Most companies would prefer to treat their workers as independent contractors rather than employees since, among other things, it relieves them of the obligation of withholding income taxes, and of paying the employers' 7.65% share of the social security taxes. The IRS uses a facts and circumstances approach to determine whether workers are employees or independent contractors under federal common law. Revenue Ruling 87-41, 1987-1 C.B. 296. A company which has for several years treated its workers as independent contractors, only to be audited by the IRS and have their treatment changed, can be faced with potential ruinous consequences. Additional taxes due, plus interest and penalties, can run hundreds of thousands of dollars even for the smallest businesses. Furthermore, in appropriate circumstances, the IRS may hold the officers, directors and shareholders of a corporation personally responsible for these taxes. Internal Revenue Code Section 6672.
Section 530 of the Revenue Act of 1978, as amended ("Section 530"), allows workers who are admittedly employees to be treated as independent contractors if certain tests are met. These safe harbor rules do not apply to technical service workers such as engineers, computer programers and others providing similar services to a company through an intermediary, such as an employee leasing firm. Section 530(d). Furthermore, they apply only to employment tax provisions. Thus, for example, a worker may still have to covered under the company's pension plan. California has no provisions similar to Section 530. Therefore, it is not uncommon for workers to be classified inconsistently for federal and state purposes.
To be entitled to the protections of Section 530, a company must show that: (1) for federal employment tax purposes it never treated the individual as an employee for any period, nor did it ever treat workers holding substantially similar positions as employees during any period beginning after December 31, 1977;(2) all federal tax returns were filed on a basis consistent with the company's treatment of the individual as not being an employee; and (3) a reasonable basis existed for classifying the individual as an employee.
The IRS has instituted a settlement program which allows companies who agree to treat workers as employees on a prospective basis to settle their back taxes for an amount substantially less than actually due, even if they do not meet requirements one or three.
Generally requirement one will be met by not withholding income taxes or filing employment tax returns with the IRS. Requirement three will be fulfilled by filing Forms 1099 with the IRS. An employer will have a reasonable basis if it reasonably relied on any of the following: a judicial precedent; published IRS rulings; IRS private letter rulings issued to the taxpayer (but not those issued to other taxpayers); certain types of past IRS audits of the company; a long-standing recognized practice of a "significant segment" of the industry; or any other reasonable basis. In the case of taxable periods beginning after December 31, 1996, if the company can show that 25% or more of the industry treated similarly situated workers as independent contractors, then the significant segment test will be deemed to be met. Section 530(e)(2)(B).
The reasonable basis standard is to be construed liberally in favor of taxpayers. H.R. Rep. No. 1748, 95th Cong. 2d Sess. 5 (1978). Indeed, a company may show the existence of a reasonable basis through reliance on knowledgeable counsel. See Smokey Mountain Secrets, Inc. v. United States, 95 TNT 210-85 (E.D. TN 1995). The burden of proving that the employer had a reasonable basis for treating a worker as an independent contractor will be on the IRS if the company first establishes a prima facie case that its treatment was reasonable, and that it has fully cooperated with reasonable IRS requests for information. Section 530(e)(4).
Careful planning should ensure that most companies can treat their workers as independent contractors and avoid tax withholding. Nevertheless, vigorous and sustained audit representation, or even litigation, may be necessary for a company to defend its position, since the IRS has traditionally been hostile to classification of workers as independent contractors.
*Dennis Brager, Esq., is a State Bar Certified Tax Specialist in Los Angeles. A former IRS senior trial attorney, Mr. Brager now devotes his efforts exclusively to helping clients resolve their tax problems with the IRS and California State tax agencies. Services include negotiating Tax Debts, Tax Fraud Representation, Tax Litigation, Tax Audit and Appeals Representation, Tax Preparer Penalty Mitigation, Payroll Tax Audits, and California Sales Tax Problems. He may be reached at 800.380.TAX LITIGATOR.