsides should businesses be aware of? Join me after the jump for some answers!
Section 530 terminates a business’s liability for federal income tax withholding, FICA (Federal Insurance Contributions Act, aka Social Security) and FUTA (Federal Unemployment Tax Act, which contributes to the costs of administering state Unemployment Insurance programs). Since a business qualifying for Section 530 relief is not liable for these taxes it is also not liable for interest and penalties. Note however that I said Section 530 terminates a business’s liability. It does not terminate an employee’s liability for his or her share of these taxes.
If you are concerned that you may have misclassified your workers as independent contractors, you might be thinking, “How and where do I sign on?” This is the point where I tell you, “Wait a minute, slow down!” There are some stringent requirements, and if your business does not meet them, Section 530 will not help. Under Section 530, the business must be able to show that:
- It filed annual Forms 1099 with the IRS, reporting all “non-employee compensation” paid to the worker (they call this “”Reporting Consistency);
- It treated other workers holding substantially similar positions as independent contractors (they call this “Substantive Consistency”);
- It had a “reasonable basis” for treating the worker as an independent contractor (they call this — surprise–“Reasonable Basis”).
A company shows Reasonable Basis by reasonably relying on any one of the following four “safe harbors” (now you know why Section 530 is called the “Safe Harbor” Provision):
- Court decisions, published IRS rulings, (even if they do not relate to the particular business or industry in which the company is engaged) or technical advice, a private letter ruling or determination letter from the IRS relating to the specific company in question (this is called “Precedent Safe Harbor”). If the business is relying on attorney or accountant advice, the business must show that the attorney or accountant was knowledgeable about the applicable law and facts before rendering the advice. The business need not investigate the attorney or accountant’s credentials, but it should at least provide the professional with sufficient relevant facts.
- A past IRS audit in which there was no assessment attributable to the treatment (for employment tax purposes) of workers holding positions substantially similar to positions held by workers whose status is currently in question (this is called “Prior Audit Safe Harbor”);
- A longstanding recognized practice of a significant segment of the industry in which the worker is engaged (this is called “Industry Practice Safe Harbor”);
- Other reasonable basis for treating the workers as Independent Contractors (this is called “Other Reasonable Basis Safe Harbor“–no surprise!). This basis is supposed to be interpreted broadly in favor of the business. A company can show reliance on this Safe Harbor by showing that it reviewed the common law standards ( which I discussed here two weeks ago) and concluded (incorrectly) that the worker(s) in question did not fall into the employee category.
These “Safe Harbor” requirements so far, do not really sound that stringent., The first two are fairly straightforward. Either the company filed its 1099’s in a timely manner, or they didn’t. Either the company treated all workers in the same class in the same fashion or they didn’t. The Reasonable Basis criteria is where things tend to get murky. The company will argue that it had a reasonable basis for classifying the worker as an independent contractor, and, not surprisingly the IRS will often disagree. For example, an IRS auditor, presented with published rulings or cases on which the company says it relied, may feel that those cases or rulings are factually distinct from the situation at hand. Maybe the company or the professional advising the company was unaware of certain relevant and significant facts that formed the basis of those rulings. Maybe the professional advising the company was not an employment tax law specialist, or for some other reason was not qualified to give reliable, appropriate advice.
If the auditor is unwilling to grant Section 530 relief, it may offer a settlement under the standard Classification Settlement Program (CSP). Under this program, the IRS will make one of the following two “graduated settlement offers”:
- If the company had Reporting Consistency, but not Substantive Consistency and no Reasonable Basis, the offer is 100% of the employment tax liability for the one tax year under audit, calculated in accordance with Section 3509 of the Internal Revenue Code. 3509.
- If the company had Reporting Consistency and a “colorable argument” that it also had either Substantive Consistency or a Reasonable Basis (i.e. two-out-three ain’t bad) , then the offer is 25% of the employment tax liability for the one year under tax audit, also calculated per the instructions under IRC Section 3509.
NOTE: Both of the above options require the business to agree to reclassify the workers in question as employees going forward, starting the first day of the quarter following the date of the Closing Agreement issued by the IRS at the conclusion of the audit and settlement. FURTHER NOTE: Everything I have outlined here presupposes that the business is involved in an audit on this very issue. YET ANOTHER NOTE: The business can decide to accept or reject the offer. If it accepts, then it signs a Closing Agreement, makes the appropriate payment of back taxes for the tax year in question, re-classifies the relevant workers as employees, and, as long as it complies with the terms of the Closing Agreement, everyone goes their merry way (for the most part). If the business rejects the offer, the IRS will expand the audit to cover all open years, issue an “unagreed” audit report, and the business would then be able to file a protest letter, elevating the issue to the IRS Appeals Office. Even then, the CSP offer remains available throughout the appeal process. Businesses should be aware that if they have misclassification issues and do not accept a settlement offer, they are subject to much greater back tax liability if the case ends up before tax court and the business loses at that level.
After the last few posts, you hopefully have a better idea as to whether you need to re-visit how you have classified your workers. Whatever you decide, consult with your friendly, trusted (and qualified!) professionals–and make sure, going forward that you appropriately classify your workers!
OK, enough about this subject. Next week we move on to a different misclassification area–exempt and non-exempt employees. Do you need to be paying overtime wages? Let’s jump on that wagon next week and see where it goes!
Disclaimer: Contents of this post are for informational purposes only, are not legal advice and do not create an attorney-client relationship. Always consult with competent local employment counsel on any issues discussed here.
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