United States: Explore Safe Harbors Before Hitting Worker Classification Snags

The IRS is battling worker misclassification more than ever, scrutinizing employers that classify workers as independent contractors. Payment of income tax and Federal Insurance Contributions Act (FICA) tax is less certain because it isn't automatically withheld, and some independent contractors who should file and pay don't do so. Employers who use independent contractors should be aware of Section 530 of the Revenue Act of 1978, a federal safe harbor that relieves qualifying employers from federal employment tax obligations related to workers the IRS might not consider independent contractors.

Background

Under Section 530, employers aren't liable for employment taxes on workers regardless of their classification if the employers can satisfy two consistency requirements and demonstrate a reasonable basis for classifying the workers as independent contractors. Employment taxes refer to the employee and employer portions of FICA taxes, Federal Unemployment Tax Act (FUTA) taxes, federal income tax withholding and Railroad Retirement Tax Act (RRTA) taxes.

To qualify for Section 530 relief, employers must satisfy two consistency requirements:

  1. Reporting consistency — Employers must have filed all required federal tax returns in a timely way. This includes information returns that are consistent with treating workers as independent contractors (for example, Forms 1099-MISC).
  2. Substantive consistency — Employers must demonstrate that they consistently treated the group of workers (and workers holding the same or similar positions) as independent contractors. For example, a landscaping company that has historically treated its residential lawn-mowing workers as independent contractors and its commercial lawn-mowing workers as employees could fail the substantive consistency requirement if the residential lawn-mowing group's status is questioned.

What to do

Employers looking for Section 530 relief must also have a reasonable basis for treating the workers as independent contractors. This requires them to show that when they decided to classify the workers as independent contractors, they reasonably relied on one of the following three standards:

  1. Judicial precedent such as published rulings.
  2. A prior IRS audit of the employer from which no employment tax assessment could be attributed to worker classification (related to a substantially similar group of workers).
  3. A longstanding practice by a significant segment of the industry for treating the workers as independent contractors. At least one court ruling accepted that an employer met the reasonable basis standard when reliance occurred after the initial decision to classify workers as independent contractors but before the periods under exam.

Even if employers can't show reliance on any of the reasonable basis safe havens, they may still be entitled to Section 530 relief if they can prove some other reasonable basis for treating the workers as independent contractors. That can include relying on an attorney, an accountant or a prior state administrative action that determined the worker was an independent contractor.

Employers should proactively document that they considered one or more of these factors and the rationale behind their conclusion. As part of Section 530 consideration during an IRS audit, the IRS will request written, contemporaneous evidence that the employer did this and may not accept verbal assumptions.

IRS examiners are required to offer taxpayers Section 530 consideration as the first step in any case involving employment status reclassification. If an employer qualifies for relief, the IRS will immediately end the worker classification examination and make no official determination regarding worker status.

Because the IRS won't consider the workers to be either independent contractors or employees for federal employment tax purposes, the employer will continue to report payments to the workers on Forms 1099-MISC and won't be liable for withholding or remitting employment taxes. If an employer doesn't qualify for Section 530 relief, the worker classification examination will continue, with the IRS analyzing behavioral, financial and relationship characteristics of the workers and the employer in order to determine the workers' classification.

It's important to reiterate that Section 530 relief only terminates the employer's liability for federal employment taxes. It doesn't officially classify workers as an independent contractors or keep workers from being classified as employees through some other means and for some other purpose. For example, an employer could achieve Section 530 relief for a group of workers for federal employment tax purposes, but the workers could still be deemed employees by a state taxing authority.

Additionally, the workers may be considered employees for participation in employee benefit plans or the requirement to be offered affordable health care coverage. Section 530 relief doesn't affect workers' liability for employment taxes on the compensation received for services rendered, though it can complicate the matter of whether workers are subject (on their own) to only the employee's portion of FICA or the full amount of self-employment taxes.

Defending a worker classification can be exhausting, and IRS reclassification of independent contractors to employees can be costly for employers, who must pay back employment taxes and may face penalties even if the misclassification was unintentional.

Conclusion

Employers should analyze the behavioral, financial and relationship characteristics of each prospective worker during onboarding to mitigate the risk of worker misclassification. Employers that classify workers as independent contractors should know the ins and outs of Section 530 as a first defense against an IRS challenge of worker classification and document their basis for the classification when they make the decision.

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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