EMPLOYMENT TAXES

1. INDEPENDENT CONTRACTOR

1.10 Beginning in the mid 1980's the IRS began test programs in several Districts auditing employers who allegedly misclassified their employees as "independent contractors." This program, called the Special Compliance Employment Tax Examination Program, began in 1984 in seven districts. It was later expanded to 26 Districts. The Internal Revenue Service reported in 1988 that in the first year 92% of the taxpayers examined on the issue of worker classification were confronted with additional tax assessments. As a result of the large revenues generated by the IRS's test program, it has now expanded its employment tax examination program to include all districts. The program was originally called the Employment Tax Examination Program or ETEP. Later, the Internal Revenue Service changed the name of the program to the Office of Employment Tax and Compliance (OETAC).

1970's

1.20 During the 1970's, the Internal Revenue Service also stepped up its efforts in Employment Tax Audits. As a result of complaints by taxpayers, however, Congress sought to rein the IRS in by passing IRC § 530 of the Revenue Act of 1978. That provision sought to provide relief for companies that were the subject of IRS Employment Tax examinations. As a result of the passage of IRC § 530, the IRS suspended most of its Employment Tax examination efforts from 1978 to 1984. Section 530 was intended to be temporary to allow Congress to pass specific definitions of employees, but as a result of conflict among various industries, Congress was unable to come up with a definition. Therefore, as of 1988, the IRS resumed its aggressive Employment Tax Examination Program. That program continues up through the date of this publication even though the IRS has a classification settlement program which is discussed later in this Section. Section 530 was also amended by the Small Business Jobs Protection Act which is also discussed later in this Section.

Effect of Reclassification

1.30 The financial impact of IRS reclassification of independent contractors can be disastrous. The stakes are very high, in excess of 43% of payments to independent contractors. The IRS might also seek to impose personal liability pursuant to IRC § 6672 on corporate officers. Reclassification also leads to requirements that employees be included under state tax programs and under employee benefit programs.

Potential Liability

1.40 IRC § 3509 provides for assumed rates for FICA and withholding which would result in deficiencies between about 11% and 14% of a company's reclassified payroll. Section 3509 rates apply if the company did not intentionally disregard worker classification rules. Absent application of IRC § 3509 rates, the IRS assumes a rate for withholding of 28% of payments to reclassified workers. It also imposes liability for both employee and employer FICA and Medicare for a total of 15.3% of payments. The employer also becomes liable for FUTA. A redetermination for the three past years will normally destroy most labor intensive service businesses.

2. COMMON-LAW TEST

2.10 For purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and income tax withholding, the term "employee" includes any individual who, under the usual common-law rules for determining the employer/employee relationship, has the status of an employee. [See IRC 4§ 3121 (d), 3306(i), 3401 (c)]

Control and Direction

2.20 Under the common-law rules, a worker is an employee when the person for whom services are performed has the right to control and direct the individual who performs the service. This control must reach not only the result to be accomplished, but also the details and means by which the results are to be accomplished. The employer need not actually exercise control. It is sufficient that the right to do so exists. It is the substance of each particular relationship that governs; therefore, the employers may not simply contract away their employment tax liabilities.

Employees for FICA Purposes

2.30 The IRC §3508 also provides that certain individual occupation groups, who may not be employees under common-law rules, will be treated as employees for FICA purposes only. This category was originally referred to as "Statutory Employees" and identified under IRC § 3121 (d)(4) as agent drivers, traveling or city salesmen, full-time life insurance salesmen and homeworkers. It also includes corporate officers who receive remuneration for services as corporate officers.

3. TWENTY COMMON-LAW FACTORS

3.10 Twenty common-law factors have been identified by the IRS for determining whether a worker is in fact an employee. [See Rev Rul 87-41, 1987-1 CB 296] Unfortunately the degree of importance of each of these factors varies from case to case. Some factors do not apply to certain occupations and therefore, should not be given any weight. Although 11 of the 20 factors may indicate employee status, this does not necessarily mean an employer/employee relationship exists. Some of the factors may be inappropriate under the circumstances and some may be more significant than others. The weight to be given and degree of importance of each factor varies depending on the occupation and the reasons for its existence.

Factors

3.20 The following 20 common-law factors are used by the IRS. These factors are the basis of Form SS-8, which is used by the IRS to analyze the employee/independent contractor question:

(1) Compliance with instructions. A person who is required to comply with instructions about when, where, and how to work is ordinarily an employee. The control factor is present if the employer has the right to instruct, whether or not he in fact does so.

(2) Training. Training of a person by an experienced employer, by correspondence, by required attendance at meetings, and by other methods indicates control because it shows that the employer wants the services performed in a particular method or manner. This is especially true if the training is given periodically or at frequent intervals. Independent contractors ordinarily rely upon their own resources for training and receive no training from the purchasers of their services.

(3) Integration with business. Integration of the person's services in the business operations generally shows that the person is subject to direction and control. In determining whether integration exists, it is necessary to determine the scope and function of the business and whether the services of the individual are merged into it.

(4) Personal rendition of service. If services must be rendered personally, it indicates that the employer is interested in the methods as well as the results. The employer is interested not only in getting a desired result, but also in who does the job. Lack of "employer"-type control may be indicated when an individual has the right to hire a substitute without the employer's knowledge.

(5) Hiring, supervising and payment of assistants. Hiring, supervising, and payment of assistants by the employer generally shows control over the workers on the job. Sometimes one worker may hire, supervise, and pay the other workers. This may result from a contract under which the worker provides materials and labor and is responsible only for the attainment of a result. In this case, the worker is an independent contractor. On the other hand, if the worker hires, supervises, and pays other workers at the direction of the employer, the worker may be acting as an employee in the capacity of a supervisor or representative of the employer.

(6) The existence of a continuing relationship. The existence of a continuing relationship between an individual and the person for whom the individual performs services is a factor tending to indicate the existence of an employer-employee relationship. Continuing services may include work performed at frequently recurring, though somewhat irregular, intervals. If the arrangement contemplates continuing or recurring work, the relationship is considered permanent, even if the services are rendered on a part-time basis, or the person actually works only a short time.

(7) Set hours of work. The establishment of set hours of work by the employer is a factor indicative of control. This condition bars the worker from being master of her own time, which is a right of the independent contractor. Of course, an independent contractor often must work when facilities are open to her and must complete an entire job within a certain period of time. However, it is the flexibility within these necessary time restraints that separates the independent contractor from the employee. Where fixed hours are not practical because of the nature of the occupation, a requirement that the worker work at certain times is an element of control.

(8) Exclusive full-time work. If the worker must devote full time to the business of the employer, the employer has control over the amount of time the worker spends working. This implicitly restricts the worker from doing other gainful work. An independent contractor, on the other hand, may choose for whom and when to work.

Full-time does not necessarily mean an eight-hour day or a five or six-day week. Its meaning may vary with the intent of the parties, the nature of the occupation, and the customs of the locality.

(9) Work on employer's premises. Doing the work on the employer's premises is not control in itself; however, it does imply that the employer has control, especially where the work is of such a nature that it could be done elsewhere. A person working in the employer's place of business is physically within the employer's direction and supervision. The use of desk space and of telephone and stenographic services provided by an employer places the worker within the employer's direction and supervision, unless the worker has the option as to whether to use these facilities.

Work done off the premises does indicate some freedom from control; however, it does not by itself mean that the worker is not an employee.

(10) Sequence of work done. If a person must perform services in the order or sequence set by the employer, it shows that the worker may be subject to control as the worker is not free to follow his own pattern of work, but must follow the established routines and schedules of the employer. This is true if the employer retains the right to do so even if in fact he does not.

(11) Reports recruited. If regular oral or written reports must be submitted to the employer, it indicates control in that the workers are compelled to account for her actions.

(12) Payment by hour, week, or month. An employee is usually paid by the hour, week, or month, whereas payment on a commission or job basis is customary where the worker is an independent contractor. Payment by the job includes a lump sum, which is computed by the number of hours required to do the job at a fixed rate per hour.

The guarantee of a minimum salary or the granting of a drawing account at stated intervals with no requirement for repayment of the excess over earnings indicates the existence of an employer-employee relationship.

(13) Expense account. Payment by the employer of the worker's business and/or traveling expenses is a factor indicating control over the worker. Conversely, a lack of control is indicated where the worker is paid on a job basis and has to take care of all incidental expenses.

(14) Tools and materials supplied. The furnishing of tools, materials, etc., by the employer is indicative of control over the worker. Where the worker furnishes the tools, materials, etc., it indicates a lack of control; but in some occupational fields, it is customary for employees to use their own hand tools.

(15) Facilities-furnished. A significant investment in facilities by the person performing the services tends to show an independent status. On the other hand, the furnishing of all necessary facilities by the "employer" tends to indicate the absence of an independent status on the part of the worker.

Facilities generally include equipment or premises necessary for the work, but not tools, instruments, clothing, etc., that are provided by employees as a common practice in their particular trade.

(16) Risk of loss. Individuals who are in a position to realize a profit or suffer a loss as a result of their services are generally independent contractors, while individuals who are employees are not in such a position.

(17) Number of "employers." If a person works for a number of persons or firms at the same time it usually indicates an independent status because in such cases the worker is usually free from control by any of the firms. It is possible, however, that a person may work for a number of people or firms and still be an employee of one or all of them.

(18) Availability to general public. Workers who make their services available to the general public are usually independent contractors.

(19) Power to fire. The right to discharge is an important factor it: indicating that the person possessing the right is an employer. The employer exercises control through the ever-present threat of dismissal that causes the worker to obey instructions. Independent contractors, on the other hand, cannot be fired as long as they produce results that measure up to their contract specifications.

Sometimes an employer's right to discharge is restricted because of the employer's contract with a labor union or through increasingly more liberal judicial decisions in favor of employees. Such restrictions do not weigh unfavorably against the existence of an employment relationship.

(20) Termination damages. An employee has the right to end the relationship with the employer at any time the employee wishes without incurring liability. An independent contractor usually agrees to complete a specific job and is responsible for its satisfactory completion or is liable for breach of contract.

4. INTERPRETATION OF COMMON-LAW TEST

4.10 Because of the conflicting nature of the various tests, they become a weapon in the hands of IRS employees. The author has found it almost impossible to convince front-line Revenue Officer Examiners (ROE's) and Revenue Agents (RA's) that a particular group of workers meet the common law test as independent contractors. The Internal Revenue Service appears to have an inherent bias in favor of determining employee/employer relationship. Only at the Appeals Division does the putative employer have the potential to have a fair consideration of the common-law test. Some taxpayers are forced to initiate refund litigation suits to finally secure justice in employment tax disputes with the IRS.

Worker Agreement

4.20 One common misconception that many people have is that if there is a contract signed by the worker agreeing to independent contractor status, that creates such a relationship. That is not in fact the case. The common-law test controls even if the worker has agreed to be an independent contractor. The Internal Revenue Manual instructs its employees as follows:

When an employer-employee relationship exists, it is of no consequence whether the employee is designated as a trustee, agent, independent contractor, or other title. Additionally, signing a contract does not always indicate the worker is self-employed. What does govern is the substance of a particular relationship, and consequently employers cannot contract away their employment tax liabilities. [IRM 104.6.5.6]

State Tests

4.30 Even if a worker is an employee pursuant to state unemployment tax or worker's compensation laws, that does not in fact mean that that worker is a worker for federal purposes. Many states impose a much harsher test, known as the ABC test, for determination of a worker's status. Therefore, a worker might be an independent contractor for common-law test purposes and an employee for worker's compensation and state unemployment tax purposes.

5. SECTION 530 OF REVENUE ACT OF 1978

5.10 In the early 1970's, the Internal Revenue Service stepped up its enforcement of the employment tax laws. As a result, many businesses faced the severe economic consequences of reclassification. Because of pressure from these businesses, Congress passed Section 530 of the Revenue Act of 1978 as an interim relief provision. Section 530 of the Revenue Act of 1978, as amended, is not part of the Internal Revenue Code (IRC). However, some publishers include its text after IRC § 3401(a). Unfortunately, Congress was not able to come up with a definition of employee. In 1982, the Senate Finance Committee proposed a five-factor test which, if met, would provide safe harbor for independent contractors. The five factors proposed by the Senate Finance Committee were:

(1) Control of hours worked;

(2) Place of business;

(3) Investment or income fluctuation;

(4) Written contract and notice of tax responsibilities; and

(5) Filing of required returns.

This legislation was not passed by Congress. Congress was able to agree upon passage of IRC §§ 3508 and 3509, which are discussed later in this material. [See Sections 11-8 and 11-9]

Safe Harbor of § 530

5.20 Section 530 provides that "an individual shall be deemed not to be an employee for purposes of determining tax liabilities, unless the taxpayer had no reasonable basis for treating such individual as an employee." [Revenue Act of 1978 § 530(a)(1)] Section 530 further provides three statutory safe havens and one general safe haven for meeting the reasonable basis requirement. Under Section 530, a taxpayer is deemed to have a reasonable basis for not treating an individual as an employee where the taxpayer's treatment of the worker was in reasonable reliance on any of the following:

(1) Judicial precedents, published IRS rulings, technical advice memorandum, or private letter ruling or determination letter ruling directed to the taxpayer;

(2) A prior IRS audit of the taxpayer, not necessarily for employment tax purposes, in which there was no assessment attributable to the taxpayer's employment tax treatment of the class of workers whose present status is at issue. The Small Business Jobs Protection Act of 1996 removes this protection for tax returns filed for years after 1996;

(3) A long-standing, recognized practice of a significant segment of the industry in which the taxpayer is engaged; and

(4) A general safe haven (any other reasonable basis). In addition to the three statutory methods set forth above, the statute allows the taxpayer to demonstrate "reasonable basis" for its treatment of workers in some other manner.

Additional Requirements

5.30 Even though the taxpayer has satisfied one of the designated statutory safe havens, Section 530 relief will be denied where the taxpayer fails to meet two additional requirements:

(1) The taxpayer must not have previously treated the individuals in question as an employee; and

(2) The taxpayer must have timely filed all required information returns for each worker consistent with classification as an independent contractor (i.e., Form 1099).

Burden of Proof

5.35 The Small Business Jobs Protection Act provides that for post-1996 periods if a taxpayer establishes a prima facie Section 530 case, the burden of proof shifts to Internal Revenue Service.

Consistency Provisions

5.40 Under the "consistency provisions" [Revenue Act of 1978 § 530(a)(3)] relief is unavailable to the taxpayer if the taxpayer (or predecessor) has treated any individual after December 31, 1977, holding a substantially similar position as an employee for employment tax purposes. Under this section, relief would also be denied in the successor taxpayer's business. The author defended a client who met at least two of the Safe Harbors of Section 530, but the IRS claimed that there is inconsistent treatment. The taxpayer employed union truck drivers to drive company-owned trucks and contracted with independent drivers who owned their own trucks to provide additional trucking resources. The Internal Revenue Service used the term "truck driver" to describe both categories (union drivers and owner operators). Because both categories are truck drivers, the IRS refused to grant Section 530 relief based upon its determination that there was inconsistent treatment. The author believes such cases indicate bad faith of the IRS when negotiating the use of Section 530 Safe Harbors. The case was settled in Appeals after three years of dispute with a full concession by the IRS, but to gain that victory the taxpayer spent thousands of dollars for legal and accounting fees.

Treatment as Employee

5.50 The IRS has published guidelines in Revenue Procedure 85-18 for purposes of interpreting "treat." In general the word "treat" includes the following:

(1) The withholding of income tax or FICA tax from an individual's wage; or

(2) The filing of employment tax returns (i.e., Form 940, 941 or W-2).

[Rev Proc 85-18, 1985-1 CB 518]

Effect of Section 530 Relief

5.60 The IRS takes the position that a successful Section 530 defense does not change the status of an employee to independent contractor for other purposes. The IRS Manual [IRM 104.6.5.5] provides as follows:

(1) It is important to remember that even if an employer is entitled to relief under Section 530, the employees remain employees for other purposes of the Code. Section 530 only terminates the liability of the employer for the employment taxes but has no effect on the employee's status. It does not convert workers from the status of employee to the status of self-employed (independent contractor). The Section 530 employee is still considered an employee for income tax and qualified benefit plan eligibility purposes. Therefore, the employer must consider the Section 530 employees as employees in determining whether its pension, profit-sharing, or stock-bonus plan satisfies the qualification requirements of Section 401 (a).

(2) The Section 530 employee remains liable for the employee share of FICA tax with respect to all wages received. The employee's share of FICA is reported on Form 8919, Uncollected Social Security and Medicare Tax on Wages,, by substituting the word "wages" for the word "tips." Revenue Procedure 85-18, Section 3.08; Section 31.3102-1 (c). See also Revenue Ruling 86-111, 1986-2 CB 176.

(3) Where Section 530 employees have filed and paid their tax under the Self Employment Tax Contributions Act (SECA), they may file a claim for refund for the difference between SECA tax and the employee share of FICA.

(4) As an employee, the worker generally cannot deduct unreimbursed business expenses above the line on Schedule C, but must deduct them, if at all, as miscellaneous itemized deductions on Schedule A, Form 1040, subject to the two percent limitation of IRC § 67. This sometimes results in liability for the alternative minimum tax. Further, the worker cannot adopt or maintain a self-employment retirement plan. Finally, certain benefits provided by the business to a worker as an employee may be excludable from income by the employee due to specific IRC exclusions provided only to employees (e.g., employer provided accident and health insurance.

Judicial Interpretation

5.70 In Lambert Nursery and Landscaping, Inc. v, United States, the United States Court of Appeals ruled that the nature of the relationship and not the services performed, is a critical factor in determining if two groups of workers hold substantially similar positions. The Lambert Nursery test appears to be correct because it is clear that attorneys, accountants and doctors and other persons who are historically independent contractors may be employees even though the services they perform as either employees or independent contractors are identical. Therefore, the position requirement should be interpreted to relate to the relationship between the worker and the business, not the nature of services performed. Once the consistent treatment requirement is met for the worker or group of workers, it should not be forfeited for that period. It may, however, be forfeited for future periods if inconsistent treatment is not maintained.

6. REASONABLE BASIS FOR INDUSTRY PRACTICE

6.10 Unfortunately for taxpayers, despite the direction of Section 530, the IRS has not liberally construed the industry practice safe haven, In Technical Advisory Memorandum 8733004, the Service denied Section 530 relief even though the taxpayers established that 60% of the companies providing associate dentists to dental clinics in the geographic area have treated the associate dentists as independent contractors. In TAM 8749001, the Service restated the narrow interpretation of industry practice as set forth in TAM 8733004. Moreover, the Service indicated that the safe harbor is wholly unavailable in the case of a new industry which did not exist at the time of Section 530's enactment.

Impact of Small Business Jobs Protection Act

6.15 The Small Business Jobs Protection Act provides specific guidance on the industry practice safe harbor. A significant segment does not require a showing of more than 25% of the industry. The committee reports say this rule is a ceiling only and a lower percentage may constitute a significant segment. The practice need not have continued for more than 10 years, as the IRS has argued in some cases.

Geographical Definition

6.20 Fortunately, most courts have rejected the Internal Revenue Service's narrow interpretation of industry practice. In General Investment Corp. v. United States, the 9th Circuit held the determination of what constitutes a relevant industry practice should be liberally construed in favor of the taxpayer in light of the remedial character of such since Section 530. Before the 9th Circuit, the government argued that in order to rely upon the industry practice standard, General Investment Corporation should be required to prove the industry standard for mining companies throughout the United States, or at least for small mining companies throughout the United States which process and extract ore. The 9th Circuit soundly rejected both arguments. It found that "Congress intended to protect employers who exercise good faith in determining that workers were employees or independent contractors." The Court cited the legislative history of Section 530, which stated that "reasonable basis" is to be construed liberally for the taxpayers.

Industry Cooperation

6.30 Historically, it has been very difficult for taxpayers to provide sufficient proof of relevant industry practice, particularly because competitors, out of fear of an IRS audit, refuse to cooperate. Although understandable, an industry as a whole is generally both served and protected by cooperation in this regard.

Application of Section 530 Relief

6.40 The Small Business Jobs Protection Act reversed the IRS' position that there must be a determination that the worker is an employer under common law standards before the taxpayer may use Section 530 safe harbors. The Act also provides that for post-1996 periods if a taxpayer wished a prima facie Section 530 case, the burden of proof shifts to the Internal Revenue Service.

7. SUBSECTION D

7.10 Section 1706 of the Tax Reform Act of 1986, amended Section 530 with respect to "technical service specials" by adding Subsection D. Subsection D provides that the relief under Section 530 is not available with respect to individuals referred to "Technical Service Specialists" whose services are engaged by a broker. Subsection D only applies to three party transactions involving, the worker (Technical Service Specialists), the broker firm and the client who uses the service of the worker.

8. IRC § 3508

8.10 IRC § 3508 provides specific relief for certain industries from worker reclassification. Qualified real estate agents will be relieved from redetermination if the person is a licensed real estate agent and receives all of her remuneration based upon sales or other output, rather than hours worked, pursuant to a written contract. Direct sellers will be relieved of recharacterization if they are engaged in a trade or business of selling consumer products (i.e., Avon, Amway) and receive substantially all of their remuneration based upon sales or other output, rather than hours worked, pursuant to a written contract.

9. IRC § 3509

9.10 Congress passed IRC § 3509 in 1982 to provide for reduced employment tax liability to employers for certain retroactive recharacterization of workers. The Act provided that if Forms 1099 were filed with respect to the workers, then the following rates would apply:

(1) 1.5% of liability of total payments for income tax withholding; and

(2) The employers share of FICA plus 20% of the employees share of FICA. If no 1099's were filed with respect to the workers, then the liability would be:

(3) 3% liability for income tax withholding; and

(4) The employer's share of FICA plus 40% of the employee's share.

FUTA Liability

9.20 IRC § 3509 is not applicable for FUTA tax liability, and no adjustment is available under IRC § 6205 with respect to interest and penalties. The lower tax rates provided under IRC § 3509 do not apply where the employer intentionally disregards reporting requirements. [See Ltr Rul 8415010]

10. INTEREST FREE ADJUSTMENTS — IRC § 6205

10.10 A special interest free adjustment is provided with respect to certain under-payments of FICA and withholding tax liability. This rule does not apply with respect to FUTA taxes. The underpaid FICA and/or withholding tax liability must be paid at the time that "error is ascertained." An error is ascertained when the employer has sufficient knowledge of the error to be able to correct it. [See Rev Rul 75-465, 1975-2 CB 474 for special rules]

11. SPECIAL ABATEMENT RULES — IRC §§ 3402(D), 6511(D)(7) AND 6521

11.10 IRC § 3402(d)(1) provides that an employer has the ability to obtain relief from a retroactive assessment of income withholding tax liability if an employer can demonstrate that the worker reported the income covered by the assessment on his Form 1040 return. IRS Form 4669 is designed for this purpose. Forms 4669 are transmitted to the IRS with Form 4670, IRC § 3402(d) relief is unavailable if the special tax rates of IRC § 3509 apply.

Mitigation of the Statute of Limitations

11.20 IRC § 6521 provides mitigation of the effect of the Statute of Limitations on obtaining a refund of FICA and SECA taxes in situations involving retroactive recharacterization of workers. Under IRC § 6521, the employer may obtain credit for her share of FICA taxes if the statute of limitations for the worker obtaining the a SECA refund has expired. Section 6521 relief is unavailable if the special tax rates of IRC § 3509 apply.

Refund Claims by Redetermined Employees

11.30 Under the prior law, the taxpayer was required to file a claim for refund of excess self-employment taxes paid after redetermination to be an employee within three years after the due date of the return, the return is filed or two years after the tax was paid. The Taxpayer Relief Act of 1997 provided that a redetermined employee, may now file a claim for overpayment of self-employment taxes any time before the last day of the second year after the Tax Court decision becomes final in a Tax Court proceeding regarding redetermination. In other words, the redetermined individual does not have to file a claim until after all proceedings by the putative employer have concluded before the United States Court.

12. CLASSIFICATION SETTLEMENT PROGRAM

12.10 The IRS announced in FS-96-5 that it will be testing procedures under an optional workers classification settlement program. The Classification Settlement Program (CSP) is also intended to ensure that the taxpayer relief provisions of Section 530 of the Revenue Act of 1978 are properly applied. [IRM 104.6.6.1] Since announcement the program as a test the IRS has now apparently made the program permanent by incorporating it within the Internal Revenue Manual.

Training Manual

12.15 As part of its classification settlement program, the IRS has issued training materials to its employees. Those training materials require a much more liberal view of employment tax issues. The authors have noted that in many instances the IRS is much more willing to discuss the issue in a manner more favorable to the taxpayer than prior to the issuance of these training materials. [Training 3320-102 (10-96)]

Eligibility

12.20 Under the CSP, an examiner will develop the worker classification issue, including the business' eligibility for relief under Section 530. The examination group manager must then confirm the business' eligibility for a CSP settlement. If an offer is made and accepted by the business, a standard closing agreement provided by the IRS National Office will be executed.

Graduated Settlement Offers

12.30 A series of graduated settlement offers will be available. If the business meets the Section 530 reporting consistency requirement but either clearly doesn't meet the Section 530 substantive consistency requirement or clearly can't satisfy the Section 530 reasonable basis test, the offer will be a full employment tax assessment for the one year under examination, computed using IRC § 3509, if applicable. If the business meets the reporting consistency requirement and has a colorable argument that it meets the substantive consistency requirement and the reasonable basis test, the offer will be an assessment of 25% of the employment tax liability for the audit year, computed under Section 3509, if applicable. The business must agree to properly classify its workers prospectively. [IRM 104.6.6.13.1 ]

Section 530

12.40 If the requirements of Section 530 are fully met, no assessment will be made, and the business may continue to treat its workers as independent contractors. Furthermore, a business that wishes to treat its workers as employees may enter an agreement to begin treating its workers as employees currently or at the beginning of the next year. If it does so, the business will not give up its claim to Section 530 relief for prior years.

13. TAX COURT JURISDICTION

13.10 The Taxpayer Relief Act of 1997 allows the taxpayer, upon filing an appropriate pleading, to obtain Tax Court review of an "actual controversy" involving an IRS redetermination as part of an examination, that: (1) one or more individuals performing services for the taxpayer are employees for employment tax purposes [IRC § 7436(a)(1)], or (2) the taxpayer is not entitled to relief under Section 530(a) with respect to such an individual. The Code Section does not define actual controversy but the term is used in the federal court system to mean a real dispute between adverse parties involving substantial legal interests.

Party in Interest

13.20 A pleading before the Tax Court can only be filed by the person for whom the services are performed. [IRC § 7436(b)(1 )] The taxpayer must file a petition with the Tax Court within 90 days of the time the IRS issues a certified or registered mail notice to the taxpayer of its determination in an employment tax matter. If there is a Tax Court proceeding, the change of employment tax treatment of any individual from that of an intended contractor to that of an employee, the treatment as an employee will not be taken into account by the Tax Court. The assessment and collection of taxes is suspended while the matter is pending before the United States Tax Court.

All Case Procedures

13.30 If the amount of the employment tax dispute is $50,000 or less for each calendar quarter involved, the case may be conducted under the rules of evidence, practice and procedures applicable to small income tax cases. [IRC § 7436(c)(1 )] Decisions entered under the small tax case rules will not be reviewed in any other court and will not be treated as precedent for any other case not involving the same petition and the same determinations. The Tax Court decision, together with a brief summary of the Court's reasons for its decision, will satisfy requirements for reports on Tax Court proceedings, hearings and determinations.

Effect of Tax Court Decision in Larger Cases

13.40 The Tax Court determination of an employment tax matter will have the same force and effect as any other Tax Court decision. It is appealable in the same manner as any other Tax Court proceeding. The Taxpayer Relief Act of 1997 also amended the prohibition against suits to restrain assessment and collection of taxes with respect to employment status cases. [IRC § 7421 (a)] Employment status cases are also eligible for awards of administrative and litigation costs pursuant to IRC § 7430.

Limits of Tax Court Jurisdiction

13.50 The Tax Court had previously held that IRC § 7436, which granted its jurisdiction to make certain employment status determinations, didn't give it jurisdiction to decide the proper amount of employment tax and income tax withholding due as a result of its status determination. The Code was amended in 2000 to read as follows:

“IRC §7436(a)(2) such person is not entitled to the treatment under subsection (a) of section 530 of the Revenue Act of 1978 with respect to such an individual, upon the filing of an appropriate pleading, the Tax Court may determine whether such a determination by the Secretary is correct and the proper amount of employment tax under such determination. Any such redetermination by the Tax Court shall have the force and effect of a decision of the Tax Court and shall be reviewable as such.”

Therefore the Court may determine liability the amounts due as a result of its determination.

14. TRUST FUND RECOVERY PENALTY — IRC § 6672

14.10 The liabilities imposed under IRC § 6672 are known as the Trust Fund Recovery Penalty (formerly 100% Penalty). There are two major tests to determine if someone is subject to provisions of IRC § 6672. The two issues in question may be stated as follows:

(1) Whether the party against whom the penalty is proposed had the duty to account for, collect and pay over trust fund taxes; and

(2) Whether he or she wilfully failed to perform this duty.

Personal Liability of Officers

14.20 In the context of employment tax examinations, IRC § 6672 poses a danger to officers of a company which is forced to cease operations as a result of a large employment tax deficiency. Although the Internal Revenue Service has a policy of not pursuing officers of companies for personal liability in cases where IRC § 3509 rates have been applied, it has pursued officers of companies when the higher assumed rates of liability were imposed. Obviously, once an assessment is made using the higher assumed rates of 20% for withholding and the employee portion of FICA, a person who controlled the corporate taxpayer has significant risk of liability pursuant to IRC § 6672. The controlling officer of the corporation would not have the defense that he was not a responsible person. The sole defense available to the officer would be that his conduct was not willful. The word "willfully," as used in IRC § 6672, does not signify an act done with a fraudulent or evil purpose, but merely knowingly or intentionally disregarding the statutory provision. The Seventh Circuit has defined willfulness as follows:

An act is willful if it is voluntary, conscience and intentional. A responsible person acted willfully if he knowingly used available funds to prefer other creditors over the Internal Revenue Service.

Personal Fault

14.30 The Supreme Court has observed that "the fact that the provision imposes penalty and is violated only by willful failure is itself strong evidence that it was not intended to impose liability without personal fault."

Lack of Knowledge

14.40 In the case of an Employment Tax Examination, an officer certainly might raise the defense that he was unaware of the liability and therefore, should not be found to have been willful. Unfortunately for the taxpayer utilizing that defense, in order to use the higher rates, other than IRC § 3509 rates, there must be a finding that the taxpayer intentionally disregarded the rules for employment taxes. Obviously, that standard would relate directly to the willfulness standard of IRC § 6672. If the original tax deficiency was never litigated, then the taxpayer retains the right to defend that the corporate entity did not intentionally disregard tax rules and therefore, the potentially responsible person was not willful.

15. SUMMARY OF EMPLOYMENT TAX AUDITS

15.10 The stepped up employment tax examination process by the Internal Revenue Service has placed many types of businesses at risk of economic destruction by an IRS audit. Many industries rely upon independent contractors as their primary service providers, and a large employment tax deficiency would destroy an individual business. Many industries, such as the messenger industry, trucking companies, and some construction businesses face economic destruction as a result of employment tax audits. Because the area of law is complex, the practitioner must defend each individual examination on a case by case basis. The IRS has failed to liberally apply IRC § 530 as anticipated by Congress. In most instances, the original audit will result in a finding against the taxpayer. Although the CSP program has allowed the settlement of some employment tax exams at the field level, Appeals is still offering better deals than the field in most cases. If you think the IRS is wrong, appeal.

Form 8919

The Internal Revenue Service has developed a new form for employees who have been misclassified as independent contractors by an employer. Form 8919, Uncollected Social Security and Medicare Tax on Wages, will now be used to figure and report the employee’s share of uncollected social security and Medicare taxes due on their compensation.

Generally, a worker who receives a Form 1099 for services provided as an independent contractor must report the income on Schedule C and pay self-employment tax on the net profit, using Schedule SE. However, sometimes the worker is incorrectly treated as an independent contractor when they are actually an employee. When this happens, Form 8919 will be used beginning for tax year 2007 by workers who performed services for an employer but the employer did not withhold the worker’s share of social security and Medicare taxes.

In addition, the worker must meet one of several criteria indicating they were an employee while performing the services. The criteria include:

The worker has filed Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and received a determination letter from the IRS stating they are an employee of the firm.

The worker has been designated as a section 530 employee by their employer or by the IRS prior to January 1, 1997.

The worker has received other correspondence from the IRS that states they are an employee.

The worker was previously treated as an employee by the firm and they are performing services in a similar capacity and under similar direction and control.

The worker’s co-workers are performing similar services under similar direction and control and are treated as employees.

The worker’s co-workers are performing similar services under similar direction and control and filed Form SS-8 for the firm and received a determination that they were employees.

The worker has filed Form SS-8 with the IRS and has not yet received a reply.

By using Form 8919, the worker’s social security and Medicare taxes will be credited to their social security record. To facilitate this process, the IRS will electronically share Form 8919 data with the Social Security Administration.

In the past, misclassified workers often used Form 4137 to report their share of social security and Medicare taxes. Misclassified workers should no longer use this form. Instead, Form 4137 should now only be used by tipped employees to report social security and Medicare taxes on allocated tips and tips not reported to their employers.

IRS may prepare substitute returns in worker classification cases

Chief Counsel Advice 200822026

A Chief Counsel Advice (CCA) has concluded that, in employment tax cases where worker classification issues are present, revenue officers have authority under Code Sec. 6020(b) to prepare employment tax returns, but the requirements of Code Sec. 7436 must be met before assessment.

Background. Where there is an actual controversy involving a determination by IRS that one or more individuals performing services for the taxpayer are employees as part of an examination, Code Sec. 7436 gives the Tax Court jurisdiction to determine certain “worker classification issues” (i.e., the proper amount of the additions to tax, additional amounts, and penalties that relate to the employment tax with respect to determinations of worker classification and whether the taxpayer is entitled to relief under § 530 of the Revenue Act of 1978). To meet Code Sec. 7436 's requirements, certain procedures must be followed before assessment of employment taxes. They are spelled out in Notice 2002-5, 2002-1 CB 320. For example, Notice 2002-5 provides generally that a taxpayer will first receive a “30-day” letter listing the proposed employment tax adjustments to be made and describing the taxpayer's right either to agree to the proposed adjustments or to protest the proposed adjustments to the IRS's Appeals function (Appeals) within 30 days of the date of the letter.

If the taxpayer does not respond to the “30-day” letter by agreeing to the proposed adjustments or by filing a protest to Appeals, the taxpayer will receive a Notice of Determination of Worker Classification (NDWC). The taxpayer may also receive the NDWC if the taxpayer files a protest with Appeals and the worker classification issues are not settled in Appeals. As indicated in Notice 2002-5, under Code Sec. 7436(d)(1), the mailing of the NDWC suspends the period of limitations for assessment of taxes attributable to the worker classification issues for the 90-day period during which the taxpayer can bring suit and precludes IRS from assessing the taxes identified in the NDWC before the expiration of the 90-day period during which the taxpayer may file a timely Tax Court petition.

If IRS erroneously makes an assessment of taxes attributable to the worker classification issues without first either issuing a NDWC or obtaining a waiver of restrictions on assessment from the taxpayer, the taxpayer is entitled to an automatic abatement of the assessment. However, under Notice 2002-5, once any procedural defects are corrected, IRS may reassess the employment taxes to the same extent as if the abated assessment had not occurred.

The amount of any tax imposed by the Code is to be assessed within 3 years after the return was filed, subject to certain specified exceptions. (Code Sec. 6501(a))

Under Code Sec. 6020(b), if a taxpayer fails to file a return when required, IRS may prepare a return based on its own knowledge and on information it obtains through testimony or other means. The failure-to-pay penalty under Code Sec. 6651(a)(2) applies to the amount of tax shown on the return, including, under Code Sec. 6651(g)(2) , any amount shown on a substitute return prepared by IRS. Absent the existence of a return under Code Sec. 6020(b), the Code Sec. 6651(a)(2) penalty doesn't apply to a nonfiler. [For discussion of recently issued regs on substitute returns, see Federal Taxes Weekly Alert 02/14/2008]

Facts. The Chief Counsel was asked to review a memorandum which addressed the issue of whether a revenue officer has authority under Code Sec. 6020(b) to prepare employment tax returns on behalf of taxpayers who fail to file such returns in a case in which worker classification issues are present and where the revenue officer did not refer the case to the Employment Tax Program as required under the Internal Revenue Manual (IRM).

For the years at issue, the taxpayer took the position that certain workers were independent contractors for federal tax purposes. However, for prior years, the taxpayer had treated the workers as employees. After reviewing the facts of the case, the revenue officer determined that the workers should have been treated as employees and prepared Substitute for Returns (SFRs) under Code Sec. 6020(b).

The taxpayer objected to the preparation of the SFRs and requested an appeal. The appeals officer concluded that the worker classification issue was undeveloped and that “the revenue officer did not have the authority to prepare Forms 941 under Code Sec. 6020(b) procedures because the IRM requires the issue to be referred to the Employment Tax Program,” and recommended the government concede the case.

Analysis. The CCA observed that the taxpayer failed to file an employment tax return and did not submit evidence to establish that no employment tax return was due. The revenue officer determined that some of the taxpayer's workers were employees and that an employment tax return should have been filed. The revenue officer prepared returns under Code Sec. 6020(b).

The CCA said that, because the revenue officer failed to meet Code Sec. 7436 's requirements, an assessment of employment taxes based on the Code Sec. 6020(b) return prepared by him is improper. However, the CCA said that the facts do not indicate that the government is required to concede the case. The CCA said that, under Notice 2002-5 , once the procedural defects are corrected and Code Sec. 7436 's requirements are met, employment taxes may be assessed.

Overassessment (Excise or Employment Tax), and Form 2504-WC, Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment in Worker Classification Cases (Employment Tax)) constitute adjusted returns. (Reg. § 31.6205-1)

Interest-free adjustments. The final Code Sec. 6205 regs set out the procedures for making interest-free adjustments for underpayments of employment taxes. If a return is filed and less than the correct amount of employee or employer FICA or RRTA tax is reported, and the employer discovers the error after filing the return, the employer adjusts the resulting underpayment of tax by reporting the additional amount due on an adjusted return for the return period in which the wages or compensation was paid. The adjustment must be made by the due date of the return for the return period in which the error is ascertained, and the amount of the underpayment must be paid by the time the adjustment is made, or interest will begin to accrue from that date. An underpayment adjustment can only be made within the period of limitations for assessment. For underpayments of ITW where the incorrect amount was withheld, subject to limited exceptions, an adjustment can only be made for errors ascertained during the calendar year in which the wages were paid. (Reg. § 31.6205-1(b)(2))

The final regs also provide for interest-free adjustments of underpayments of FICA tax, RRTA tax, and ITW under certain circumstances where the underpayment arises because the employer failed to file an original return or failed to report and pay the correct type of tax. (Reg. § 31.6205-1(b)(3), Reg. § 31.6205-1(c)(3))

The final Code Sec. 6413(a) regs set out the procedures for making interest-free adjustments for overpayments of employment taxes. If an employer ascertains an overpayment error within the applicable period of limitations on credit or refund, it's required to repay or reimburse its employees the amount of overcollected employee FICA or RRTA tax before the expiration of that period. However, the requirement to repay or reimburse doesn't apply to the extent that taxes weren't withheld from the employee or if, after reasonable efforts, the employer cannot locate the employee. In such a case, the employer can make an adjustment for only the employer share of FICA or RRTA tax. An interest-free adjustment for an overpayment cannot be made once a claim for refund has been filed. (Reg. § 31.6413(a)-1)

Once an employer repays or reimburses an employee to the extent required, the employer may report both the employee and employer portions of FICA or RRTA tax as an overpayment on an adjusted return. The employer must certify on the adjusted return that it has repaid or reimbursed its employees to the extent required.

Under the final regs, the reporting of the overpayment constitutes an interest-free adjustment if the overpayment is reported on an adjusted return filed before the 90th day prior to expiration of the period of limitations on credit or refund. Similar rules apply for making interest-free adjustments for ITW overpayments, except that an interest-free adjustment can only be made if the employer ascertains the error and repays or reimburses its employees within the same calendar year that the wages were paid and reports the adjustment on an adjusted return. (Reg. § 31.6413(a)-2)

No repayment or reimbursement for interest-free adjustments of overpayments. Unlike in the proposed reg, in the final regs the employer isn't required to repay or reimburse the employee or to adjust the overpayment by the due date of the return for the return period following the return period in which the error is ascertained. (Reg. § 31.6402-2(a)(1)) After reconsideration, IRS determined there was insufficient reason to impose a timing restriction other than the period of limitations on credit or refund of taxes. (T.D. 9405, 06/30/2008)

Deposits, payments, and credits. An employer making an interest-free adjustment must pay the amount of the adjustment by the time it files an adjusted return. The timely payment satisfies the employer's deposit obligations for the adjustment. (Reg. § 31.6302-1(c)(7)) In determining the amount of accumulated taxes in an agricultural employer's lookback period (which determines the employer's deposit schedule), adjustments to tax liability made under the filing of adjusted returns or refund claims aren't taken into account; new agricultural employers are treated as having employment tax liabilities of zero for any lookback period before the date the employer started or acquired its business. (Reg. § 31.6302-1(g)(4))

If the underpayment amount isn't paid when the adjusted return is filed, interest begins to accrue as of the date the adjusted return is filed. (Reg. § 31.6205-1(b)(2))

The adjusted overpayment amount will be applied as a credit toward payment of the employer's liability for the calendar quarter (or calendar year for annual returns being adjusted) in which the adjusted return is filed, unless IRS notifies the employer that the credit will be applied to a different return period or that the employer isn't entitled to the adjustment under applicable laws or procedures. (Reg. § 31.6413(a)-2(b)(2))

Refunds for overpayments. As in the prior regs, instead of making an interest-free adjustment for an overpayment, employers can file a claim for refund for the amount of the overpayment. Furthermore, if an employer can't make an interest-free adjustment for an overpayment because the period of limitations for claiming a credit or refund for the overpayment will expire within 90 days or because IRS has otherwise notified the employer that it's not entitled to the adjustment, the employer can recover the overpayment only by filing a claim for refund. (Reg. § 31.6413(a)-2(d))

An employer can file a claim for refund of an overpayment of FICA or RRTA tax, but must certify that it has repaid or reimbursed the employee's share of FICA or RRTA tax to the employee or has secured the employee's written consent to allowance of the refund or credit. However, the employer isn't required to repay or reimburse the employee or obtain the written consent of the employee to the extent that the overpayment doesn't include taxes withheld from the employee or, after reasonable efforts, the employer cannot locate the employee or the employee, once contacted, will not provide the requested consent. (Reg. § 31.6402(a)-2(a)) The final regs under Code Sec. 6414 set out similar procedures for filing a claim for refund of overpaid ITW, except that an employer can't file a claim for refund of an overpayment of ITW for an amount the employer deducted or withheld from an employee. (Reg. § 31.6414-1(a))

IRS intends to issue guidance to provide examples of how the final regs apply in different factual scenarios. (T.D. 9405, 06/30/2008)

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