Section 530 Relief for Worker Classification Controversies

By Claire Y. Nash, Ph.D., CPA

 

EXECUTIVE
SUMMARY

 

  • It can be difficult to determine whether workers are independent contractors or employees, and making a mistake can be expensive if a taxpayer is audited. Taxpayers may be liable for employment taxes and penalties, which can be financially devastating.
  • One relatively new form of relief is the IRS’s voluntary classification settlement program (VCSP), which permits taxpayers who qualify to begin treating their workers as employees prospectively while paying a fraction of the prior employment tax liability and no penalties.
  • Taxpayers who do not qualify for the VCSP or otherwise choose not to participate may qualify for relief under Section 530, which applies to taxpayers who have a reasonable basis for treating their workers as independent contractors, even if it is later found to be mistaken.
  • A large body of case law demonstrates that the courts continue to construe Section 530 relief liberally.

The IRS continues to be concerned about the appropriateness of taxpayers’ classifications of workers as independent contractors. IRS estimates show that the underpayment of federal income taxes on self-employment income and the underpayment of self-employment taxes contribute $122 billion and $57 billion, respectively, to the “tax gap.” 1 To reduce underreporting of these taxes and narrow this portion of the tax gap, 2 the IRS will generally scrutinize the classification of workers as independent contractors, rather than employees, during income tax audits of firms, and assess taxpayers for the underpayment of employment taxes.

In an effort to increase tax compliance and provide certainty for taxpayers, in September 2011 the IRS announced a new voluntary classification settlement program (VCSP). The VCSP provides partial relief from retroactive federal employment tax assessments for eligible taxpayers that agree to prospectively treat their workers, or a class or group of their workers, as employees. 3 To be eligible for the VCSP, a taxpayer must have consistently treated the workers in question as nonemployees and must have filed all required Forms 1099 for the workers for the previous three years. Taxpayers must apply for admission to the program. At the time of application, the taxpayer cannot be under audit by the IRS or, concerning the classification of its workers, by the U.S. Department of Labor or a state government agency. 4

By design, the initial cost to participate in the VCSP is relatively small. Consequently, the IRS retains discretion whether to admit a taxpayer into the program. Taxpayers admitted into the program must pay 10% of the employment tax liability that might have been due on compensation paid to the workers reclassified as employees for the most recent tax year, determined under the reduced rates of Sec. 3509(a). Participants will not be liable for any interest and penalties on the reduced employment tax amount, and the IRS will not challenge the prior classification of the workers reclassified under the VCSP.

However, taxpayers with more than one class of workers should be aware that participation in the program will not prevent an IRS challenge to the classification of workers not covered under the VCSP. Additionally, for the first three years following admission to the program, participants must agree to an extended six-year statute of limitation on employment taxes for the workers involved.

After careful analysis of the VCSP, taxpayers might find that, even though the initial cost to participate in the program is relatively small, the future costs (i.e., the future employment taxes and future employee benefit costs associated with the prospective reclassification of workers as employees) may be too high and untenable for the certainty it provides. Under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), taxpayers must pay Social Security, Medicare, and unemployment taxes 5 for the benefit of workers classified as employees and withhold and remit amounts from employees’ wages for the employees’ share of Social Security and Medicare taxes.

FICA and FUTA taxes are significant costs of employing workers. The current FICA tax rate paid by an employer is 7.65%. (Employees pay 5.65% for 2012 because of temporary legislation cutting the rate by 2 percentage points.) A taxpayer with employees must contribute 6.2% of a worker’s earnings for Social Security and 1.45% for Medicare. 6 The maximum earnings to which the Social Security rate is applied are adjusted annually; however, there is no maximum level of earnings to which the 1.45% Medicare rate is applied. For 2012, the maximum earnings subject to the Social Security tax are $110,100 per worker. 7 Taxpayers are also required to pay a 6% FUTA tax on the first $7,000 of earnings for each employee annually. 8

Taxpayers that treat workers as independent contractors not only avoid the costs of employment taxes, but they also avoid the administrative costs associated with calculating and withholding taxes from workers’ earnings; depositing employment taxes with the Treasury; and reporting employment tax withholdings, contributions, and deposits on the appropriate forms during the year. In addition, they avoid employee benefit costs for workers’ compensation insurance, health and welfare benefits, and retiree plans. However, if upon audit, the IRS determines that a taxpayer should have classified its workers as employees, the retroactive employment tax assessments could be large and potentially financially devastating.

Taxpayers that choose to continue to treat their workers as independent contractors can still prevail in an IRS challenge to their worker classifications and avoid retroactive employment tax assessments if they qualify for relief under Section 530 of the Revenue Act of 1978. 9 Section 530 provides relief for taxpayers who reasonably, but erroneously, classify workers as independent contractors instead of employees. Recent court decisions show that, consistent with Congress’s intent to protect taxpayers that exercised good faith in determining that their workers were not employees, the courts continue to liberally construe the “reasonable basis” requirement in the law in favor of taxpayers.

Taxpayers that meet the consistency requirements (described below) and have a reasonable basis for not treating workers as employees can still prevail in the application of the Section 530 safe-harbor provisions to the facts and circumstances of their respective working relationships. This article reviews the common law principles and authoritative guidance available to distinguish when workers are employees and the Section 530 safe-harbor provisions. This article also discusses how taxpayers have met the statutory standards for the safe harbor and prevailed in IRS challenges to classifications of workers as independent contractors.

Common Law Employee or Independent Contractor

The extent to which a worker is subject to the control of the taxpayer is the crucial test in determining the nature of the working relationship. However, whether a worker is an employee is predicated not only on whether the worker is subject to the taxpayer’s control, but also on whether the taxpayer has the right to control the worker. Regs. Sec. 31.3121(d)-1 defines the common law employer-employee relationship as follows:

Generally such relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. 10

Control or the Right to Control

Early court decisions establish that the right to control and direct the specific manner in which an individual works toward the desired end work product is just as fundamental as control in defining the employer-employee relationship. In Capital Life & Health Ins. Co., 11 the taxpayer failed to show that the commissioned salesmen it treated as independent contractors were free from the control of the company. The taxpayer provided regular training to the salesmen, did not have a written contract with the salesmen, could terminate the relationship at will, and issued a guidebook of rules governing the salesmen’s conduct. Following the termination of their relationship with the company, the salesmen retained no economic interest in the insurance policies they wrote. When considered collectively, all of the elements of the working relationship showed that the salesmen were not free of the company’s control.

Usually, performing professional services requires a high degree of expertise or skill, which can make it difficult or impossible for the taxpayer to actually supervise the work of a professional. Consequently, a lower standard is applied when considering whether control or the right to control is exercised over the work of a professional. 12 Rev. Rul. 57-21 indicates that “the control of an employer over the manner in which professional employees shall conduct the duties of their positions must necessarily be more general than the control over nonprofessional employees.” 13

In Professional & Executive Leasing (PEL), 14 PEL attempted to classify physicians and other professionals it “leased” as employees. PEL devised a plan to “hire” the professionals and lease them back to their respective practices or businesses. The contract between PEL and the professionals specified that they would be employees of PEL. The Tax Court rejected PEL’s classification of the professionals as employees. The control PEL exercised over them was not sufficient to establish an employer-employee relationship even under the lower standard applicable to professionals. The professionals were not PEL’s employees but, rather, remained either self-employed or employed by their practice or business. 15

All of the facts and circumstances surrounding the working relationship must be considered when determining a worker’s status. In Texas Carbonate Co., 16 the court held the relationship between the taxpayer and worker was so extensive that it outweighed the absence of control by the taxpayer. In this case, Luther Miller, who was a shareholder in the company and a member of its board of directors, vacated his job as general manager and entered into an agreement to work for the company as a commission-based independent contractor. The IRS challenged the change in his worker status. The court ruled in favor of the IRS, noting that, although the company did not control and had no right to control Miller’s performance of his duties, his degree of involvement with the company was so extensive that it made the company’s lack of control over him irrelevant. The Fifth Circuit’s decision shows that, although control or the right to control is the primary consideration, a worker’s status is based on all of the facts and circumstances of his or her relationship with the taxpayer.

The courts have shown that, absent control, no other single factor is dispositive and determining whether a worker is sufficiently subject to a taxpayer’s control to be an employee rather than an independent contractor is subjective. Consequently, conflicting court decisions on workers’ employment tax status are common. 17

20-Factor and Other Tests

In 1987, the IRS issued Rev. Rul. 87-41 to guide taxpayers in determining whether workers are employees under the common law rules. 18 It lists 20 factors that were derived from court decisions and earlier rulings on specific classes of workers and evaluates three primary characteristics: control, the relationship between the employer and worker, and economic considerations.

Federal courts are not bound by the IRS’s administrative guidance in the revenue ruling. Over the years, the courts have referred to Rev. Rul. 87-41 as a “help” to the court in making its decision 19 and useful to the court as an “aid” in its analysis. 20 In other instances, courts have chosen to disregard the revenue ruling altogether.

Several court decisions have used the “Darden factors,” from a ruling by the Supreme Court on employee status for purposes of the Employee Retirement Income Security Act of 1974. 21 In numerous other instances courts have relied on case law precedent rather than Rev. Rul. 87-41 in deciding whether an individual should be classified as an employee. 22 Thus taxpayers considering the appropriate classification of workers should be aware that the courts may not simply apply the 20-factor test provided in Rev. Rul. 87-41 to determine whether a taxpayer’s basis for treating workers as nonemployees is reasonable and instead may consider all of the particular facts and circumstances of the working relationship and apply the case law precedent of the appropriate appellate circuit.

Section 530 Statutory Safe Harbor

If the IRS finds that a taxpayer has technically been treating workers who should be classified as employees as nonemployees, all may not be lost. As discussed more fully below, a taxpayer can rely on the safe-harbor provisions of Section 530 to obtain relief from the retroactive assessment of federal employment tax liabilities when the taxpayer has consistently classified workers as independent contractors, consistently reported workers as nonemployees, and has had a reasonable basis for doing so.

Congressional Intent

Through the safe-harbor provisions of Section 530 of the Revenue Act of 1978, Congress sought to provide relief for taxpayers that had consistently treated workers as independent contractors and exercised good faith in making the decision to do so, even though under common law the workers might be considered employees. 23 Congress’s motivation for enacting the safe-harbor provisions is described in a 1979 Joint Committee on Taxation report. The report states in part that relief for taxpayers was needed because: 24

In the late 1960s, the IRS increased its enforcement of the employment tax laws. Previously, employment tax audits had been superficial or sporadic and only occasionally entailed examination of employment status issues. Many controversies developed between taxpayers and the Service about whether individuals treated as independent contractors should be reclassified as employees. . . .

Before the 1970s . . . most [IRS] audits did not focus on employment tax status determinations; so most taxpayers relied on their own judgment, industry practice, or, in a few industries, published Revenue Rulings. . . .

The Congress believes that it is appropriate to provide interim relief for taxpayers who are involved in employment tax status controversies with the Internal Revenue Service, and who potentially face large assessments, as a result of the Service’s proposed reclassifications of workers, until the Congress has adequate time to resolve the many complex issues involved in this area.

Clearly, Congress enacted Section 530 to provide relief from potentially large retroactive employment tax assessments for taxpayers who had acted in good faith. 25 It has also been suggested that Congress intended to curb the IRS’s overly aggressive enforcement of the employment tax laws. 26 Regardless of the explanation, the relief was meant to be temporary, until Congress could “resolve the many complex issues involved in this area.” Nonetheless, Section 530 continues to be available as a safe harbor for taxpayers involved in worker classification controversies today, and the new VCSP is evidence that those same issues remain unresolved.

Section 530 Provisions

Section 530 was initially set to expire on Dec. 31, 1979, and, after being extended twice, it was made a permanent provision by Section 269 of the Tax Equity and Fiscal Responsibility Act of 1982. 27 In 1996, paragraph (e) was added to Section 530, which makes it incumbent upon the IRS to inform the taxpayer of the safe-harbor provisions before it begins an audit of the employment status of the taxpayer’s workers. 28

Section 530 does not supplant the common law; rather, it protects the independent contractor status during the period in question for workers of taxpayers that meet its conditions.

Specifically, Section 530 states in part that:

If—

(A) for purposes of employment taxes, the taxpayer did not treat an individual as an employee for any period, and

(B) in the case of periods after December 31, 1978, all Federal tax returns (including information returns) required to be filed by the taxpayer with respect to such individual for such period are filed on a basis consistent with the taxpayer’s treatment of such individual as not being an employee,

then, for purposes of applying such taxes for such period with respect to the taxpayer, the individual shall be deemed not to be an employee unless the taxpayer had no reasonable basis for not treating such individual as an employee. 29 [Emphasis added.]

Section 530 further provides that a taxpayer is deemed to have had a reasonable basis for not treating an individual as an employee if the taxpayer reasonably relies on any one of the following:

(A) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer;

(B) a past Internal Revenue Service audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; or,

(C) long-standing recognized practice of a significant segment of the industry in which such individual was engaged. 30 [Emphasis added.]

These safe-harbor provisions provide relief for the taxpayer that treats workers as independent contractors, even though under the common law the workers might be considered employees. 31 However, for relief under the provisions, the initial burden of establishing prima facie reasonableness is on the taxpayer. Once the taxpayer has made a prima facie case of reasonable basis and has fully cooperated with reasonable requests by the IRS, the burden of proof shifts to the IRS to show otherwise. 32

Meeting the Statutory Standards for Safe Harbor

Substantive Consistency

To prevail under the safe harbor, not only must the taxpayer not have treated a particular worker as an employee during the periods in question but must also have treated the worker and other workers holding a substantially similar position consistently during the same periods. The safe-harbor provisions will not apply if, “with respect to the treatment of any individual for employment tax purposes for any period ending after December 31, 1978, the taxpayer (or a predecessor) has treated any individual holding a substantially similar position as an employee for purposes of employment taxes for any period beginning after December 31, 1977.” 33

Under Section 530(e)(6), the determination of whether an individual holds such a position “shall include consideration of the relationship between the taxpayer and such individuals.” Therefore, taxpayers should keep in mind that showing subtle differences in the working relationship between the taxpayer and the worker in question, and the taxpayer and another worker with a similar position, may be enough to establish that the two workers are not in substantially similar positions. 34

Reporting Consistency

Section 530(a)(1)(B) includes as a condition for relief that the taxpayer file all required federal tax returns (including information returns) with respect to the worker or workers in question, on a basis consistent with treating them as nonemployees. 35 Generally, taxpayers will have met the reporting requirement when they file annual information returns, Form 1096, Annual Summary and Transmittal of U.S. Information Returns, and Form 1099-MISC, Miscellaneous Income, to report payments made during the year to workers classified as independent contractors. However, neither the Code nor the regulations define “payment,” and the IRS has argued in some cases that Section 530 does not apply because during the period in question the taxpayer made reportable noncash payments that it did not report.

In Deja Vu-Lynnwood, Inc., 36 the taxpayer’s relief under the safe harbor was challenged because the taxpayer had not filed Forms 1099-MISC for what the IRS alleged were payments to workers that should be reported under Sec. 6041. Payments that are required to be reported under Sec. 6041 include payments of $600 or more made in the course of a trade or business for rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income. 37 Sec. 6041 does not require an employer-employee relationship, only a payment.

Deja Vu-Lynnwood provided free legal services for its workers (dancers at a nightclub) and provided them credits against the rent it charged them when customers bought them drinks. The IRS argued that free legal services and the credits constituted payments that should be reported under Sec. 6041. The court disagreed and held that the government’s assertion that Deja Vu-Lynnwood had not met the reporting requirement of the safe harbor was unreasonable. 38 Neither the free legal services nor the credits constituted a payment as defined by Sec. 6041.

In an earlier decision, Marlar, Inc., 39 in which a similar issue was before the Ninth Circuit, the court held that the employer was acting as a mere conduit for payments between customers and the workers, and that it would be illogical and absurd for “conduit” transfers to constitute payments under Sec. 6041. The court noted this would require essentially any individual (including, for example, a messenger, a postal worker, or an armored car employee) who operated as a conduit to file a Form 1099-MISC.

Reasonable Basis

The language of Section 530(e)(4)(A) essentially instructs the IRS to accept presumptively the taxpayer’s classification of a worker as a nonemployee unless the taxpayer had no reasonable basis for doing so. 40 Although it is not specified in the statute, Congress intended that the reasonable basis inquiry be construed liberally in favor of the taxpayer. 41 In McClellan , the court held that a taxpayer’s burden in establishing that it falls within the safe harbor of Section 530 is less than a preponderance of the evidence. 42 The court based its finding on an earlier district court decision that indicated that

[t]here is no practical objective method to carry out Congress’s directive of liberally construing the applicable tax provision other than lowering the hurdle of the taxpayer’s burden of proof. The Court therefore holds that a taxpayer need only show a substantial rational basis for its decision to treat workers as independent contractors in order to prevail. 43

Accordingly, in subsequent decisions courts have construed that the burden on the taxpayer is relatively low and can be met with any reasonable showing. Clearly, the three methods specified in Section 530(a)(2)—judicial precedent or administrative ruling, past IRS audit of worker status, or long-standing industry practice—give taxpayers ample opportunity to meet the reasonable basis burden of proof. However, judicial precedent shows that the reasonable basis safe harbor can also be satisfied if the taxpayer can show any other reasonable basis for not treating workers as employees.

Applying a Judicial Precedent or Administrative Ruling

Generally, judicial decisions issued to other taxpayers can be used to support a taxpayer’s decision to classify workers as individual contractors, but only if those decisions are based on substantially similar facts and circumstances to those of the taxpayer. Published IRS rulings provide sufficient authority upon which to establish reasonable basis, but they, too, must involve similar facts and circumstances to those of the taxpayer to be of any value. A taxpayer who receives a private letter ruling is normally entitled to rely on it fully, absent a change in the law. The IRS generally may not retroactively revoke a private letter ruling unless relevant facts were withheld in the ruling request, or the ruling request contains some other fraudulent information or misrepresentation. 44

Using a Past IRS Audit

Under Section 530(a)(2)(B), evidence that the IRS accepted the taxpayer’s classification of its workers during an audit may qualify as reasonable basis for continuing the same classification for those workers (and other workers holding substantially similar positions) in periods after the audit. In Lambert’s Nursery and Landscaping, Inc., 45 the Fifth Circuit set out four requirements that the taxpayer must meet to prevail under the prior audit provision: (1) that the IRS conducted a prior audit of the taxpayer for a particular tax year; (2) that the IRS determined in the prior audit that the taxpayer’s workers were independent contractors; (3) that the workers who were the subject of the prior audit are “substantially similar” to the workers at issue; and (4) that the taxpayer treated the two groups of workers in a “substantially similar” fashion. 46 In 1996, Congress added Section 530(e)(2)(A), which clarifies that for purposes of Section 530(e)(2)(B), a taxpayer may not rely on an IRS audit conducted after 1996 unless the audit included an examination of employment status of the taxpayer’s workers.

Relying on Long-Standing Practice

In Section 530(e)(2)(B), Congress provided some guidance regarding what constitutes a “long-standing recognized practice of a significant segment of the industry” for purposes of Section 530(a)(2)(C). “[I]n no event” should it be necessary for a taxpayer to show that more than 25% of an industry, exclusive of the taxpayer, is engaged in the practice for it to be deemed to be a practice engaged in by a significant segment of the industry. 47 Moreover, to show that a practice qualifies as long-standing, a taxpayer need not show that it has been in effect for longer than 10 years. 48 Congress also made it clear that it is not necessary to show that the practice was in effect before passage of Section 530 in 1978. This stipulation makes Section 530 prospective and allows taxpayers to meet the requirement by showing that relatively recent practices are prevalent in an industry. 49

General Investment Corp. 50 is a landmark opinion and a frequently cited precedent in challenges to a taxpayer’s claim that there is a long-standing practice to treat workers as independent contractors. The taxpayer (GIC) showed that it met the long-standing practice standard of the safe harbor because it had treated its workers as independent contractors ever since it acquired a mining operation, and its treatment was consistent with the previous owners’ practice. GIC also provided evidence that several dozen small mining operations in the area treated their workers as independent contractors. The Ninth Circuit found that proof of nationwide practices was not necessary as long as proof of the practices of a significant segment of the industry was offered. The court ruled that GIC’s limited proof was sufficient to establish that a long-standing practice existed in the industry. 51

In RI Unlimited, Inc., 52 the taxpayer relied on the statement of four individuals with experience in the industry to show that it was entitled to relief under the long-standing practice safe harbor. In separate statements, each individual declared that substantially more than 25% of the firms in the industry treated their workers as independent contractors for employment tax purposes. The Tax Court found that an individual’s personal experience, standing alone, would not be evidence of the long-standing recognized practice of a significant segment of the industry. But the Tax Court found that the declarations of three individuals with decades of experience in the industry, plus that of a fourth individual who had studied the industry’s practices, was sufficient evidence of a long-standing recognized practice of a significant segment of the industry. The court concluded that to hold otherwise would place an unreasonably high burden on taxpayers claiming relief under Section 530(a)(2)(C).

In McClellan, 53 the taxpayer, Paul McClellan, surveyed companies that hired flooring installers to obtain evidence that the treatment of flooring installers as independent contractors was a long-standing industry practice. Posing as an installer looking for work, McClellan asked each company surveyed whether he would be treated as an employee or independent contractor. Forty of the 41 companies McClellan contacted indicated that they treated their installers as independent contractors. Even though the IRS argued that McClellan’s decision to treat his own workers as independent contractors could not have been based on the subsequently conducted survey, and that a recently conducted survey could not constitute direct evidence of industry practice during the years in question, the court found in his favor. 54 The court noted that the statute states that “[i]f . . . the taxpayer did not treat an individual as an employee . . . the individual shall be deemed not to be an employee unless the taxpayer had no reasonable basis for not treating such individual as an employee” (emphasis added by the court).

Again, the long-standing practice need not be industrywide for the taxpayer to demonstrate that its workers should not be deemed employees. In Springfield, 55 the taxpayer continued to treat its salesmen as independent contractors after purchasing an independent used car dealership. 56 The taxpayer presented evidence to show that independent used car dealerships, which comprised a significant segment of the used car industry in the area, treated their salesmen as independent contractors. The IRS argued that independent and franchised used car dealerships should be considered collectively. Franchised used car dealerships, also a significant industry segment in the area, generally treated salesmen as employees. The court held that “[t]he plain language of Section 530 makes clear that to demonstrate a reasonable basis for [treating workers as nonemployees], a taxpayer must prove that a significant segment of the industry follows a particular practice—not that every segment of the industry follows that practice.” 57

A taxpayer may be able to show a long-standing industry practice for treating workers as independent contractors if there is evidence that the IRS has essentially approved of the treatment as an industry practice. In Marlar, Inc., 58 the Ninth Circuit noted that before its challenge to Marlar’s workers’ status, the IRS had audited a competitor of Marlar that conducted its business in much the same way and had approved of the competitor’s classification of its workers as nonemployees. The court indicated that its decision for Marlar was reinforced by the IRS’s own prior acceptance of the treatment of the industry’s workers.

Other Reasonable Basis

In addition to the safe-harbor standards specified in Section 530(a)(2), a taxpayer is entitled to relief when it can demonstrate in some other manner any other reasonable basis for treating its workers as independent contractors. 59 Surprisingly, the term “reasonable basis” in this context is not defined in the statute. However, the district court in Smoky Mountain Secrets, Inc., 60 considered it analogous to the term “reasonable cause,” which is a standard used to determine whether income tax penalties should be imposed on a taxpayer. 61 In determining if reasonable cause exists, the standard set out in IRS regulations and used by courts is whether the taxpayer “exercised ordinary business care and prudence.” 62 The court noted however that the reasonable basis standard is construed liberally in favor of the taxpayer while the reasonable cause test is not. 63

The courts have liberally construed “any other” reasonable basis in favor of the taxpayer. In Peno Trucking, Inc., 64 the Sixth Circuit found that the taxpayer’s reliance on the findings of a workers’ compensation audit conducted during the taxpayer’s early years of business met the reasonable basis requirement for not treating its workers as employees. The court found in favor of the taxpayer, even though the workers’ compensation audit occurred after the taxpayer decided to treat its workers as independent contractors.

Taxpayers that rely on the advice of a professional expert generally will be deemed to have a reasonable basis for treating workers as nonemployees. The Supreme Court has stated that:

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. “Ordinary business care and prudence” do not demand such actions. 65

In Smoky Mountain Secrets, Inc., the district court found that the taxpayer’s reliance on the advice of two professional tax advisers was sufficient to demonstrate a reasonable basis for not treating workers as employees.

The district court’s decision in Western Neuro Residential Centers, Inc., 66 shows that there are numerous other ways taxpayers can establish a reasonable basis for the treatment of workers as independent contractors. The court not only found that the taxpayer had established that there was a long-standing practice for its not treating medical directors as employees, but that the taxpayer had also established a reasonable basis for its treatment of the medical directors by the advice of lawyers and accountants, the corporate practice of medicine doctrine, its reasonable treatment of workers under the traditional common law rules, and its continual efforts to properly classify its workers.

Conclusion

Congress intended for Section 530 to provide relief for taxpayers that have a reasonable basis for not treating workers as employees, but taxpayers nonetheless could face large retroactive employment tax assessments as a result of an IRS challenge to the classification of their workers. The safe-harbor provisions of Section 530 protect a taxpayer from retroactive employment tax assessments when the taxpayer has consistently classified workers as independent contractors, filed all appropriate federal tax returns consistent with treating workers as nonemployees, and had a reasonable basis for not treating workers as employees.

A taxpayer must make a prima facie case to establish that it had a reasonable basis for the treatment of its workers, but the courts continue to construe the reasonable basis safe harbor liberally in favor of taxpayers. In addition to establishing a reasonable basis through one of the methods specified in the statute, taxpayers may be able to prevail in worker classification controversies if they can demonstrate any other reasonable basis for not treating workers as employees.

Although Announcement 2011-64, establishing the new VCSP, does not mention the relief available to taxpayers under Section 530, the provisions of the section serve to mitigate the risk of retroactive employment tax assessments for taxpayers that can meet its requirements for relief. For taxpayers that are uncertain whether they can meet the requirements of the safe harbor under Section 530 and prevail in challenges to their worker classifications by the IRS, the VCSP provides an opportunity to rectify past worker misclassifications at a relatively low cost. 67 For taxpayers who decide the costs of the VCSP are too high, Section 530 remains an alternative for those who meet its requirements.

 

 

Footnotes

1 IRS, Tax Gap for Tax Year 2006—Overview (Jan. 6, 2012). See also IRS, Reducing the Federal Tax Gap: A Report on Improving Voluntary Compliance, p. 10, (Aug. 2, 2007).

2 The tax gap is the difference in the amount of tax revenues that the federal government actually collects and the amount that it would collect if all taxpayers fully complied with the federal tax laws and paid their taxes on time. Reducing the Federal Tax Gap, at 6.

3 Announcement 2011-64, 2011-41 I.R.B. 503.

4 See Announcement 2011-64 for the application requirements and information regarding the appropriate form to file.

5 Throughout the remainder of the article, the term “employment taxes” refers to taxes payable under the Federal Insurance Contributions Act (FICA), Secs. 3101 and 3111, and the Federal Unemployment Tax Act (FUTA), Sec. 3301.

6 Sec. 3111.

7 For 2012, self-employed taxpayers pay a nominal rate of 13.3% in self-employment tax on their first $110,100 in net self-employment income, which is the combined rate of the employer’s and employee’s shares of FICA tax. An above-the-line income tax deduction of 57.5% of the SE tax (for 2011 and 2012; otherwise 50%) reduces the effective rate for most self-employed taxpayers. The Middle Class Tax Relief and Job Creation Act of 2012, P.L. 112-96, reduced the usual 15.3% self-employment tax rate to 13.3% by cutting the employee portion of the Social Security tax to 4.2% from 6.2% through the end of 2012.

8 The rate was 6.2% before the second half of 2011. A credit for contributions for state unemployment insurance reduces the current effective rate for most taxpayers to 0.6%.

9 Section 530 of the Revenue Act of 1978, P.L. 95-600.

10 Regs. Sec. 31.3121(d)-1(c)(2).

11 Capital Life & Health Ins. Co., 186 F.2d 943 (4th Cir. 1951).

12 Rev. Rul. 57-21, 1957-1 C.B. 317.

13 Id.

14 Professional & Exec. Leasing, Inc., 89 T.C. 225 (1987).

15 The Tax Court’s decision was affirmed on appeal (Professional & Exec. Leasing, Inc., 862 F.2d 751 (9th Cir. 1988)).

16 Texas Carbonate Co., 307 F.2d 289 (5th Cir. 1962).

17 For example, a noteworthy inconsistency exists among decisions involving the classification of workers associated with the trucking industry. See McGuire, 349 F.2d 644 (9th Cir. 1965); Bonney Motor Express, Inc., 206 F. Supp. 22 (E.D. Va. 1962); and Service Trucking Co., 347 F.2d 671 (4th Cir. 1965).

18 Rev. Rul. 87-41, 1987-1 C.B. 296.

19 Leb’s Enters., Inc., No. 97 CV 4718 (N.D. Ill. 2000).

20 Hospital Res. Personnel, Inc., 68 F.3d 421 (11th Cir. 1995).

21 Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318 (1992).

22 See, e.g., Weber, 60 F.3d 1104 (4th Cir. 1995). In Ewens and Miller Inc., 117 T.C. 263 (2001), the Tax Court used an eight-factor test derived from the Weber opinion.

23 See General Inv. Corp., 823 F.2d 337 (9th Cir. 1987).

24 Joint Committee on Taxation, General Explanation of the Revenue Act of 1978 (JCS-1-79), p. 300 (March 12, 1979); see also S. Rep’t No. 1263, 95th Cong., 2d Sess. (1978); H.R. Rep’t No. 1748, 95th Cong., 2d Sess. (1978).

25 Smoky Mountain Secrets, Inc., 910 F. Supp. 1316 (E.D. Tenn. 1995).

26 McClellan, 900 F. Supp. 101 (E.D. Mich. 1995).

27 Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.

28 Amended by Section 1122 of the Small Business Job Protection Act of 1996, P.L. 104-188. In Announcement 2011-64, the IRS does not mention the relief available under Section 530.

29 Revenue Act of 1989, §530(a)(1) (Controversies Involving Whether Individuals Are Employees for Purposes of the Employment Taxes).

30 Id., §530(a)(2).

31 Hospital Res. Personnel, Inc., 68 F.3d 421 (11th Cir. 1995).

32 Revenue Act of 1989, §530(e)(4)(A).

33 Id., §530(a)(3).

34 Id., §530(e)(6).

35 Note that the reporting requirement is reduced to three previous years for participants in the VCSP.

36 Deja Vu-Lynnwood, Inc., 21 Fed. Appx. 691 (9th Cir. 2001).

37 Sec. 6041(a).

38 Deja Vu-Lynnwood, Inc., 21 Fed. Appx. at 693.

39 Marlar, Inc., 151 F.3d 962 (9th Cir. 1998).

40 McClellan, 900 F. Supp. 101 (E.D. Mich. 1995).

41 H.R. Rep’t No. 1748, 95th Cong., 2d Sess. (1978).

42 McClellan, 900 F. Supp. at 105.

43 McClellan, 900 F. Supp. at 105, quoting REAG, Inc., 801 F. Supp. 494 (W.D. Okla. 1992).

44 Lesavoy Foundation, 238 F.2d 589 (3d Cir. 1956).

45 Lambert’s Nursery and Landscaping, Inc., 894 F.2d 154 (5th Cir. 1990).

46 Smoky Mountain Secrets, Inc., 910 F. Supp. 1316 (E.D. Tenn. 1995).

47 Revenue Act of 1989, §530(e)(2)(B).

48 Id., §530(e)(2)(C)(i).

49 Id., §530(e)(2)(C)(ii).

50 General Investment Corp., 823 F.2d 337 (9th Cir. 1987).

51 The Ninth Circuit reversed the district court’s decision with respect to 1979 because GIC failed to file information returns for its workers for that year as required by Section 530(a)(1)(B).

52 RI Unlimited, Inc., T.C. Memo. 2010-205.

53 McClellan, 900 F. Supp. 101 (E.D. Mich. 1995).

54 See also REAG, Inc., 801 F. Supp. 494 (W.D. Okla. 1992) (taxpayer performed a survey and found that 15 out of 20, or 75%, of the survey respondents (real estate appraisal firms in the Oklahoma City area) treated nonowner appraisers as independent contractors).

55 Springfield, 88 F.3d 750 (9th Cir. 1996).

56 See also Images in Motion of El Paso, Inc., T.C. Memo. 2006-19 (taxpayer continued to treat dance instructors as independent contractors after purchasing a business).

57 Springfield, 88 F.3d at 754.

58 Marlar, Inc., 151 F.3d 962 (9th Cir. 1998).

59 Rev. Proc. 85-18, 1985-1 C.B. 518.

60 Smoky Mountain Secrets, Inc., 910 F. Supp. 1316 (E.D. Tenn. 1995).

61 Id at 1324.

62 See, e.g., Regs. Sec. 301.6651-1(c)(1).

63 Smoky Mountain Secrets, Inc., 910 F. Supp. at 1324, n.3.

64 Peno Trucking, Inc., 296 Fed. Appx. 449 (6th Cir. 2008).

65 Smoky Mountain Secrets, Inc., 910 F. Supp. at 1324, quoting Boyle, 469 U.S. 241, 251 (1985).

66 Western Neuro Residential Centers, Inc., No. 8:01-cv-00645-AHS-AN (C.D. Cal. 2/28/02).

67 Readers should be aware that President Barack Obama continues to be concerned about the proper classification of workers. In 2007, then-Sen. Obama sponsored the Independent Contractor Proper Classification Act of 2007 (S. 2044), which would have eliminated the defense of industry practice as justification for classifying workers as independent contractors. The administration’s Living Within Our Means and Investing in the Future: The President’s Plan for Economic Growth and Deficit Reduction, released in September 2011 and available at www.budget.gov, proposes many of the same amendments to Section 530 included in S. 2044.

 

EditorNotes

Claire Nash is an assistant professor of accounting at Florida Atlantic University in Boca Raton, Fla. For more information about this article, please contact Prof. Nash at cnash8@fau.edu.

 

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James M. Greenwell Wins 2014 Best Article Award

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

 

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