Deficits are high, and taxes need to be higher to pay the high costs of government. But raising taxes is politically difficult. So, where can the IRS look to increase revenues? The “tax gap”.
The Tax Gap Misclassification Solution
On February 4, 2009, “TIGTA” (Treasury Inspector General for Tax Administration) issued a report and recommendation noting, among other things, that the IRS has not done a comprehensive study of work misclassification since 1984. In that year, the IRS had estimated that misclassified employees accounted for understatement of FICA, federal withholding, and unemployment taxes of approximately $1.6 billion. According to the TIGTA report, that underpayment is now estimated to be around $2.72 billion. This is one of the reasons that the TIGTA report recommended that the IRS should conduct a study (meaning audits):
Recommendation 2: The Deputy commissioner for Services and Enforcement should consider conducting a formal National Research Program reporting compliance study for employment taxes that includes measuring the impact of worker misclassification on the tax gap.
This is why the IRS is conducting audits; the Service is studying worker classification in an effort to find misclassified workers and recover funds otherwise lost to the Tax Gap. Under this research effort, which will go through 2012, the IRS has begun to audit 6,000 employers at a rate of 2,000 per year.
The primary focus of the audits will be to determine whether workers are correctly classified as employees or independent contractors. Of course, other issues can arise during such an audit, such as whether employees deemed exempt from wage and hour laws should be considered non-exempt. If an employee has been underpaid because of incorrect treatment as exempt rather than non-exempt, then that employee’s taxes have been underpaid too.
Contractor or Employee?
There can be serious consequences if an employer misclassifies a worker who is really an employee as an independent contractor. Of course, identifying misclassified employees is a primary thrust of the ongoing audits. If an employer classifies an employee as an independent contractor and has no reasonable basis for doing so, the employer may be held liable for employment taxes for that worker. If there is no reasonable basis, the employer loses the benefit of the relief provisions in Section 530 of the Internal Revenue Code.
Review of Section 530 Relief Requirements
If you meet the Section 530 Relief Requirements, you will not owe employment taxes for misclassified workers. You must meet all three requirements.
- Reasonable Basis-You reasonably relied on a court case about Federal taxes or a ruling issued to you by the IRS;
-Your business was audited by the IRS at a time when you treated similar workers as independent contractors and the IRS did not reclassify those workers as employees. (You may not rely on a audit commenced after December 31, 1996, unless the audit included an examination for employment tax purposes of whether the individual involved should be treated as an employee)
-You treated the workers as independent contractors because you knew that was how a significant segment of your industry treated similar workers; or
-You relied on some other reasonable basis (advice of attorney or accountant who understood the facts about your business)
- Substantive ConsistencyIn addition to the above, you must have treated the workers and any similar workers as independent contractors in the past. If you treated similar workers as employees, then Section 530 relief is not available.
- Reporting ConsistencyIn addition to the above, you must have filed all required federal tax returns, including information returns, consistent with your treatment of each worker as not being an employee. So, for example, if you treated a worker as an independent contractor and paid her $600 or more, you must have filed Form 1099-MISC for her. For any year you failed to file the required information returns, no relief is available under Section 530.
(Part 1 of 2. Part 2 will be posted on 9/15)
Michael L. Schultz is a partner at the Indianapolis office of Parr Richey Frandsen Patterson Kruse LLP. He concentrates his practice on civil litigation and routinely handles a wide variety of employment related disputes, representing employees and employers, as well as commercial and residential property damage cases where property owners seek recovery from insurers and third parties. He also has litigated extensively in the areas of civil rights, personal injury, toxic torts, unincorporated associations, contract disputes, and workers compensation.
The statements contained herein are for information purposes only and are not to be considered legal advice and should not be construed to form an attorney-client relationship. If you have questions regarding this article, please contact an attorney.