For fiscal year 2008, the IRS’s Small Business/Self-Employed division assessed over $64 million in related taxes and penalties based upon employers’ misclassification of workers. Employers can expect increased enforcement activities in the future as the GAO recommends that, “[t]o assist in preventing and responding to employee misclassification, and to increase its detection of Fair Labor Standards Act (“FLSA”) and other labor law violations, the Secretary of Labor should direct the Wage and Hour Division (“WHD”) Administrator to increase the division’s focus on misclassification of employees as independent contractors during targeted investigations.” In addition, the IRS recently embarked on an employment tax audit program that involves a significant number of randomly selected employers in the next few years with a particular focus on “employment tax challenged industries.”
To make matters worse for employers, new federal legislation has been introduced that would make it more difficult for employers to receive protection from a potentially large employment tax assessment after incorrectly classifying a worker as an independent contractor. The legislation, which is called the “Taxpayer Responsibility, Accountability, and Consistency Act of 2009,” would increase information reporting penalties. Under existing laws, employers that meet the following three requirements are protected from potentially large employment tax assessments, even though they incorrectly categorized a worker as an independent contractor: (1) reasonable basis, (2) substantive consistency, and (3) reporting consistency.
An employer can meet the first requirement of “reasonable basis” if there is judicial precedent, IRS rulings, a past IRS audit, or industry practice supporting the classification of a worker as an independent contractor. An employer meets the “substantive consistency” requirement if it (and any predecessor business) consistently treated the workers in question as independent contractors. The :”reporting consistency” requirement is met if the employer has not classified the workers as employees on any required federal tax returns, including information returns.
Proposed New Legislation
The new legislation, if passed, would make it more difficult for employers to avoid employment tax liability if they misclassified a worker as an independent contractor. The new rules would generally require employers to have a “reasonable basis” for classifying a worker as an independent contractor. The “reasonable basis” standard would be met only if:
The employer classified the worker as an independent contractor based on: (i) a written determination that addresses the employment status of either the worker in question, or another individual holding a substantially similar position with the employer; or (ii) a concluded employment tax examination of the worker, or another individual holding a substantially similar position with the employer, that did not conclude that the worker should be treated as an employee; and
The employer (or a predecessor) has not treated any other individual holding a substantially similar position as an employee for employment tax purposes for any period beginning after Dec. 31, ’77.
The new legislation would allow an employer to rely on an examination commenced, or a written determination issued, if: (a) the controlling facts and circumstances that formed the basis of a determination of employment status have changed or were misrepresented by the taxpayer, or (b) IRS subsequently issues contrary guidance related to the determination of employment status that has a bearing on the facts and circumstances that formed the basis of the determination of employment status. IRS would issue its determination of worker status no later than 90 days after the filing of a petition with respect to employment status in any industry where employment is transient, casual, or seasonal (e.g., construction). The new rules would only apply prospectively, to services rendered more than one year after the date that the legislation is enacted.
The IRS has announced plans to audit as many as 6000 companies for employment tax compliance and proper worker classification beginning in November of 2009. The audits are part of the Treasury’s National Research Program and will be the first quantitative study of the problem of worker misclassification since 1984. Given the anticipated step up in enforcement of existing laws and the more stringent legislation under consideration, it is critical that all businesses that utilize independent contractors carefully review with competent counsel whether such workers are properly classified as independent contractors and, if they are not, take appropriate measures to rectify the misclassification.