“Employee Misclassification in the Spotlight as a Way to Reduce the Tax Gap” by Frank C. Carnahan
Missouri Tax Collection
If the employer and worker both know all the facts, there is typically little money to be saved in misclassifying a worker. An independent contractor will usually demand more compensation than an employee because they bear the burden of the employer’s share of social security and a business risk. The employer also risks a large employment tax and fringe benefit liability if it incorrectly classifies the worker. Classification also impacts the requirement to provide worker’s compensation insurance and the companion limit on an employer’s liability for work worker injuries it provides. The Missouri Division of Employment Security seems to focus on who can best afford the risk of unemployment, and generally finds the employer better able to bear that risk. It is more likely than the IRS or Department of Revenue to find a worker is an employee, and consequently that unemployment contributions are owed.
The Government Accountability Office (GAO) and Congressional Research Service (CRS) have released reports and recommendations on employer misclassification of workers as independent contractors. A recently introduced bill would revamp so-called “Section 530” relief, and starting in February 2010, the IRS is conducting annual employment tax audits of 2,000 selected U.S. companies. The CRS reported that the last IRS estimate in 1984 was that 15% of employers misclassified 3.4 million workers as independent contractors rather than as employees causing an estimated total loss of $1.6 billion in taxes. The IRS audits will include the first such IRS study conducted since 1984. The audits are intended to help reduce the size of the tax gap, i.e., the difference between the tax the IRS estimates is due and the amount actually paid by taxpayers.
The GAO report included 19 specific recommendations for reducing employee misclassification, including:
- narrowing the definition of “a long-standing recognized practice of a significant segment of the industry” so fewer firms qualify for penalty relief under the §530 of the Revenue Act of ‘78 reasonable basis standard;
- require service recipients to withhold taxes for independent contractors if the IRS cannot verify their TIN, or it has determined they are not fully tax compliant;
- require universal tax withholding for payments made to independent contractors using relatively low tax rates (e.g., 1% to 5% of payment amounts);
- require each independent contractor to apply for a separate business tax number;
- require service recipients to withhold taxes from payments made to independent contractors who request withholding in writing;
- require service recipients to submit Forms SS-8 for all newly retained independent contractors
Rep. James McDermott (D-WA) has again introduced legislation (H.R. 3408, 7/30/09) called the “Taxpayer Responsibility, Accountability, and Consistency Act of 2009”, primarily focusing on §530 of the Revenue Act of 1978. The legislation would make it more difficult for employers to receive protection under §530, and increase information reporting penalties. Section 530 protects employers from employment tax assessments even though they incorrectly categorized a worker as an independent contractor if they have: 1) a reasonable basis (judicial precedent, IRS rulings, a past IRS audit, or industry practice supports the classification), 2) have consistently treated the workers in question as independent contractors, and 3) have not classified the workers as employees on any required federal tax returns, including information returns.
The new legislation would repeal §530 and replace it with new rules that would only apply prospectively to services rendered more than one year after the date the legislation is enacted. It provides the “reasonable basis” standard would be met only if:
- The employer classified the worker as an independent contractor based on a: 1) written determination that addresses the employment status of either the worker in question, or another individual holding a substantially similar position with the employer; or 2) concluded employment tax examination of the worker, or another individual holding a substantially simila position with the employer, that did not conclude that the worker should be treated as an employee; and
- The employer (or a predecessor) has not treated any other individual holding a substantially similar position as an employee for employment tax purposes for any period beginning after Dec. 31, 1977.
Employers would not be able to rely on an examination commenced, or a written determination issued, if: (a) the controlling facts and circumstances that formed the basis of a determination of employment status have changed or were misrepresented by the taxpayer, or (b) IRS subsequently issues contrary guidance related to the determination of employment status that has a bearing on the facts and circumstances that formed the basis of the determination of employment status. The IRS would issue its determination of worker status no later than 90 days after the filing of a petition with respect to employment status in any industry where employment is transient, casual, or seasonal (e.g., construction).
The IRS audits are expected to focus on five employment tax issues: 1) worker classification (employee vs. independent contractor); 2) fringe benefits; 3) officer’s compensation; 4) reimbursed expenses; and 5) non-filers.
The IRS primarily enforces worker classification compliance through employer examinations, but offers settlements through which eligible employers under examination can reduce taxes they might owe if they maintain proper classification of their workers in the future.
The IRS has long used the “20 factors” set out in Rev. Rul. 87-41, centering largely on “control,” including how paid (by the job or hourly), if there is a continuing relationship, who furnishes tools, etc. (see: http://carnahanlaw.com/payroll/20factors.html). In approximately 1996 the IRS regrouped the factors into three broad categories (see http://carnahanlaw.com/payroll/20factor update.html):
- Behavioral Control – focusing on whether there is a right to direct or control how the work is done;
- Financial Control – focusing on whether there is a right to direct or control how the business aspects of the worker’s activities are conducted, and if there is significant investment and risk of loss; and
- Relationship of the Parties – focusing on how the parties perceive their relationship and their intent.
The ruling stated that the factors did not weigh equally and were weighted differently in different cases, leaving lots of uncertainty. The updated three categories still leave room to argue about the correct classification.