Who qualifies as an independent contractor?
With today's changing business landscape, the answer is not always black and white. Between the provisions of the Patient Protection and Affordable Care Act, P.L. 111-148, and the rise of the "sharing economy," independent contractor classification is making headline news. And woe to the company that gets the answer wrong, since it can lead to a painful assessment from the IRS.
Nelly Home Care Inc. recently ran into a problem with this issue. The IRS disagreed with Nelly's independent contractor classification and assessed back taxes under Sec. 3509(a). This happened even though Nelly made an upfront effort to properly classify its workers. Fortunately, Nelly found tax relief (Nelly Home Care, Inc., No. 15-439 (E.D. Pa. 5/10/16)). This case serves as both a warning and a guiding light for any employer looking to classify its workers as independent contractors.
Overview of Sec. 3509(a)
Under Sec. 3509(a)(1), if an employer misclassifies an employee, that employer will face a back withholding tax liability "equal to 1.5 percent of the wages . . . paid to such employee," assuming that the employer followed all the correct reporting requirements for an independent contractor. If the employer did not follow the correct procedures, the amount due doubles to 3% of the wages paid to the employee (Sec. 3509(b)(1)(A)).
Example: A hires B for $40,000, treating B as an independent contractor. The IRS determines that A should have treated B as an employee. Assuming A filed B's Form 1099-MISC, Miscellaneous Income, and followed the other rules related to independent contractors, A will owe $600 to the IRS, or 1.5% of $40,000. If A did not correctly follow the independent contractor rules, that amount doubles to $1,200.
Similarly, under Sec. 3509(a)(2), if an employer misclassifies an employee, the employer will face a back Social Security tax in the amount of 20% of the employee's FICA tax liability if he or she had been treated as an employee, assuming that the employer followed all the correct reporting requirements for an independent contractor. If the employer did not follow the correct procedures, the amount due doubles to 40% of the employee's share of FICA tax liability if he or she had been treated as an employee (Sec. 3509(b)(1)(B)).
If an employer has multiple misclassified employees over many years, the tax bill can be quite large. Sec. 3509(a) requires the payment of these taxes notwithstanding the intent of the employer, which is to say that, if the IRS disagrees with an employer's classification, the employer has to pay no matter how much effort it put into determining the correct classification.
That does not mean an employer is totally out of luck. Relief, however, is found outside of the Code.
Section 530 of the Revenue Act of 1978
Relief from Sec. 3509(a) back taxes can be found in Section 530 of the Revenue Act of 1978, P.L. 95-600. This provision is not part of the Internal Revenue Code. It is good law, though, and was the basis for tax relief inNelly.
Under Section 530, an employer may qualify for relief only after it has established that it has filed all the required returns consistent with treating the worker as an independent contractor and that it did not treat any other worker holding substantially the same position as an employee (Henry, 793 F.2d 289 (Fed. Cir. 1986); IRS Internal Revenue Manual (IRM), Technical Guidelines for Employment Tax Issues, §§18.104.22.168.2.1 and 22.214.171.124.2.2).
Once these two requirements are met, the employer may use Section 530's safe harbor to avoid the federal employment tax liability. Here, the employer must show it had a "reasonable basis" for not classifying workers as employees. This would require the employer to show that, in making the decision, it reasonably relied on:
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. A long-standing recognized practice of a significant segment of the industry in which such individual was engaged. [IRM §126.96.36.199.2.3 (internal citations omitted)]
The court also noted in Nelly that "a taxpayer who can demonstrate a 'reasonable basis' for not classifying workers as employees outside the three statutory safe harbor categories can be entitled to relief."
In other words, if an employer meets the requirement of any of the three statutory safe-harbor categories or otherwise shows it had a reasonable basis for not classifying its workers as employees, it may avoid the taxes assessed under Sec. 3509(a).
Section 530 Only Applies to Tax Relief
Section 530 is an important tool to avoid paying the taxes assessed for an incorrect employee classification. It does not, however, address whether that classification was correct. In other words, even if an employer successfully receives tax relief under Sec. 530, it may still have to prospectively classify its workers as employees.
Nelly Home Care, Inc.
Nelly LLC and subsequent company Nelly Home Care Inc. recently received relief from the back taxes of Sec. 3509(a). The case provides a deeper look at the Section 530 safe harbor.
Nelly provides health care companions for elderly residents in the Philadelphia area. The companions have been treated as independent contractors since the company's inception. In 2011, the IRS determined this treatment was incorrect. Nelly paid the back taxes it was assessed and then brought an action to recover those taxes.
Nelly first argued that it was entitled to the Section 530 safe harbor because, in a previous audit, the IRS had signed off on the independent contractor classification, thus qualifying the company for the Section 530 safe harbor.
The court rejected this argument, stating that the audit safe-harbor category applies only to a taxpayer that shows that:
(1) the IRS previously audited the taxpayer, (2) the IRS determined in that prior audit that the taxpayer's workers were independent contractors, (3) the workers subject to the prior audit were substantially similar to the workers at issue, and (4) the taxpayer treated the two groups of workers in substantially similar fashion.
The court concluded that Nelly did not meet these four requirements.
It was not Nelly, but company owner Helen Carney who previously was audited. During this audit of her personal returns, the IRS requested the documents related to Nelly's independent contractors. The documents were requested not to determine whether the classification was correct but to determine whether Carney had paid the correct amount of personal taxes related to her business. The IRS's silence on the independent contractor treatment, the court ruled, could not be seen as approval.
Nelly next argued that it relied on "long-standing recognized practice of a significant segment of the industry." Nelly demonstrated that it took several steps to correctly classify its companions as independent contractors. Before Nelly LLC was formed, Carney asked other providers in the area how they treated their companions. While setting up her company, Carney had an attorney draft an independent contractor contract based on the contract of one of these other providers.
Several years later, Carney surveyed 22 home care providers and determined that nine used independent contractors. In 2010, she attended a mandatory conference hosted by the Pennsylvania Department of Health, which informed attendees that the "regulatory definition of a 'home care registry' was a business that 'supplies, arranges or refers independent contractors to provide home care services.' " Nelly argued that these two points served as evidence that a significant segment of the industry used independent contractors.
The court also rejected this argument. To qualify for the long-standing industry practice safe-harbor category, the court said that "a taxpayer must show that (1) a long-standing recognized industry practice exists in a significant segment of the industry, and (2) the taxpayer reasonably relied on this practice in the tax treatment of its workers." The court found that evidence Carney gathered did not establish a significant segment of the industry followed a particular practice, since many of the companies surveyed were outside of Nelly's Philadelphia market, and none of the evidence pointed to the practice as long-standing.
Reasonable Basis for Classification
Even though the court rejected Section 530 relief for Nelly under the statutory safe-harbor categories, it stated that "a taxpayer who can demonstrate a 'reasonable basis' for not classifying workers as employees . . . can be entitled to relief." On this basis, the court found that Nelly qualified for relief.
While none of the evidence submitted met the statutory requirement, the court agreed that the IRS's silence on the independent contractor classification on Carney's audit could reasonably be seen as acquiescence. The court also noted that Carney's personal research and surveys showed she made an effort to correctly classify her health care companions. Under these facts and circumstances, the court concluded that Nelly had a "reasonable basis" for classifying its workers as independent contractors.
All may not be lost for a taxpayer that does not meet the statutory safe-harbor categories of Section 530. As the decision in Nelly demonstrates, courts may be willing to provide Section 530 relief to employers that put in reasonable efforts to determine the correct classification.
Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or email@example.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.