A recent ruling by the Tax Court might help soften the blow to employers confronted with income tax liability for workers that have been reclassified as employees.
In a case of first impression, Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11, the court unanimously ruled that such employers can access IRS records of the reclassified workers’ tax returns to ascertain whether the employees themselves had paid income tax on their earnings. If they have, the employer’s liability is reduced by the amount the employee paid. Unfortunately, there is no bright-line test of whether a worker is an employee or an independent contractor, but the consequences of misclassification, whether inadvertent or deliberate, can be severe.
Code section 3402(a) requires every employer to deduct and withhold a tax on the wages it pays. The employer itself is liable for this withholding tax. Employees get a credit on their income tax bill for the money withheld by their employers. If the employer misclassifies its employees as independent contractors, it can get hit with a huge bill for the amount it failed to collect and pay over. But if the employer actually paid the tax even though it was not withheld, the employer is off the hook under Code section 3402(d).
In this case, the IRS reclassified hundreds of employees of the Mescalero Apache Tribe as employees and determined the tribe owed the applicable withholding tax. The tribe moved for discovery of the workers’ return information because the workers’ independent payment of their income tax would absolve the tribe of its liability. The IRS objected under Code section 6103 because the information the tribe requested is confidential taxpayer information.
The Tax Court held that the disclosure of third-party taxpayer information to absolve an employer of its Code section 3402(a) tax liability is not barred by Code section 6103(h).
The court noted that during the years at issue, the tribe timely issued Forms W-2 to its employees and Forms 1099 to its contractors. The case began when the IRS audited the tribe on suspicion that some of the workers classified as contractors were really employees. Although the tribe still contests the reclassification of those people it called contractors, the court observed that it’s really fighting the major consequence of that reclassification—a large tax bill.
One way to show the workers whom it labeled independent contractors, and thus escape liability, would be to ask each worker to complete Form 4669, Statement of Payments Received. In fact, the court noted, the tribe tried to do just that, but it was only partly successful because many of the tribe’s former workers had moved, and some lived in hard-to-reach areas. The tribe was ultimately unable to find 70 of these workers and thus could not secure executed Forms 4669 from them.
The general rule under Code section 6103(a) is that returns and return information should be kept confidential. However, Code section 6103(h)(4) provides an exception. It states generally that a return or return information may be disclosed in a federal or state judicial or administrative proceeding pertaining to tax administration, but only if the treatment of an item reflected on such a return is directly related to the resolution of an issue in the proceeding; or if the return or return information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer which directly affects the resolution of an issue in the proceeding.
The Tax Court noted that circuit courts of appeal have split on the issue of whom such information may be disclosed to under the exception. Since it was likely the tribe’s case would be appealable to the Tenth Circuit, it followed that circuit court’s interpretation that third-party tax return information can be disclosed in tax proceedings to persons other than government officials so long as the other requirements of the exception are met.
“How the Tribe’s workers viewed themselves—as employees or independent contractors—is a factor in worker-classification cases,” said the court. “And whether the Tribe’s workers paid their income tax liabilities as independent contractors would tend to prove or disprove the Tribe’s case, which would directly relate to the resolution of one of the issues here. We also shouldn’t overlook the big issue here: If the Tribe’s workers did indeed pay their tax liabilities, then the Tribe’s section 3402(d) defense would be proved and would be entirely resolved.”
Consequently, the court ruled the information was disclosable under section 6103(h)(4)(C).
The case can be an aid to employers who can’t get Forms 4669 from their reclassified workers. As the court noted, one of the factors in worker-classification cases is whether or not the workers in question viewed themselves as independent contractors or employees. The fact that they paid taxes would be evidence they viewed themselves as independent contractors. And, of course, to the extent they paid taxes, it would absolve the employer from liability on the employee’s income tax withholding, and on a host of other liabilities: FICA, FUTA, workers’ compensation, vacation pay, sick pay, minimum wage violations and overtime pay.