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Worker Misclassification: How to Beat the IRS

© Iqoncept | - <a href="">Freelance Indpendent Contractor Website Developer Word Collage Photo</a>

One of the hottest issues with the IRS continues to be worker classification. Businesses may treat workers as independent contractors while the IRS may argue they are employees.

If the IRS is successful in its position, companies must reclassify workers; reclassification means paying back employment taxes, plus interest and penalties.

In many cases, it also means giving the reclassified workers employee benefits they were entitled to (e.g., medical coverage, retirement plan contributions).

In other words, the consequences for being wrong are severe. However, there is some relief.

Section 530 relief

A provision in the Revenue Act of 1978 (“Section 530”) created a safe harbor for a company when the IRS asserts it misclassified workers. The safe harbor allows the company to avoid liability for back employment taxes if there was a reasonable basis for not treating the workers as employees. Reasonable basis can be any of the following:

  1. A case, published IRS ruling, or private ruling for the company
  2. A past IRS audit in which the company’s treatment of workers as independent contractors was determined to be correct
  3. A long-standing industry practice of a significant segment of the industry in which the company was engaged
  4. Any other reasonable basis

The company must also show that it filed all required returns consistent with this treatment (i.e., issued Forms 1099-MISC) and did not treat other workers doing substantially the same work as employees.

Note: From time-to-time there have been Congressional proposals to repeal Section 530, but none have come to pass.

Relief in action

A recent case illustrates what you need to do to obtain this relief. The case involved a small business in Pennsylvania that classified its non-medical homecare service providers as independent contractors. The IRS said they should have been treated as employees. Initially, the company paid back employment taxes. Then it filed in district court for a tax refund. The court sided with the company.

When it comes to worker classification, the facts matter. Here, the company owner had been working as an independent contractor in the capacity of a home companion and then decided to start her own business. She said her company operated like a matchmaker, helping elderly clients find companions from its registry. The company didn’t supervise the workers, who received no training from the company. The company did, however, obtain worker compensation insurance for these workers, which is something that companies do for employees. The company knew that other similar businesses in the area were treating their companions as independent contractors and, from time-to-time, surveyed homecare companies on their classification practices.

The court said that she had a “reasonable basis” (option #4) for the classification so the safe harbor relief applied and she was entitled to a refund of the employment taxes. Factors that helped her show “reasonable basis”:

  • Before forming the company the owner had been a home health aide who was treated as an independent contractor. She knew many other aides who were similarly treated.
  • She reached out to three other similar companies and learned that two of them treated their workers as independent contractors.
  • She also reviewed worker classification with her attorney and directed him to draft independent contractor agreements for her workers to sign.
  • She attended a mandatory conference conducted by the Pennsylvania Department of Health where attendees were informed that the regulatory definition of a “home care registry” was a business that “supplies, arranges or refers independent contractors to provide home care services.”

Voluntary Classification Settlement Program (VCSP)

If you’re treating workers as independent contractors but are unsure of whether you’re right, you can muster the facts to present a Section 530 claim for relief if the IRS challenges you. Alternatively, the IRS lets you voluntarily reclassify workers through its Voluntary Classification Settlement Program (VCSP). If you opt to use it (before you’re under an employment tax audit), you limit the amount of back employment taxes and penalties. However, unlike Section 530 relief, you can’t avoid them entirely. So the program may help you sleep better at night, but it will cost you.

Bottom line

Review your worker classification. Understand the IRS’ position and what you can do now to ensure that your treatment of independent contractors will be respected. Keep in mind that the U.S. Department of Labor, the NLRB, and your state labor department may still challenge you on the same classification, and how you come out with the IRS may not determine your results with these other departments and agencies.