Businesses often find themselves the subject of an audit by the IRS or California’s Employment Development Department (EDD) because they have misclassified their employees as independent contractors. Generally speaking, employees are subject to tax withholding and get W-2s from their employer at the end of each year while independent contractors are responsible for their own taxes and get a 1099-MISC from their employer at the end of each year, IF their earnings exceeded $600.
Since the IRS and EDD prefer to collect tax revenues early on they have a preference or natural inclination to determine that ALL workers are employees rather than independent contractors. In contrast, many businesses would prefer to treat their employees as independent contractors to avoid filing payroll tax returns and paying payroll taxes. Employee misclassification is a persistent problem in many industries, including construction, home care, janitorial, trucking and drayage, hospitality, nail spas, massage parlors and restaurants.
The IRS has learned that 10% to 30% of all employers have misclassified some employees as independent contractors. Estimates of the “tax gap” related to this issue amount to $3-$4 billion annually. Accordingly, it is understandable as to why the IRS goes to such great lengths to conduct worker classification audits.
The purpose of this article will be to discuss how to differentiate between independent contractors and employees. This particular area of the law is actually a very grey area for even tax practitioners so it is no wonder that businesses and owners find themselves confused.
Since 1954, the usual common law rules state that if an employer has the right to control both the ends as well as the means by which the worker performs his or her services, the worker is an employee. The existence of the employer’s right to control is critical, the exercise of that control is not. Thus, the Treasury Regulations state that “it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so.”
By 1987, the IRS issued Revenue Ruling 87-41 in which the IRS distilled years of case law into a more manageable 20 factor test, It is applied by asking the following 20 questions.
Is the worker…
The inherent problem with this test was that some factors may be given more weight than others in any particular case.
By 1996, the IRS reorganized the twenty factors into three broad categories in its training materials:
Using these tests, IRS revenue officers are able to make an assessment of a business and conclude whether the worker classification is proper or not. If an employer is found to be misclassifying their workers, an investigation will follow which can have serious consequences. In order to best protect your business in this event, it is critical that you consult with a tax attorney to assist you at every level of the audit and appeal.
It is also very important to know the various relief provisions available to your business.
Section 530 of the Revenue Act of 1978 was enacted in response to complaints by taxpayers that the IRS was too aggressive with respect to worker classification issues. Section 530 is a safe harbor that prevents the IRS from retroactively reclassifying “independent contractors’ as employees and subjecting an employer to federal employment taxes, penalties and interest for such misclassification. To qualify for Section 530 relief, an employer must have:
The Voluntary Classification Settlement Program (VCSP) is a new optional program that provides taxpayers with an opportunity to reclassify their independent contractors as employees for future tax periods for employment tax purposes with partial relief from federal employment taxes. To participate in this new voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in the CSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS. To be eligible, a taxpayer must have consistently treated the workers as nonemployees, and must have filed all required Forms 1099 consistent with the nonemployee treatment for the previous 3 years with respect to the workers to be reclassified. Unfortunately, EDD has no similar counterpart to the VCSP.
Finally, an employer may appeal the IRS determination of a worker’s misclassification. IRC § 3402(d) provides that an employer will be able to avoid liability for income taxes that should have been withheld if he or she submits IRS Forms 4670 and 4669 reflecting that the employee(s) in question satisfied their income tax liability. An employer can also arrange for an appeals conference with IRS officials. However, it is highly recommended that you be accompanied by an experienced tax attorney during this conference.
In order to be more successful during the appeals process it is imperative that your tax counsel be both knowledgeable and experienced with the IRS procedures, so as to better assist you in bringing your appeal to a successful resolution.
For more information or to schedule a free initial consultation with Rex Halverson and Associates, please call (916)-444-0015 or email us at firstname.lastname@example.org.
 Treas. Reg. § 31.3121(d)-(1)(c).
 Treas. Reg. § 31.3121(d)-(1)(c)(2).