Payroll Taxes, Worker Misclassification and Options for Resolving IRS Audits
By Joel N. Crouch on January 23, 2017
Employment taxes and worker misclassification continue to be priorities for the IRS and the Tax Division of the Department of Justice. The IRS has announced information sharing agreements with the Department of Labor and state agencies to find businesses that are misclassifying their workers as independent contractors. The DOJ has made employment taxes and worker misclassification priorities for its civil tax and criminal tax sections. It is very important for any business that uses independent contractors to be aware of its options in an IRS employment tax/worker misclassification audit.
The IRS test for determining a worker’s classification is based on control and independence and can be complex and confusing for a business owner. There is no bright line test, but instead it is factual specific and highly subjective. Facts that provide evidence of the degree of control and independence fall into three categories:
1. Behavioral: Does the business control or have the right to control what the worker does
and how the worker does his or her job?
2. Financial: Are the business aspects of the worker’s job controlled by the business?
(These include things like how worker is paid, whether expenses are reimbursed, who
provides tools/supplies, etc.)
3. Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension
plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work
performed a key aspect of the business?
No particular fact is controlling and it is not unusual for a taxpayer and IRS to agree on the facts but disagree about the interpretation of the facts.
If a business does not qualify for one of the relief provisions or settlement programs discussed below, a determination that the business has improperly treated one or more of its workers as independent contractors can be very expensive. A determination can result in the business owing federal employment taxes of up to 40% of the amounts paid to the misclassified workers each year, plus penalties and interest. Due to information sharing agreements, the business may also face audits or investigations from the Department of Labor or state agencies.
Luckily, there are a number of IRS provisions and settlement programs that provide relief from an employment tax/worker classification audit for a business that qualifies.
1. Section 530 Safe Harbor. Section 530 allows a business to avoid all liability for
misclassified workers if it meets three criteria.
a. The business must have filed all required Forms 1099 for the independent contractors.
The filing of Forms 1099 is important not only for Section 530 relief but for some of the
alternatives discussed below.
b. Each group of workers that holds similar positions must be treated consistently. For
example, the business cannot treat any worker doing similar work as a W-2 employee.
c. The business must have a reasonable basis for treating the workers as independent
contractors. Reasonable basis includes:
i. Reliance on court cases, published rulings or a ruling the taxpayer received
from the IRS;
ii. A past IRS audit in which there was no assessment with respect to the class of
workers at issue;
iii. Establishing that a significant segment of the industry treats similar workers as
independent contractors; or
iv. Any other reasonable basis, such as reliance on the advice of a business lawyer
or accountant who knew the facts about the business.
2. Section 3509 Relief. In order to take advantage of Section 3509 relief, a business
generally must have filed all required Forms 1099 or have a reasonable basis for failing to
do so. Section 3509 relief limits a business’ liability as follows:
a. Withholding liability is 1.5% of the total wages paid to the worker;
b. 20% of the employee’s portion of FICA tax; and
c. 100% of the employer’s portion of FICA taxes.
If the business cannot establish reasonable cause for failure to file the required Forms
1099, but it did not intentionally disregard the law in treating a worker as an independent
contractor, the withholding rate is raised to 3% and the FICA tax rate for the employee’s
portion is raised to 40%. If the business intentionally failed to file Forms 1099, Section
3509 relief is not available.
3. Classification Settlement Program. The Classification Settlement Program (CSP)
provides two settlement options for a business in an IRS employment tax audit, if the
business agrees to classify its workers as employees prospectively. If a business has filed
all required Forms 1099 and has a colorable claim to Section 530 relief, the CSP offer is
25% of the employment tax liability for such workers for the most recent year under audit,
computed using the reduced rates of Section 3509 discussed above. Colorable claim is
defined as a claim strong enough to have a reasonable chance of being valid if the legal
basis is generally correct and the facts can be proven in court.
If the business has filed all the required Forms 1099 but does not have a colorable claim to
Section 530 relief, the CSP offer is a full employment tax assessment under the reduced
Section 3509 rates. For a business with multiple tax years under examination or pending, a
CSP settlement can provide significant relief.
4. Voluntary Classification Settlement Program. The Voluntary Classification Settlement
Program (VCSP) provides a resolution option for a business that is currently not in an IRS
employment tax audit, but with concerns about potential liability. In the VCSP, the business
and IRS agree to prospectively treat the class or classes of workers as employees for
future tax periods. In return, the business will:
a. Pay 10% of the employment tax liability that would have been due on compensa-
tion paid to the workers for the most recent tax year, determined under the
reduced rates of Section 3509;
b. Not be liable for any interest and penalties on the amount; and
c. Not be subject to an employment tax audit with respect to the worker classification of
the workers being reclassified under the VCSP for prior years.
To be eligible for a VCSP settlement the business must have consistently treated the
workers to be reclassified as independent contractors or other nonemployees, including
having filed all required Forms 1099 for the previous 3 years. In addition, the business
cannot currently be under an IRS employment tax audit or under audit concerning
the classification of the workers by the Department of Labor or by a state govern-
ment agency. If the IRS or the Department of Labor has previously audited the
business concerning the classification of the workers, the taxpayer will be eligible
only if the taxpayer has complied with the results of that audit and is not
currently contesting the classification in court.
For any questions on this or any other tax-related matter, please feel free to contact me at (214) 749-2456 or firstname.lastname@example.org.
The material contained within Meadows Collier Tax Blog - MC Talks Tax and any attached or referenced pages, has been written or gathered by Meadows, Collier, Reed, Cousins, Crouch & Ungerman, L.L.P., for information purposes only. It is not intended to be and is not considered to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel.