The Congressional Research Service recently commented in its report, "Tax Gap: Misclassification of Employees as Independent Contractors," that tackling the problem of misclassification of workers "would reduce federal, state and local tax gaps and provide other important benefits."

While the issue of worker misclassification is not new - a 1984 report had identified it as a growing problem - the current economic downturn has created new cause for alarm. Because a solution to worker misclassification would generate much-needed tax revenues while doing so under the banner of "fairness" to compliant businesses, the government appears poised to pursue "misclassifiers" with a new sense of purpose.

The statistics in favor of tighter enforcement are convincing. According to the Government Accountability Office, approximately 10 million workers are classified as independent contractors, while as many as 20 percent of employers misclassify workers as independent contractors. Recent estimates peg more than 60 percent of federal revenues coming through the employment tax system. Classification of a worker as an employee immediately raises wage reporting by the worker by way of Form W-2 reporting and withholding. Another estimate reveals that reporting by workers increases by 25 percent over those issued Form 1099s as independent contractors. Also in play for the Internal Revenue Service is statistical evidence that up to 30 percent of workers who are not issued either W-2s or 1099s do not report either all income or a portion of their income.

IMPACT OF RECENT TRENDS

There is a growing bias, particularly among small-business owners, toward hiring at least part of the business' workforce as independent contractors, rather than employees. In addition to removing the employer's direct share of FICA tax and unemployment insurance from the equation, independent contractors may be excluded from health and retirement benefits, as well as more easily terminated under state employment laws.

Recent tax laws admittedly have created several additional incentives to hire certain new workers as employees, rather than independent contractors -namely, payroll tax forgiveness and the worker retention credit under the HIRE Act, and the small-employer health insurance tax credit under the health care package. These benefits are only available with respect to employees. Nevertheless, many businesses, especially small businesses, continue to prefer the flexibility typically provided by using independent contractors for at least a portion of their workforce.

Trends such as telecommuting, bottom-up innovation, flex time, fewer brick-and-mortar operations that require a worker to be "in the office" or "on the assembly line," and productivity innovations that allow workers to "own their own jobs" only reinforce characterization of many workers in today's economy as independent contractors when measured against traditional "control" factors used to distinguish them from employees. The economic downturn, too, has increased pressure on workers to accept positions as independent contractors, since the negotiating position of workers, who as a class generally prefer employee status, has been weakened by the current oversupply of available workers.

USING SECTION 530

In addressing worker classification issues involved in the employment tax audit, the IRS examiner generally first determines whether the Section 530 safe harbor applies. The Section 530 safe harbor gets its name from Section 530 of the Revenue Act of 1978, which provided relief from what Congress then saw as the IRS's overzealous application of worker classification criteria. The Section 530 safe harbor allows employers to classify certain workers as independent contractors, even though they may be common-law employees. In fact, if the employment status of any individual performing services for the taxpayer is going to be the subject of an audit inquiry, the IRS must provide the taxpayer with written notice of the Section 530 rules before or at the start of the audit.

The Section 530 safe harbor provides that an individual who has not been treated as an employee will not be reclassified as an employee if:

The taxpayer had a reasonable basis for not treating the individual as an employee;

The taxpayer did not treat the worker or any worker in a similar position as an employee for payroll tax purposes; and,

The taxpayer has filed all required federal tax returns, including any Form 1099 information returns, in a manner consistent with the worker not being an employee.

An employer is considered to have a reasonable basis for not treating an individual as an employee if treatment was based on:

Judicial precedent, published rulings, technical advice to the employer or a letter ruling to the employer;

A past examination of the taxpayer by the IRS in which there was no assessment attributable to the treatment for employment tax purposes of individuals holding positions substantially similar to the position held by this individual; or,

A long-standing recognized practice of a significant segment of the industry in which the individual was engaged.

The safe harbor rule governs employee status only with respect to employment taxes, and not for other purposes. For example, employees who have been misclassified as independent contractors must be allowed to retroactively participate in a qualified plan. This result applies even if the worker has signed an agreement with the employer acknowledging their claimed status as an independent contractor and foregoing benefits.

In addition, standards for qualification as an employee or independent contractor vary when entitlement to state law benefits is being challenged. In fact, qualifying for independent contractor status under Section 530 may place a target on the employer's back with respect to increased vulnerability to wage and hour litigation, as well as lawsuits over a variety of other benefits.

THE COMMON-LAW ROUTE

If the taxpayer does not satisfy the requirements for Section 530 relief, the workers are not automatically employees. Instead, common-law analysis of the worker's status is applied. In that case, the employment tax examination proceeds to look at three categories: behavioral control, financial control, and the relationship of the parties. Within these three categories, the IRS will apply its 20 common-law factor test as first announced in Rev. Rul. 87-41. No one factor is determinative, nor are all factors necessarily present in any employee or independent contractor relationship. While the examiner generally tries to resolve questions through documentation first, in-person interviews of workers and the employer are not so rare that they should not be anticipated.

One factor that the IRS reportedly is using more frequently lately in our "new economy" that can tip the scales in favor of independent contractor status is the presence of a worker's opportunity for profit or loss regarding the work they undertake: "Most employees can't lose money, but an independent contractor can lose money; for instance, if they price a bid wrong," the chief of IRS Employment Tax Operations recently observed.

EMPLOYMENT TAX NRP

To get a better handle on employment tax compliance in tailoring more effective audits, the IRS has begun conducting employment tax National Research Project exams. Under the program, the IRS will conduct 6,000 random audits of taxpayers over the next three years, taken equally from the Large and Mid-Size Division, the Small Business and Self-Employed Division, and the Tax-Exempt/ Government Entity Division. Those audits will not stop if the taxpayer qualifies for the Section 530 safe harbor. Each year, the IRS plans to audit 2,000 taxpayers. Officials say they are on target to achieve that level for 2010.

The last employment tax NRP was conducted in 1984; IRS officials have acknowledged that employment tax practices have drastically changed since then. IRS officials also say that they will not wait until the 2012 close of this program but will use data from this NRP on the fly as audit opportunities unfold.

PROPOSED LEGISLATION

Congress is determined not to be left behind in improving employee classification compliance. It sees putting pressure on the IRS to improve enforcement statistics as one necessary focal point. It also has been looking into making changes in the law, not only to improve compliance as a goal in and of itself, but also as a means of presenting "revenue-raising" provisions to offset tax cuts in conformity with "pay-go" rules.

Four bills have been introduced so far during the 111th Congress to address the misclassification of workers. S. 3254 and HR 5107, the Employee Misclassification Prevention Act, would require employers to maintain records of non-employees who work for them and would impose stiff penalties on misclassifying employees as non-employees. S. 2882 and HR 3408, the Taxpayer Responsibility, Accountability and Consistency Bill, on the other hand, would all but eliminate the existing Section 530 safe harbor. It would allow safe harbor relief only if independent contractor classification has been based on a reasonable reliance on either a written determination from the IRS that the individual (or someone holding a substantially similar position) was not an employee, or if an IRS employment tax examination concluded the same.

The Obama administration also supports changes to worker classification rules. The president's fiscal year 2011 federal budget proposes to reform Section 530, to allow the IRS to issue generally applicable guidance on worker classification, and to increase funding of the Labor Department to hire additional enforcement personnel and more closely coordinate activities with the IRS.

CONCLUSION

Worker classification is primarily a small-business issue when it comes to strategies, since larger operations generally establish protocols in hiring that safeguard against incorrect classification. Best practices nevertheless should be pushed down into smaller enterprises as closer scrutiny and higher penalties for noncompliance make their way into mainstream IRS audit procedures.

Change is likely coming in worker classification, in the form of not only more robust enforcement of existing rules but also less leeway than now given to incorrect classifications. The "when" and the "how" are still not entirely settled. The competing argument against immediate change, of course, is itself convincing: Businesses that are the engine of an economic and "jobs" recovery cannot afford misclassification penalties while they continue to operate on razor-thin profit margins.

No matter what the eventual timetable, however, businesses would do well to review their present worker classification procedures and prepare in advance the evidence needed to receive a "no change" on any audit that may develop.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

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