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ROBERT E. MCKENZIE, ESQ.
ARNSTEIN & LEHR LLP
120 SOUTH RIVERSIDE PLAZA, SUITE 1200
CHICAGO, IL 60606
312-876-6927
312-876-7318 fax

During the 1970's, the Internal Revenue Service also stepped up its efforts in Employment Tax Audits. As a result of 11-1 INTRODUCTION

11-1.10 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 issued 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). [See also Independent Contractors: Tax and Business Planning]

11-1.20 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 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 recently announced a new classification settlement program which is discussed later in this Chapter. Section 530 was also amended by the Small Business Jobs Protection Act which is also discussed later in this Chapter.

11-1.30 The financial impact of IRS reclassification of independent contractors can be disastrous. The stakes are very high, in excess of 35% 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.

11-1.40 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 20% or 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. [See Apps 11-F to 11-K]

11-2.10 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)]

11-2.20 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.

11-2.30 The Code 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.

11-3.10 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.

11-3.20 The following 20 common-law factors are used by the IRS. These factors are the basis of Form SS-8, [See App 11-A] 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.

11-4.10 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.

11-4.20 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. [App 11-L]

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]

11-4.30 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.

11-5.10 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:

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 of this work]

11-5.20 Section 530 [see App 11-B] 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.

11-5.30 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).

11-5.35 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.

11-5.40 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.

11-5.50 The IRS has published guidelines in Revenue Procedure 85-18 for purposes of interpreting "treat." In general the word "treat" includes the following:

11-5.60 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 4137, Social Security and Medicare Tax on Unreported Tip Income, 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.

11-5.70 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.

11-6.10 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.

11-6.15 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.

11-6.20 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.

11-6.30 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.

11-6.40 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.

11-7.10 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.

11-6.10 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.

11-9.10 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:

If no 1099's were filed with respect to the workers, then the liability would be:

11-9.20 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]

11-10.10 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]

11-11.10 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 [see App 11-C] is designed for this purpose. Forms 4669 are transmitted to the IRS with Form 4670, [See App 11-D] IRC § 3402(d) relief is unavailable if the special tax rates of IRC § 3509 apply.

11-11.20 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.

11-11.30 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.

11-12.10 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.

11-12.15 As part of its new classification settlement program, the IRS has issued new 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)]

11-12.20 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.

11-12.30 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 ]

11-12.40 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.

11-13.10 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.

11-13.20 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.

11-13.30 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.

11-13.40 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.

11-13.50 The Tax Court has held that IRC § 7436, which gives its jurisdiction to make certain employment status determinations, doesn'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 Taxpayer Relief Act of 1997 enacted IRC § 7436, which gives a taxpayer the right to petition the Tax Court to review a controversy with IRS over whether individuals performing services for the taxpayer are or are not employees, and whether the taxpayer is entitled to relief under Section 530(a) of the Revenue Act of 1978. The provision was effective on August 5, 1997. Small case procedures can apply if the amount in controversy is $10,000 or less for each calendar quarter involved ($50,000 or less for proceedings begun after July 22, 1998). Following an employment tax audit, IRS mailed Henry Randolph Consulting, a sole proprietorship, a Notice of Determination Concerning Worker Classification Under Section 7436, stating that certain of Randolph's workers should have been classified as employees and that the company was not entitled to Section 530 relief. Observation: The Tax Court will not review an employment status controversy until IRS has issued a worker classification determination notice. The IRS attached to the determination notice an Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment (Form 2504) proposing that the taxpayer consent to immediate assessment and collection of over $53,000 in FICA, FUTA, and income tax withholding for periods in 1994 and 1995, along with detailed calculations of the amounts of proposed assessment. The taxpayer petitioned the Tax Court contending that its service providers were not employees, that it was entitled to Section 530 relief, and that IRS's tax computations were incorrect. IRS disputed the Tax Court's jurisdiction to determine the amounts of tax due in the event that the Tax Court sustained its position that the workers were employees. As a court of limited jurisdiction, the Tax Court may only exercise jurisdiction that is expressly permitted or provided by statute. The Tax Court said that IRC § 7436(a) expressly grants it jurisdiction to decide whether service providers are employees or independent contractors for employment tax and income tax withholding purposes, and whether Section 530 of the Revenue Act of 1978 applies. However, the court pointed out that IRC § 7436(a) does not expressly give it jurisdiction to decide any other matter, such as the amount of the taxpayer's employment tax liability that results from IRS's worker classification determination. It said that this contrasts with the Tax Court's deficiency jurisdiction, which permits it to redetermine the "amount" in controversy. The court said that IRC § 7436(a) more closely parallels its authority to make declaratory judgments under various Code sections, which do not state that the court may decide the amount of tax due. The taxpayer put forth a variety of arguments in its favor based on statutory construction and legislative history, all of which were rejected by the Tax Court. Observation: Thus, a taxpayer that does not totally prevail in the Tax Court on an employment tax issue under IRC § 7436 may have to pay tax and sue for a refund in a district court or the Court of Federal Claims if it is unable to agree with IRS about the amounts owed.

11-14.10 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

[See Chapter 5 of Representation Before the Collection Division of the IRS and Chapter 7 of Tax Penalties and Interest]

11-14.20 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 "wilfully," 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 wilfulness as follows:

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

11-14.30 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."

11-14.40 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. [See App 11-E]

11-15.10 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.