Preserving the Availability of Section 530 Relief When Workers are Misclassified

Employers are generally required to withhold and pay employment taxes on wages paid to employees. Conversely, employers are generally not required to withhold and pay employment taxes on wages paid to independent contractors or nonemployees. If an employer incorrectly treats an employee as a nonemployee, the employer is potentially liable for the employment taxes which should have been withheld. The employer may often not learn of this liability for years, until an IRS notice appears in the mail.

Section 530 of the Revenue Act of 1978, as amended, provides relief for employers who have treated workers as nonemployees if the following requirements are met:

  1. The employer consistently treated the workers (and any individuals holding a substantially similar position) as nonemployees for employment tax purposes for the tax periods at issue and all prior tax periods after 1978.
  2. The employer filed all returns required for the workers for those periods and all periods after 1978 and the returns were consistent with nonemployee status; and
  3. The employer had a reasonable basis for treating the workers as nonemployees.

Section 530 provides three "safe harbors" for establishing a reasonable basis for treating workers as nonemployees. A taxpayer may also establish other reasonable grounds for its classification. H.R. Rep. No. 1748, 95th Cong., 2d Sess. 5 (1978), 1978-3 (Vol. 1) C.B. 629, 633; Rev. Proc. 85-18.

The safe harbors provide that reasonable basis is established if the taxpayer reasonably relies upon any of the following:

  1. Judicial precedent, published rulings, or technical advice or letter ruling to the taxpayer;
  2. A past employment tax audit in which no assessment was made on account of improper classification of workers holding substantially similar positions; or
  3. A long-standing recognized practice of a significant segment of the industry in which the worker worked.

In a Program Manager's Technical Advice, PMTA 2011-15, the IRS has now determined that an employer does not need to demonstrate that it reasonably relied on a safe harbor before engaging a worker to provide services. A taxpayer merely needs to demonstrate that it determined to rely on a safe harbor for its decision to treat a worker as a nonemployee at some point before any employment periods under IRS audit.

Taxpayer Impact

Section 530 prevents the IRS from retroactively reclassifying nonemployees as employees and subjecting the employer to federal employment taxes, penalties and interest for such misclassification. A long line of cases have determined that a taxpayer must rely on a safe harbor in fact in order for relief to be available. In other words, an employer cannot develop its case once an IRS audit begins. Instead, an employer should document the authority relied upon at the beginning when a worker is hired.

The PMTA offers employers an opportunity to document the basis of treating a worker as a nonemployee presently, even if no authority was actually relied upon when a worker was hired. By presently documenting the authority for treating a worker as a nonemployee, the employer preserves the availability of Section 530 relief for future employment periods in the event the IRS audits such periods and determines that the workers should have been treated as employees.

Employers with any question concerning whether workers should be treated as employees or nonemployees should review their files and document any authority which supports the characterization of workers as nonemployees. Over the next three years, the IRS is auditing 6,000 randomly selected businesses to determine whether they have workers who've been classified as contractors when they should be treated as employees. The IRS has reportedly hired and trained 200 new agents to conduct the examinations. If the audits produce revenue, the IRS will likely continue in the future.

An employer who fails to satisfy the Section 530 relief requirements may still be able to participate in the Classification Settlement Program ("CSP"). The CSP is an administrative program that allows qualifying employers who have misclassified workers to pay a portion, but not all, of the employment taxes that would otherwise be due.

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