Worker Classification Challenges
Employee Plans & Employment Tax Challenges
Henry Talavera, Partner
Hunton & Williams, LLP
(214) 468-3386
htalavera@hunton.com
Employee/Worker Classification Matters
• Importance of Worker Classification from Tax
Perspective
– Fundamental to Internal Revenue Code system
– Employment Taxes
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FICA, FUTA (small amount) & Income Tax
15.3% FICA (slightly less this last year)
Income tax withholding – 25% plus may be possible
60% roughly of all revenue (or more) from employment tax
system per IRS
• Classification of employees is important to shore up
revenue
Reasons Why Employment Tax
System is Important
• Compliance is high when there is withholding,
but less so when there is disclosure and no
withholding (for example, Form 1099-Misc)
• Bigger gap when no disclosure
• Fundamental to keep system working
Study on Worker Classification
• Government Accounting Office Report on
Worker Classification, August 10, 2009, GAO 09-717
• U.S. Treasury Inspector General for Tax
Administration report on Worker Classification
• http://www.treasury.gov/tigta/auditreports/2009re
ports/200930035fr.html (February 4, 2009)
Legislative Efforts
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Legislation Proposed on Worker Classification to Remove Section 530
Relief
– The Taxpayer Responsibility, Accountability and Consistency Act of
2009 (S. 2882, H.R. 3408)
Employee Misclassification Prevention Act (S. 3254, H.R. 5107), introduced
in April 2010.
– This law would amend the Fair Labor Standards Act of 1938 to require
companies to notify both employees and non-employees of their
classification, and to require companies to keep detailed records of nonemployees who perform labor or service for remuneration.
The Fair Playing Field Act of 2010 (FPFA) (S. 3786 and H.R. 6128).
– Would revise the current tax law governing employment status
determinations by repealing Section 530.
• Legislation would not likely pass now.
Questionable Employment Tax Program
– 35 States – IRS & States shares employment
tax information – perhaps workers’ comp audit
– For IRS it is just a referral program, but it is a
lead
– IRS shares information with the states
– On June 17, 2010, DOL hearing on Fair Labor
Standards Act legislation regarding employee
classification issues
http://www.irs.gov/newsroom/article/0,,id=17545
7,00.html
Employee Tax National Research
Program Audit
• 6,000 audits through 2012 over three years
• Full scale audits – random
– Large, small and mid-size
– Government also
• Audits to gather information on compliance
– Tailor to be sure that audits ensure compliance and to
target audits
– Worker classification a key piece to audit – will not be
only piece of audit
– Will continue audit regardless of whether Section 530
relief is met – (different than regular audit)
Common Law Standard
• Right to direct and control service provider and
how service is performed
• Right may not be exercised and may not be
exercised in full – it is the right that is key.
• Statutory Exceptions
– Corporate officers are employees
– Certain real estate agents and direct sellers
are not employees for employment taxes
Rev. Rul. 87-41
• 20 standard test
• Too much of a checklist –
– IRS revamped
– Training materials added in 1996
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Weighing factors
Sum total of circumstances
Behavior, Financial & relational control are key
Facts & Circumstances
Tax Court Guidance
• Uses 7 or 8 factor test depending upon where
you are in the country
• Go to same facts, but group factors in a little
different manner
• Supreme Court - Darden case
– Nationwide Mutual Insurance Company v.
Darden, 503 U.S. 318, 112 S. Ct. 1344
(1992).
Context Matters in Determining Issue
• Employee versus partner – can you be both an
employee and a partner? Not necessarily
– Sometimes entry level employees – told they
are a minor partner in a related partnership
• Disgruntled employees sometimes will raise these
issues
• Temporary agency or leased employee versus
actual employee can be an issue
Assistance from IRS
• Form SS-8 can be secured from IRS to ask for a
ruling on a particular case
– The employer or employee can ask for the
ruling
– Most are submitted by workers
– The IRS has a process to seek information
from both parties - IRS makes a ruling
– Handled by the IRS in the Northeast
– The ones dealing with Federal government
and third-parties ruled on by Treasury
Case Law
• Bruecher Foundation, 105 AFTR2d 2020 (5th Cir.).
http://scholar.google.com/scholar_case?case=13533649387760621
263&q=%22bruecher+foundation%22+5th+circuit+2010&hl=en&as_
sdt=2,44
– IRS won at Section 530
– Ruled on specifics of case
– Recent example of worker classification case relating to Section
530
• LaDue v. Commissioner, T.C. Summ.Op. 2011-41 (2011), off-duty
policeman is self-employed and liable for taxes and not Jacksonville,
even though police department sets rules
Liability
• Employers are liable for full taxes, plus
potentially penalties and interest
– What happens if don’t withhold on a particular
piece of income?
• Full employment taxes and income withholding can
be due
• Section 530 Relief can eliminate liability
• IRC 3509 can reduce liability
• Classification Settlement Program
Section 530 Relief
• Section 530 is law until changed
– Employer gets relief for past
– Employer can continue to get relief as long as Section
530 relief is met
– Once 530 satisfied, the audit is over
– Zero bill
– Can have Section 530 for one class, but not all
classes of workers
• Discussed in much detail in the IRS materials provided
from 1996
Section 530 Relief
Reasonable Basis
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First, you had a reasonable basis for not treating the workers as employees. To
establish that you had a reasonable basis for not treating the workers as employees,
you can show that:
– You reasonably relied on a court case about Federal taxes or a ruling issued to
you by the IRS; or
– Your business was audited by the IRS at a time when you treated similar workers
as independent contractors and the IRS did not reclassify those workers as
employees.
– You may not rely on an audit commenced after December 31, 1996, unless such
audit included an examination for employment tax purposes of whether the
individual involved (or any other individual holding a substantially similar position)
should be treated as your employee; or
– You treated the workers as independent contractors because you knew that was
how a significant segment of your industry treated similar workers; or
– You relied on some other reasonable basis. For example, you relied on the
advice of a business lawyer or accountant who knew the facts about your
business.
Section 530 Relief Cont’d
• Substantive Consistency
– In addition, you (and any predecessor business) must have
treated the workers, and any similar workers, as independent
contractors.
– If you treated similar workers as employees, this relief provision
is not available.
– If you are paying an individual who is providing services as a test
proctor or room supervisor assisting in the administration of
college entrance or placements examinations, the substantive
consistency requirement does not apply with respect to services
performed after December 31, 2006, (and remuneration paid
with respect to such services).
– The provision applies if the individual (1) is performing the
services for a tax-exempt organization, and (2) is not otherwise
treated as an employee of such organization for purposes of
employment taxes.
Section 530 Cont’d
• Reporting Consistency
– Finally, you must have filed all required federal tax
returns (including information returns) consistent with
your treatment of each worker as not being
employees.
– This means, for example, that if you treated a worker
as an independent contractor and paid him or her
$600 or more, you must have filed Form 1099-MISC
for the worker.
– Relief is not available for any year and for any
workers for whom you did not file the required
information returns.
Liability Can be Reduced by IRC 3509
• Section 3509 of the IRC
– Not Optional
– For worker classification, if no intentional disregard by
employer, and FICA and income tax exclusion
occurred
– Small portion of income and FICA tax permitted
– 3509 rates – employer cannot get abatement for any
income taxes that worker may have paid.
• Income taxes may have already been paid by the worker on
a Form 1099
IRC 3509 Rates
• 1.5% of wages for income tax withholding
• 20% of amount which otherwise would have
been for employee FICA rate
• Employer taxes owed in full
• Employee cannot get any relief just because the
employer paid all of the taxes (or vice versa)
Classification Settlement Program
• Program IRS had for at least 15 years
– Started as temporary pilot
• If Prospective Change by Employer, then the
IRS will agree to further reduction
• Employer liability cut down further
– Employer agrees to reclassify workers
– Liability limited to one year to settle all years
– Depending upon Section 530 relief and other
arguments, could be 25% to 100% of liability
Tax Court
• Can go to tax court if necessary
• There are special processes for employers to
contest employee classification in order to go to
tax court
Employee Leasing
• Who is the employer?
– Can be leasing or Professional Employee Organization (PEO) or
contingent workforce
– Can be murky as to who is an employer
– Employers should be cautious (employers assume that PEO will
always be responsible)
• The PEO will not necessarily responsible for employment taxes
• The right to direct and control is the standard per the IRS
• Blue Lake Rancheria v U.S., California (9th Cir) – Docket # 08-4206
– Dealing with Indian Tribe with PEO
– Court ruled that the PEO was not the common law employer or cocommon law employer
– http://scholar.google.com/scholar_case?case=1490104966933
7692097&q=%22blue+lake+rancheria%22&hl=en&as_sdt=2,44
PEO
• Co-Employment
– The IRS does not generally recognize
– Rev. Rul. 66-162 – co-employment can be recognized in limited
circumstances, one person employee of two entities, because
both had the right to direct and control
– Professional Executive Leasing, Inc. v. Commissioner, 89 TC
225, 232 (1987), affd, 862 F.2d 751 (9th Cir. 1988).
– Chief Counsel Advice (“CCA”) 200415008 (April 9, 2004), joint
liability may be possible in PEO context.
– Sunshine Staff Leasing, Inc. v. Earthmovers, Inc.,199 B.R. 62
(M.D. Fla. 1996); and United States v. Total Employment
Company, Inc., 305 B.R. 333 (M.D. Fla. 2004). PEO found liable
with client employer.
Employee Plan Issues
• Retirement Plans – most plans have a box to
exclude independent contractors
– Correction may be possible via the Voluntary
Correction Program
– Example
• Part-time or seasonal employees excluded
• Temporary employees excluded
• Leased employees not excluded by terms of
plan –IRC section 414(n) – Can this ever apply?
The IRS has in the past been dubious of
applicability
Welfare Plans
• Welfare Plans – health, life insurance, disability,
severance and similar
– Most documents are not drafted to exclude
independent contractors
– Most documents provide that coverage is provided to
all “employees”
– Risk is litigation – i.e., Vizcaino v. Microsoft Corp., 173
F.3d 713 (9th Cir. 1999
– See Wolf v. Coca-Cola Co., 200 F. 3d 1337 (11th Cir.
2000) plan properly excluded employee
- ERISA section 510 retaliation claim is possible if act
against an employee asserting rights
Private Causes of Action for Failure to
Comply
• Courts seem split whether a private cause of
action could exist if an employee is misclassified
and there are no benefit issues.
– See The Sea Clammers Doctrine: Reeling in
Private Employment Tax Claims in Worker
Misclassification Cases, J. Aaron Ball, 1
Depaul Business & Commercial Law Journal
215 (2002-2003)
Certain Plans Cannot Exclude Anyone
Reclassified
• 403(b) Plan
• IRC 423 Equity Plans
• Cannot exclude independent contractors who
are reclassified as employees by law
• Must live with the risk of reclassification with
those programs
Other Tax Issues
• IRC 409A
– Deferred compensation rules apply regardless
of the title
– Termination of employment may not occur just
because an employee is classified as an
independent contractor
Penalties for Failures
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Employers could be subject to a number of liabilities with respect to the information reporting and
withholding errors. These liabilities include the following:
Penalties for failing to file the correct information return (i.e. the W-2 did not show the correct
amount). This would result in a $100 penalty for the incorrect filing with the government and a
$100 penalty for the incorrect filing to the affected participant.[1]
A 10 percent penalty would be applied for failure to deposit the employer portion of FICA (based
on amount of deposit).[2]
A 20 percent negligence penalty could be applied based on the amount that should have been
deposited, although this seems very unlikely.[3]
Interest could be applied at the underpayment rate to the amounts described above.[4]
The employer could be held liable for the amount of income taxes it should have withheld in
2009.[5]
[1] Code Sections 6721 and 6722.
[2] Code Section 6656 and Rev. Rul. 75-191, 1975-1 C.B. 376.
[3] Code Section 6662.
[4] Code Section 6601.
[5] Treasury Regulation 31.3402(d)-1.
Personal Liability for Taxes is Possible
• When determining whether an individual is a responsible person
liable for a corporation's failure to remit taxes to IRS, courts consider
a non-exhaustive list of factors, including whether the individual: (1)
serves as an officer or member of the board of directors; (2) owns
substantial stock in the company; (3) manages day-to-day
operations; (4) possesses the authority to hire or fire employees; (5)
makes decisions as to the disbursement of funds and payment of
creditors; (6) controls bank accounts and disbursement of records;
and (7) possesses check-signing authority. Opplinger v. United
States, 637 F.3d 889 (8th Cir. 2011).
• IRC section 6672
Relief From Penalties & Interest
• Form 4670 can be used to get a credit for any income tax paid by
the employee. IRC section 3402(d).
• Form 4669 can be used to get credit for Social Security and other
taxes paid by the employee.
• IRC 6205. Interest free adjustment permitted if correction made by
the return due date for the period in which error was ascertained.
Treasury Regulation Section 31.6205-1(c)(2) and Instructions Form
941-X.
• See also Rev. Rul. 2009-39 discussing the interest free adjustments.
• Section 530 Relief is independent and may still provide full relief,
depending upon the case.
Correction Generally
• Entirely new process – January 1, 2009
• Issue Form W-2c, along with Form W-3c
• File Form 941-X to correct payroll taxes
– Interest free adjustment is permitted if fixed quickly
• File a Reasonable Cause Statement
• Also corresponding forms for certain other situations
(e.g., Form 944-X for annual returns)
• See IRS Publication 4341 (January 2010) providing
guidance on corrections and completing forms.
Form 941-X - Example
• Line 12 and related used to correct employee
classification errors on Form 941-X
• Quarter by quarter Form 941-X should be filed
• If IRC 3509 applies, can use rates on those
forms – as long as not intentional and must be a
complete failure to withhold
• Example - June 29 discovered error, must file
941-X by July 31
Voluntary Correction Outside of Audit?
• IRS is considering setting up a program but
nothing yet
• Probably good to visit with the IRS on an
informal basis
• Can ask the IRS to open a limited scope audit,
but I do not recommend
Questions?
Henry Talavera
1445 Ross Avenue, Suite 3700
Dallas, Texas 75287
(214) 468-3386