Relief Under Section 530 of The Revenue Act of 1978: At Least There Is Some Relief For The Innocent , Unsuspecting Corporate or Other Business Entity.
By: Andrew C. Moler, Esq., M.S., J.D., LL.M. (Taxation)
Copyright © 2010 by Andrew C. Moler, Esq. All rights Reserved. ©
Notwithstanding the fact that there is a whole spectrum of business relationships between workers and services providers such as “employers" and industries that enlist the services of others to provide services, the Internal Revenue Code classifies all of such relationships into two main categories. The withholding of income tax and employment taxes now depends on whether the worker is classified as an employee or independent contractor. The proper classification of worker is very important to the business entity because it determines the obligation of the business with regard to the withholding of income tax and employment taxes. In the event the business fails to properly classify the worker, the business will fail to withhold the proper income taxes from the worker’s pay, not match the required employment taxes as required and the IRS may never receive the taxes due from the worker resulting from the possibility of non-reporting by the worker. The latter creates great concern with the IRS due to the fact that historically independent contractors understate income, overstate deductions and oftentimes fail to report income at all.
From the perspective of the employing entity, it is desirable to classify the worker as an independent contractor and not an employee. As such, the employer does not have to worry about withholding income taxes, employment taxes, matching employment taxes, reporting and payment to the IRS of said taxes and paying overtime at an increased rate pursuant to the Federal wage and hour law. From the IRS’ standpoint, no worker should be an independent contractor because the IRS actually collects more taxes when the employer must collect the taxes and be responsible for the collection and remittance of the taxes to the IRS.
The problem with classification is a concern to business advisors as well. Whenever a new worker is hired the advisor must attempt to determine the status of the worker using vague principles as set forth by common law and adopted by the Internal Revenue Service.
Actually, there are four classifications of workers as set forth by the Internal Revenue Code, the IRS Regulations and other IRS publications. The four classifications are independent contractor, common-law employee, statutory employee and statutory non-employee. Obviously, the most forthcoming classifications are statutory employees and statutory non-employees (statutory independent contractors). The problems exist with classification of common-law employees and independent contractors. A full discussion of statutory employees and statutory non-employees is beyond the scope of this paper. For the remainder of this article emphasis will be on common-law employees versus independent contractors and the application of section 530 relief.
Once it is determined that a worker has been misclassified as an independent contractor instead of an employee, the balance of the analysis is to determine if the safe harbor provisions of section 530 apply to the employing entity. Once it is determined that 530 relief is appropriate then the employer may continue to classify the worker as an independent contractor for purposes of employment taxes. Note that this does not mean that the worker is in fact an independent contractor but only that the employer may continue to classify the worker as an independent contractor with regard to employee taxes.
The Relief Offered by Section 530
First of all, it should be noted that section 530 of the Internal Revenue Code of 1978 is not codified, but appears as a note to 26 U.S.C.A. § 3401 (2002). Consequently, if one reviews the present Internal Revenue Code in an attempt to locate the safe harbor provisions of section 530 with regard to worker classification they will be unsuccessful.
Pursuant to the Internal Revenue Code, “employers must withhold federal income tax as well as social security tax from the wages they pay to employees. In addition, employers must pay social security and unemployment taxes on behalf of their employees." Since the foregoing does not apply to independent contractors no withholding is done with regard to independent contractors. Instead, the employer of an independent contractor only has to provide the IRS and the worker an “informational" Form 1099 that states the amount of compensation paid during the taxable period.
Section 530 of the Revenue Act of 1997 is a safe harbor for an employer who owes FICA and FUTA taxes resulting from the improper classification of employee as independent contractor. Thus, if a worker employee is misclassified as an independent contractor under the common-law analysis, the employer will nonetheless escape employment tax liability if the conditions of section 530 are met. Section 530 shields a taxpayer who pays workers for services from employment tax liability if the employer has consistently treated the worker as “other-than-employees" unless the employer had no reasonable basis for doing so. Section 530 should be interpreted liberally in favor of the employer.
Section 530 has three essential requirements. One, the employer must have filed the requisite federal tax returns, including all informational returns such as 1099s, on a basis consistent with the employer’s treatment of the worker in question as an independent contractor (the reporting consistency requirement); two, the employer must have treated all workers holding substantially similar positions as independent contractors (the substantive consistency requirement); and three, the employer must have had a reasonable basis for treating the worker as an independent contractor (the reasonable basis requirement). With regard to the reasonable basis test, relief is granted provided any of the following three safe haven standards are satisfied. The standards proved a reasonable basis for treating a worker as an independent contractor even though misclassified. The three alternative standards will provide relief.
With regard to the reasonable basis test, the first standard is met if the employer’s classification of the worker as an independent contractor is due to a reasonable reliance on judicial precedent, published rulings, technical advice with respect to the employer of a private letter ruling issued to the employer by the IRS. Neither the judicial precedent nor the published ruling has to directly relate to the industry engaged by the employer. The second standard is met by a reasonable reliance upon a past service audit of the employer. The previous audit of the employer does not have to be an audit for employment tax purposes. The third standard is met by a showing that the classification of the worker as an independent contractor is consistent with a longstanding practice of the industry in which the worker is engaged. In addition, it should be noted that section 530 relief has been granted where the employer relied on legal advice in classifying the worker as an independent contractor.
There lies an enormous burden on employers with regard to classification of workers as either employees or independent contractors. The wrong determination can be financially devastating to the business enterprise. An improper classification may be subject to the safe harbor provisions of section 530 of the Revenue Act of 1978 but there are thresholds that must be met to take advantage of the protection. There is no set definition of the term “independent contractor" and the issue as to whether a worker is an employee or independent contractor depends on the particular law in an area and the type of business involved. The factors used by the IRS and the courts to determine classification are very subjective and can provide an inconsistent result with different employers with different IRS agents. Notwithstanding the downside, without the safe harbor provisions of section 530 an employer would be in a much more precarious position than they are presently. At least there is some relief for the innocent, unsuspecting corporate or other business entity under section 530 if all pre-conditions are met.