Successfully Defend an IRS Worker Classification Challenge
Author: Brian Todd
Imagine your organization is going through an IRS employment tax examination, and the IRS field agent has analyzed the typical common law factors and disagrees with your independent contractor treatment of an entire class of workers. Is the classification issue a lost cause? Maybe not if you’ve consistently treated these workers as independent contractors, filed the appropriate information returns and gathered sufficient documentation to support your positions.
For many years, worker classification has been a common issue for taxpayers selected for employment tax examinations. This trend has continued in recent years and been particularly prevalent with hospitals, but similar issues may exist for taxpayers in almost any industry.
Many workers prefer to be treated as employees, since this classification often carries eligibility for benefits and a lower out-of-pocket payroll tax effect due to the employer paying half of the 15.3 percent burden. Other workers prefer to be treated as independent contractors. These workers already may have reached the Social Security contribution and benefit base, multiple business interests and/or significant unreimbursed business expenses; recent examination experience shows that locum tenens physicians commonly fit into this latter group.
Employers often prefer independent contractor treatment for workers to save on payroll taxes and employee benefits.
The IRS believes the worker classification issue has contributed to the annual tax gap. The IRS defines the gross tax gap as the difference between the true tax liability for a given tax year and the amount paid on time. The timely payment component of the tax gap keeps the worker classification issue prioritized because taxes are more reliably and efficiently collected through periodic employer withholding of taxes from employee wages. Overall tax due also is affected, since independent contractors are more likely to seek tax deductions for unreimbursed expenses than employees. The temptation to be more aggressive in taking deductions that may not truly relate to their trade or business also is prevalent with independent contractors.
The IRS hasn’t generally applied additional scrutiny to contractor relationships coordinated through staffing agencies. The employment tax responsibilities in these arrangements lie with the staffing agencies rather than the businesses contracting with them.
In its worker classification analysis, the IRS generally applies common law rules. Facts that provide evidence of degree of control and independence fall into three categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does a job?
- Financial: How and with what frequency is the worker paid? Are a worker’s expenses reimbursed? How are tools and supplies purchased and made available?
- Type of relationship: Are there written contracts or employee-type benefits? Will the relationship continue indefinitely? Is the work performed a key aspect of the business?
As previously indicated, if you cannot satisfy an IRS field agent with respect to these criteria, all may not be lost if you position your organization to qualify for Section 530 of the Revenue Act of 1978 relief.
Section 530 Relief
Section 530 includes safe harbor provisions to provide taxpayers relief when they consistently treat workers as independent contractors and exercise good faith in making the decision to do so, even though common law factors would suggest employee status. Your organization will not owe employment taxes in an employment tax examination if you meet Section 530’s relief requirements.
To receive relief, you must meet all these requirements:
- You must have a reasonable basis for not treating the workers as employees. To demonstrate you had a reasonable basis, you must show that you met one of these:
- You reasonably relied on judicial precedent, published rulings 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 didn’t reclassify those workers as employees. You only may rely on an audit commenced after December 31, 1996, if the audit included an employment tax examination involving the affected individual or similarly situated workers.
- You treated the workers as independent contractors because you knew that was a long-standing recognized practice of a significant segment of your industry.
- You relied on some other reasonable basis.
- You must meet the substantive consistency requirement by treating the workers, and any similar workers, as independent contractors.
- You must meet the reporting consistency requirement by filing all required federal information returns (Form 1099) consistent with your treatment of each worker as an independent contractor.
How Do I Position My Organization to Qualify for Section 530 Relief?
Starting with the more straightforward requirements, the first step to qualifying for Section 530 relief is simply to file all required information returns for the affected workers, i.e., make sure you file your 1099s.
Next, to meet the substantive consistency requirements, make sure you treat all similarly situated workers consistently. Going back to the example of locum tenens physicians: If you contract with 10 locum tenens physicians, make sure you treat them all consistently.
With respect to the substantive consistency requirement, an important court case for hospitals was North Louisiana Rehabilitation Center, 179 F. Supp. 2d 658, 88 AFTR2d 2001-7057 (DC la, 2001). This was one in a series of cases decided in U.S. District Court that involved medical directors. The IRS contended the hospital’s treatment of a staff physician it believed was substantially similar to medical directors caused the hospital to fail the substantive consistency requirement. The hospital was able to differentiate the positions by contending the staff physician was retained as a full-time attending physician and required to devote at least 130 hours per month to clinical care and at least 40 hours per month to administrative duties. Further, the hospital determined her schedule, and she wasn’t to be employed elsewhere or maintain a private practice. In contrast, medical directors devoted less time to the hospital, their role was primarily consultative, they had their own private practices and the hospital didn’t dictate the means or manner of their work. The court concluded in the hospital’s favor that the substantive consistency requirement was met.
What does this case mean for other employers? The key lesson employers can take is to document any and all differences between classes of workers if you plan to treat them differently.
Finally, reasonable basis seems like it would be a fairly easy standard to meet, considering the congressional intent that reasonable basis be liberally construed in the taxpayer’s favor. This position also is confirmed by the IRS in Revenue Procedure 85-18. Reasonable basis still can be challenging, particularly at the field examination level.
The most certain way to meet the reasonable basis requirement is to rely on a ruling issued to you by the IRS or a prior IRS employment tax exam. Many times, the employer doesn’t have these experiences to draw from, so they’re forced to pursue judicial precedent, industry standard or other reasonable basis.
When relying on judicial precedent or published rulings, it’s important that your facts closely align with facts in the court case or ruling. It also is important to determine contradictory cases or rulings and the timing of the issuance of those decisions. If a more recent court case exists that’s contradictory to a case you have relied on and your facts more closely align with, you may be fighting an uphill battle.
Industry standard may be the most common argument for employers in establishing a reasonable basis. Congress also intended that the provisions related to defining long-standing and significant segment would be liberally construed in favor of taxpayers, according to the Joint Committee on Taxation report JCX-26-07. However, in our experience, it may be a more challenging way to establish reasonable basis if you haven’t been proactive in gathering evidence to support your position. Hospital CFOs may know the majority of hospitals treat locum tenens physicians as independent contractors, but without some type of proof, your argument may be unsuccessful. What type of documentation can you gather for support? Surveys of peer organizations can be powerful tools to support your position. If you can convince an industry association to conduct a survey and publish or make all of the results available to its members, that can be even more persuasive. It’s important to reach a large enough sample of similar organizations. You also may gather trade publications with relevant articles or guidance for support. Attorneys who specialize in your industry also may be willing to provide you with a written opinion.
The final alternative to establishing reasonable basis is establishing that you met some other reasonable basis besides the ones listed above. Examples of other reasonable basis could include engaging legal counsel to review all independent contractor agreements and provide an opinion on the appropriate worker classification. You may find other available guidance on the internet to support your treatment. For example, if you’re a hospital CFO or controller and find a sufficient amount of evidence on the internet to support your position and no contradictory evidence, that may help to establish other reasonable basis. Of course, the sources should be carefully considered.
Other Relief Provisions
Even if you fall short of qualifying for Section 530 relief, you might qualify for another Classification Settlement Program (CSP) if you’ve gathered the appropriate documentation. These programs are different than the Voluntary Classification Settlement Program in which an employer voluntarily reclassifies its workers as employees to gain partial relief from federal employment tax assessments.
You may qualify for a 100 percent CSP offer if you meet the Section 530 reporting consistency requirement but clearly don’t meet the Section 530 substantive consistency requirement or reasonable basis test. This offer will be a full employment tax adjustment for the most recent tax year in examination. This settlement limits the employment tax exposure to one year, rather than the three years that are typically open within the statute of limitations.
You may qualify for a 25 percent CSP offer if you meet the reporting consistency requirement and have a colorable argument that you meet the substantive consistency requirement and/or reasonable basis test. This offer will be an adjustment of 25 percent for the most recent tax year in examination, rather than a full adjustment for all open years in examination.
The catch to qualify for these relief provisions is that you must agree to prospectively classify the affected workers as employees.
If your organization uses individual independent contractors, it’s important to position yourself to defend a potential IRS challenge. Ways you can position your organization for success include, but aren’t limited to:
- File all 1099s for the independent contractors
- Treat all similarly situated workers consistently
- Document differences between classes of workers the IRS could try to argue are similarly situated, i.e., medical director versus staff physician
- Gather relevant court cases and published rulings to provide judicial and administrative ruling precedent
- Conduct surveys, document discussions with peer organizations and get support from industry associations to support industry standard
- Consider legal review of the worker classification associated with independent contractor agreements
- Gather any other relevant documentation to support other reasonable basis
Improper worker classification and a subsequent reclassification can affect a number of areas outside of employment taxes, such as the employer health insurance mandate in the Affordable Care Act and employee benefits. As such, attorneys and other experts in these areas should be consulted in important worker classification decisions. Thorough documentation of your analysis and conclusions regarding worker classification can better position your organization to avoid problems in these areas.
Contact your BKD advisor with any questions or for more information.