United States: More Tax Audits Expected To Enforce Worker Classification Rulings

As the recovery of the U.S. economy drags on, and the federal budget is strained, the pressure on the Internal Revenue Service to increase revenue is mounting. One way for the IRS to increase revenue is to encourage tax compliance so that taxpayers voluntarily and timely pay a larger portion of their tax liability. Since 2001, the national tax compliance rate has remained steady at about 83 percent. As part of its push to increase compliance, the IRS recently focused its attention on the issue of worker classification. The determination of whether a worker is an employee or an independent contractor has significant tax implications as well as other financial implications for the parties involved. For example, an employee may be entitled to workers' compensation and health, retirement and unemployment benefits, while an independent contractor is not.

The Treasury Inspector General for Tax Administration (TIGTA) recently issued a report that evaluated whether the IRS's Determination of Worker Status Program (the SS-8 Program) was effectively processing worker classification requests and, more importantly, whether the subsequent worker classification rulings issued by the program were being followed. This TIGTA report found that a significant percentage of businesses that received worker classification rulings did not comply with the determinations. Based on this finding, the IRS agreed to review its internal procedures for the SS-8 Program with the ultimate goal of increasing business compliance with worker classification rulings. The end result of such review will likely translate into additional formal audits of businesses that receive worker classification rulings.

The SS-8 Program was established in 1994 to allow either a business or a worker to request a determination letter from the IRS regarding the worker's federal employment tax status as an employee or independent contractor. The determination of whether a worker is an employee or an independent contractor has significant tax implications for the worker, the business and the IRS, because the classification of the worker determines the parties responsible for paying the Social Security tax, Medicare tax and federal unemployment taxes, as well as whether or not federal income tax withholding is required.

An independent contractor is responsible for paying the entire amount of his or her Social Security and Medicare taxes (FICA tax), as well as any federal income taxes. In contrast, an employee is responsible for only half of the FICA tax, while the other half of the tax is paid by his or her employer. In addition, an employer is also responsible for paying its employees' federal unemployment taxes and funding other employee-related benefits, such as worker's compensation and health and retirement benefits.

The IRS generally favors classifying workers as employees because there is, on average, a higher tax compliance rate among employees as compared to independent contractors. The higher compliance rate is a result of the fact that an employer is required to withhold from an employee's wage the federal income tax and the employee's portion of the FICA tax. The IRS estimated in its last comprehensive study that 15 percent of businesses misclassified 3.4 million workers as independent contractors, which resulted in an estimated total tax loss of $1.6 billion in FICA tax, federal unemployment taxes and federal income taxes.

To request a worker classification ruling under the SS-8 Program, a business or a worker must file Form SS-8, Determination of Worker Status for Purposes of Federal Unemployment Taxes and Income Tax Withholding. In most cases, Form SS-8 is filed by a worker seeking unemployment benefits or other employee-related benefits, while businesses tend not to file because of the perception that the IRS generally favors classifying workers as employees. When the IRS processes a Form SS-8, it had historically considered 20 different factors that were based on the common law. These 20 factors have since been compressed into the following three different categories:

  • Behavioral: Does the business control or have the right to control what the worker does and how the worker does his or her job? An employee is generally subject to the business' instructions about when, where and how to work.
  • Financial: Are the business aspects of the worker's job controlled by the business? These include, for example, how the worker is paid, whether expenses are reimbursed and who provides tools and supplies.
  • Type of relationship: Are there written contracts or employee benefits (pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Prior to issuing a worker classification ruling, the IRS will offer an opportunity for the business to respond with information relating to the working relationship. After reviewing the information provided by both the worker and the business, the IRS will issue a determination stating whether the worker should be classified as an employee or an independent contractor.

This determination has broad ramifications for the business involved. The IRS's determination not only applies to the specific worker who submitted the Form SS-8, but also applies to all the workers who provide the same or similar services as the worker who initially filed the form. Effectively, a worker classification ruling could convert the entire workforce of a business from independent contractors to employees overnight. The financial consequences of such a conversion could cripple the business.

Due to the sweeping impact of a worker classification ruling under the SS-8 Program, the receipt of an information request from the IRS relating to a Form SS-8 should not be taken lightly. A business should respond to the IRS's request with care, deliberation and with the guidance of an experienced tax adviser. In the event a business receives an adverse worker classification ruling, the business may request that the IRS reconsider its determination, but a court cannot review the IRS's determination because the IRS's review under the SS-8 Program is not considered a formal audit.

Because the IRS review is not an audit, the business in requesting reconsideration cannot raise certain defenses, such as Section 530 of the 1978 Revenue Act, which may provide retroactive relief from employment taxes related to the proper classification of workers if certain requirements are met. For Section 530 relief to apply, the taxpayer must have consistently treated the worker (and all similarly situated workers) as an independent contractor, filed all requisite federal tax returns, and had a reasonable basis for not treating such workers as employees. While the successful defense of Section 530 relief terminates the business' liability for employment taxes, it does not affect the tax liability of its workers. Furthermore, Section 530 relief only applies to employment taxes under Subtitle C of the Internal Revenue Code of 1986, as amended, and does not provide relief with respect to other taxes, such as state and city wage taxes.

Due to its structure, the SS-8 Program has little to no ability to enforce compliance of its worker classification rulings. The program relies solely on audits conducted by the IRS's Small Business/Self-Employed Division, the Large Business and International Division, and the Tax Exempt and Government Entities Division to enforce its rulings. In 2011, the SS-8 Program closed 8,405 worker classification cases and referred 797 (9.5 percent) of those cases to the IRS's operating divisions for audit consideration. The remaining 90 percent of the worker classification cases were closed without further actions. The SS-8 Program referred 742 of the 797 to the Small Business/Self-Employed Division, which accepted 538 cases for examination. In 2011, the IRS only audited 6.4 percent of the worker classification cases closed by the SS-8 Program. Based on these findings by TIGTA, the IRS agreed to assess needed changes to the SS-8 Program to increase business compliance with worker classification rulings. Any changes to the SS-8 Program likely mean more formal audits of businesses that receive worker classification rulings. 

Originally published in the January 21 issue of The Legal Intelligencer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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