Get Ready for the Employment Tax Compliance Surge: IRS to Challenge Status of Independent Contractors

Employee Benefits Alert

The federal and state governments are moving on several fronts to counteract what they consider to be a significant contributor to the income tax gap: underreporting of employment taxes. The IRS is embarking upon a major employment tax enforcement effort. Beginning this month and continuing over the next three years, newly trained IRS employment tax agents will audit 6,000 companies as part of an "Employment Tax Compliance Program" announced last year. A primary focus of the compliance audits will be the company's classification of certain persons as independent contractors rather than employees.

The President's fiscal 2011 budget allocates funds for hiring additional agents to assist in this process. According to the budget report, increased enforcement in this area will increase Treasury receipts by more than $7 billion over ten years. For its part, Congress is expected to consider legislation that would substantially limit the availability of certain safe harbor provisions included in the Revenue Act of 1978, which have severely hampered the IRS's enforcement efforts in employee reclassification cases. Finally, many state governments are stepping up their enforcement efforts, on their own initiative or in conjunction with the Federal program.

Employers should become familiar with the IRS's audit game plan and be aware of their individual vulnerabilities, so that they can adequately defend themselves when and if they are contacted by the Service. Furthermore, even if they are not selected for audit in the Compliance Program, employers should know that their employment taxes may be examined in connection with a general audit of their income tax returns. It may be appropriate for certain employers to reevaluate and consider changing their practices in light of the enhanced enforcement activity and opportunity to avoid certain penalties if they do so voluntarily.

IRS Compliance Audit Game Plan and What You Need to Do to Be Prepared

According to the IRS Chief of Employment Tax Operations, most of the employment tax compliance audits will be conducted "face-to-face" at the employer's place of business, with additional information gathered from IRS internal sources and the internet.

A primary focus of the compliance audits will be the company's classification of workers as independent contractors rather than employees. Worker classification has always been a primary IRS concern. The IRS strongly favors employee status because subjecting compensation to the withholding system assures more accurate reporting of income and more reliable payment of income and social security taxes. Unfortunately there is no bright-line standard for classifying a worker as an independent contractor or employee. The multi-factor common law test, applied in these circumstances, is confusing, uncertain of application, and susceptible to varying interpretation depending upon the philosophical bent of the decision maker. What this means is that employers must generally be prepared for an aggressive interpretation of the common law test by IRS examiners, resulting in long drawn-out, fact-intensive battles over the classification of certain workers.

What can you do to be prepared? First, you should be aware of your vulnerabilities. Certain workers are more likely to be scrutinized than others. Are you a member of the construction, ground delivery, car service, trucking, consulting, leased employee, industries, to name a few? Do you engage as independent contractors part-time personnel, "temporary" workers, certain technical workers, former employees (including executives) who have retired from or terminated their employment with your company, workers who received continuing payments from you during the year or over several years, workers who received in the same year or over several consecutive years a Form W-2 and Form 1099 from your company? Each of these situations presents a potential employee classification issue. In each case, you should muster the facts and documents in support of your position. You should consider modifying the terms and facts of your relationship with the particular individuals going forward to strengthen your position for independent contractor classification in future periods. If you consider your position weak and irremediable, you should consider converting the individuals to employees and attempting to work out a favorable settlement with the Service. There are several Code provisions (e.g. reduced employment tax rates, interest-free adjustments) and an IRS settlement initiative that could make this conversion virtually painless, insofar as past years are concerned, and possibly avoid any criminal penalties associated with the misclassification. Of course, as part of any settlement, you would probably have to agree to treat the workers as employees in future periods.

One further word of advice: Do not lose sight of Section 530 of the Revenue Act of 1978. This "off-Code" provision was signed into law in 1978 in response to the Service's aggressive (and arguably unreasonable) application of the common law test to reclassify as employees large groups of individuals in recognized industries who had historically been treated as independent contractors. The provision allows companies to continue treating workers as independent contractors without regard to how they might be classified under the common law test provided that the requirements for "substantive consistency," "reporting consistency" and "reasonable basis" are met. Revenue agents are obligated to apprise employers of the availability of the Section 530 defense and accord them the opportunity to mount a defense under that section.

Other areas to be covered by the employment tax compliance audits include executive compensation (reasonableness in the case of Subchapter S corporations and treatment of certain portions as non-qualified deferred compensation under section 409A of the Code) and taxable fringe benefits. Examination by the IRS of the latter will likely focus on personal use of company-owned vehicles, aircraft, etc. In addition, the IRS may always choose to broaden the scope of an employment tax examination, for example to include other withholding tax substantive and technical issues, withholding practices of related entities both domestic and foreign, and the income tax returns of company executives.


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Caplin & Drysdale's tax practice has over 35 years of experience advising clients and representing them in disputes with the IRS in the employment tax area. We were involved (on the employer side) in the IRS employment tax examinations of the late 1970's that resulted in the enactment of Section 530 and played an instrumental part in drafting that legislation and shepherding it through Congress. We continue to advise clients in this area on a daily basis.

For more information please contact the following attorneys:

Daniel B. Rosenbaum at 202-862-5032 or
Charles Ruchelman at 202-862-7834 or
Niles Elber at 202-862-7827 or


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