February 21, 2012

Classifying Workers: Independent Contractors Or Employees?

The Government Proposes To Increase Certainty With Respect To Worker Classification

Current Law

For both tax and nontax purposes, workers must be classified into one of two mutually exclusive categories: employees or self-employed (sometimes referred to as independent contractors).

Worker classification generally is based on a common-law test for determining whether an employment relationship exists. The main determinant is whether the service recipient (employer) has the right to control not only the result of the worker’s services but also the means by which the worker accomplishes that result. For classification purposes, it does not matter whether the service recipient exercises that control, only that he or she has the right to exercise it.

Even though it is generally recognized that more highly skilled workers may not require much guidance or direction from the service recipient, the underlying concept of the right to control is the same for them. In addition, only individuals can be employees. In determining worker status, the IRS looks to three categories of evidence that may be relevant in determining whether the requisite control exists under the common-law test:

(i) behavioral control, (ii) financial control, and (iii) the relationship of the parties.

For employees, employers are required to withhold income and Federal Insurance Contribution Act (FICA) taxes and to pay the employer’s share of FICA taxes. Employers are also required to pay Federal Unemployment Tax Act (FUTA) taxes and generally state unemployment compensation taxes. Liability for Federal employment taxes and the obligation to report the wages generally lie with the employer. For workers who are classified as independent contractors, service recipients engaged in a trade or business and that make payments totaling $600 or more in a calendar year to an independent contractor that is not a corporation are required to send an information return to the IRS and to the independent contractor stating the total payments made during the year. The service recipient generally does not need to withhold taxes from the payments reported unless the independent contractor has not provided its taxpayer identification number to the service recipient. Independent contractors pay Self-Employment Contributions Act (SECA) tax on their net earnings from self-employment (which generally is equivalent to both the employer and employee shares of FICA tax). Independent contractors generally are required to pay their income tax, including SECA liabilities, by making quarterly estimated tax payments.

For workers, whether employee or independent contractor status is more beneficial depends on many factors including the extent to which an independent contractor is able to negotiate for gross payments that include the value of nonwage costs that the service provider would have to incur in the case of an employee. In some circumstances, independent contractor status is more beneficial; in other circumstances, employee status is more advantageous.

Under a special provision (section 530 of the Revenue Act of 1978 which was not made part of the Internal Revenue Code), a service recipient may treat a worker as an independent contractor for Federal employment tax purposes even though the worker actually may be an employee under the common law rules if the service recipient has a reasonable basis for treating the worker as an independent contractor and certain other requirements are met. The special provision applies only if (1) the service recipient has not treated the worker (or any worker in a substantially similar position) as an employee for any period beginning after 1977 and (2) the service recipient has filed all Federal tax returns, including all required information returns, on a basis consistent with treating the worker as an independent contractor.

If an employer meets the requirements for the special provision with respect to a class of workers, the IRS is prohibited from reclassifying the workers as employees, even prospectively and even as to newly hired workers in the same class. Since 1996, the IRS has considered the availability of the special provision as the first part of any examination concerning worker classification. If the IRS determines that the special provision applies to a class of workers, it does not determine whether the workers are in fact employees or independent contractors. Thus, the worker classification continues indefinitely even if it is incorrect.

The special provision also prohibits the IRS from issuing generally applicable guidance addressing the proper classification of workers. Current law and procedures also provide for reduced penalties for misclassification where the special provision is not available but where, among other things, the employer agrees to prospective reclassification of the workers as employees.

Reasons for Change

Since 1978, the IRS has not been permitted to issue general guidance addressing worker classification, and in many instances has been precluded from reclassifying workers – even prospectively – who may have been misclassified. Since 1978 there have been many changes in working relationships between service providers and service recipients. As a result, there has been continued and growing uncertainty about the correct classification of some workers.

Many benefits and worker protections are available only for workers who are classified as employees. Incorrect classification as an independent contractor for tax purposes may spill over to other areas and, for example, lead to a worker not receiving benefits for unemployment (unemployment insurance) or on-the-job injuries (workers’ compensation), or not being protected by various on-the-job health and safety requirements.

The incorrect classification of workers also creates opportunities for competitive advantages over service recipients who properly classify their workers. Such misclassification may lower the service recipient’s total cost of labor by avoiding workers’ compensation and unemployment compensation premiums, and could also provide increased opportunities for noncompliance by service providers.

Workers, service recipients, and tax administrators would benefit from reducing uncertainty about worker classification, eliminating potential competitive advantages and incentives to misclassify workers associated with worker misclassification by competitors, and reducing opportunities for noncompliance by workers classified as self-employed, while maintaining the benefits and worker protections associated with an administrative and social policy system that is based on employee status.

Proposal

The proposal would permit the IRS to require prospective reclassification of workers who are currently misclassified and whose reclassification has been prohibited under current law. The reduced penalties for misclassification provided under current law would be retained, except that lower penalties would apply only if the service recipient voluntarily reclassifies its workers before being contacted by the IRS or another enforcement agency and if the service recipient had filed all required information returns (Forms 1099) reporting the payments to the independent contractors. For service recipients with only a small number of employees and a small number of misclassified workers, even reduced penalties would be waived if the service recipient (1) had consistently filed Forms 1099 reporting all payments to all misclassified workers and (2) agreed to prospective reclassification of misclassified workers. It is anticipated that, after enactment, new enforcement activity would focus mainly on obtaining the proper worker classification prospectively, since in many cases the proper classification of workers may not have been clear. (Statutory employee or nonemployee treatment as specified under current law would be retained.)

The Department of the Treasury and the IRS also would be permitted to issue generally applicable guidance on the proper classification of workers under common law standards. This would enable service recipients to properly classify workers with much less concern about future IRS examinations. Treasury and the IRS would be directed to issue guidance interpreting common law in a neutral manner recognizing that many workers are, in fact, not employees.

Further, Treasury and the IRS would develop guidance that would provide safe harbors and/or rebuttable presumptions, both narrowly defined. To make that guidance clearer and more useful for service recipients, it would generally be industry- or job-specific. Priority for the development of guidance would be given to industries and jobs in which application of the common law test has been particularly problematic, where there has been a history of worker misclassification, or where there have been failures to report compensation paid.

Service recipients would be required to give notice to independent contractors, when they first begin performing services for the service recipient, that explains how they will be classified and the consequences thereof, e.g., tax implications, workers’ compensation implications, wage and hour implications.

The IRS would be permitted to disclose to the Department of Labor information about service recipients whose workers are reclassified.

To ease compliance burdens for independent contractors, independent contractors receiving payments totaling $600 or more in a calendar year from a service recipient would be permitted to require the service recipient to withhold for Federal tax purposes a flat rate percentage of their gross payments, with the flat rate percentage being selected by the contractor. The proposal would be effective upon enactment, but prospective reclassification of those covered by the current special provision would not be effective until the first calendar year beginning at least one year after date of enactment. The transition period could be up to two years for independent contractors with existing written contracts establishing their status.

February 15, 2012

New Proposed Federal Budget Impacts IRS

REVISED OFFER IN COMPROMISE APPLICATION RULES

I would like to pay particular attention to the president’s recent budget proposals submitted to Congress that directly impact my clients who have IRS tax problems and disputes.

One proposal that would be effective for offers-in-compromise submitted after the date of enactment of the budget by Congress would eliminate the requirements that an initial offer-in-compromise include a nonrefundable payment of any portion of the taxpayer’s offer.

As explained in other blog articles, the offer-in-compromise program is designed to settle cases in which taxpayers have demonstrated an inability to pay the full amount of a tax liability. The program allows the IRS to collect the portion of a tax liability that the taxpayer has the ability to pay.

Current law provides that the IRS may compromise any civil or criminal tax case before a reference to the Department of Justice for prosecution or defense. In 2006, a new provision was enacted to require taxpayers to make nonrefundable payments with any initial offer-in-compromise of a tax case. In the case of an offer-in-compromise involving periodic payments, the initial offer must be accompanied by a nonrefundable payment of the first installment that would be due if the offer were accepted. When the offer involves one lump sum payment, the new provision requires taxpayers to include a nonrefundable payment of 20 percent of the lump-sum with the initial offer.

The president believes that by requiring nonrefundable payments with an offer-in-compromise, access to the offer-in-compromise program may be significantly reduced. Reducing access to the offer-in-compromise program makes it more difficult and costly to obtain the collectable portion of existing tax liabilities.

EXTEND STATUTE OF LIMITATIONS WHERE STATE ADJUSTMENT AFFECTS FEDERAL TAX LIABILITY

In general, additional tax, interest, penalties and additions to tax must be assessed by the IRS within three years after the date a tax return is filed. If an assessment is not made within those three years, the IRS cannot assess or collect additional liabilities at any future time.

Similarly, the statute of limitations with respect to claims for refund expires at the later of three years from the time the return was filed or two years from the time the tax was paid. There are exceptions to the general statute of limitations.

State and local authorities use a variety of statutes of limitations for State and local tax assessments.

Pursuant to an agreement, the IRS and State and local revenue agencies exchange reports of adjustments made through examination so that corresponding adjustments can be made by each taxing authority. In addition, States provide the IRS with reports of potential discrepancies between State returns and Federal returns.

The problem perceived by the current administration is that the general statute of limitations serves as a barrier to the effective use by the IRS of State and local tax adjustment reports when the reports are provided by the State or local revenue agency to the IRS with little time remaining for assessments to be made at the Federal level.

Under the current statute of limitations framework, taxpayers may seek to extend the State statute of limitations or postpone agreement to State proposed adjustments until such time as the Federal statute of limitations expires in order to preclude assessment at the Federal level. In addition, it is not always the case that a taxpayer that files an amended State or local return reporting additional liabilities at the State or local level that also affect Federal tax liability will file an amended return at the Federal level.

The budget proposal would create an additional exception to the general three-year statute of limitations for assessment of Federal tax liability resulting from adjustments to State or local tax liability. The statute of limitations would be extended to the greater of: (1) one year from the date the taxpayer first files an amended tax return with the IRS reflecting adjustments to the State or local tax return; or (2) two years from the date the IRS first receives information from the State or local revenue agency under an information sharing agreement in place between the IRS and a State or local revenue agency.

The statute of limitations would be extended only with respect to the increase in Federal tax attributable to the State or local tax adjustment. The statute of limitations would not be further extended if the taxpayer files additional amended returns for the same tax periods as the initial amended return or if the IRS receives additional information from the State or local revenue agency under an information sharing agreement. The statute of limitations on claims for refund would be extended correspondingly so that any overall increase in tax assessed by the IRS as a result of the State or local examination report would take into account agreed-upon tax decreases or reductions attributable to a refund or credit.

The proposal would be effective for returns required to be filed after December 31, 2011.

Have a tax dispute with the IRS? Call Mitchell A. Port at (310) 559-5259 to speak with a tax attorney for help.

February 7, 2012

Getting The IRS To Pay Your Legal Bills

Internal Revenue Code Section 7430(a) provides that the prevailing party in any administrative or court proceeding may be awarded a judgment for (1) reasonable administrative costs incurred in connection with such an administrative proceeding within the IRS, and (2) reasonable litigation costs incurred in connection with such a court proceeding.

In addition to being the prevailing party, to receive an award of reasonable litigation costs a taxpayer must have exhausted all administrative remedies, shows that the position of the United States is not "substantially justified," and must not have unreasonably protracted the court proceeding.

Section 7430(c)(4)(B)(i) makes it clear that the IRS bears the burden of proving that its position was “substantially justified” (i.e., the IRS’s position has a reasonable basis in both fact and law and is justified to a degree that could satisfy a reasonable person). "Reasonable litigation costs" include reasonable court costs, expert witness fees, the cost of any study, analysis or project which is determined by the court to be necessary for the preparation of a taxpayer's case, and reasonable attorneys' fees. IRC Section 7430(c)(1). The amount of reasonable attorneys' fees are limited. For an interesting Tax Court case deciding against the Internal Revenue Service and awarding fees to the taxpayer’s attorney, read Arthur Dalton, Jr. and Beverly Dalton, Petitioners vs. Commissioner Of Internal Revenue, Respondent.

I found a handy chart that may help determine whether your attorney's fees will be paid.

Do you qualify to have your attorney’s fees paid by the Internal Revenue Service? A tax litigation attorney can help. Call Mitchell A. Port at (310) 559-5259 to discuss it.