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Worker Classification Audits

The IRS and the Employment Development Department (EDD) of the State of California, as well as other state agencies, have long wrestled with the challenge of identifying businesses that misclassify employees as independent contractors.  The employer’s motivation for such misclassification is generally to:

  • Minimize employment taxes (the employer’s share of FICA and Medicare, FUTA taxes, and various state employment taxes)
  • Avoid costly workman’s compensation premiums
  • Avoid paying for medical coverage, sick and vacation leave, retirement contributions (employer’s share), and other benefits generally granted to employees. 

From time to time, the IRS will adjust its examination priorities to include a greater focus on employment tax examinations.  I am hearing that is happening in 2025.  With the high cost of living, the adverse impact of tariffs on many products, and increased regulations concerning employees, the incentive for employers to misclassify employees as independent contractors is even greater.

Who is an employee?

Under IRS regulations, an employee is typically someone who performs services for a business, and that business has the right to control what will be done and how it will be done. This is commonly referred to as a common-law employee. 

Key characteristics of an employee under IRS guidelines:

  • Behavioral Control: The business has the right to direct and control how the work is performed, including when, where, and what equipment or methods are used.
  • Financial Control: The business oversees the financial and business aspects of the worker’s job, including payment methods, expense reimbursement, and the provision of tools and supplies.
  • Relationship of the Parties: The type of relationship between the worker and the business, including written contracts, employee benefits (like health insurance, pension plans, or vacation pay), the nature and length of the work relationship, and whether the work performed is a key aspect of the business, are considered. 

Important distinctions between employees and independent contractors:

  • Control: The IRS emphasizes the business’s right to control the details of how the services are performed, even if the employee has some discretion in their actions. Independent contractors, on the other hand, are typically free to determine how to achieve the results of their work.
  • Tax Withholding: Employers are required to withhold and deposit income taxes, Social Security taxes, and Medicare taxes from employee wages, and pay unemployment taxes. Independent contractors are responsible for paying their own self-employment taxes and income taxes.
  • Tax Forms: Employees receive annually a Form W-2 for income reporting, while independent contractors receive a Form 1099-NEC.

Consequences of misclassification:

  • For employers, misclassifying an employee as an independent contractor can lead to significant penalties, back taxes, and interest for the business.
  • For misclassified employees, they may be denied benefits and protections they are legally entitled to, such as minimum wage, overtime pay, and family and medical leave.

Section 530 relief:

1. What is section 530 relief?

Section 530 is a relief provision that terminates an employer’s employment tax liability concerning an individual not treated as an employee if three statutory requirements are met:

  • reporting consistency;
  • substantive consistency; and
  • reasonable basis.

Section 530 does not extend to the worker, who may still be liable for the employee share of FICA, but not self-employment tax.

2. When does section 530 apply?

This section applies to taxpayers in cases involving determinations of employment status, i.e. worker classification cases. Relief applies to periods under audit and all future periods, as long as the requirements are met. Section 530 provides a permanent cure for an organization’s employment tax liabilities relating to a particular group(s) of workers. The business doesn’t need to claim Section 530 relief for it to be applicable. An examiner must first explore the applicability of Section 530 even if the taxpayer does not raise the issue. Publication 1976, Do You Qualify for Relief under Section 530, must be provided to the taxpayer for all instances when Section 530 is considered, even though it is not applicable. (IRM 4.23.5.3)

Section 530 applies only to worker classification issues; section 530 does not apply to wage issues. However, if a wage issue is determined to be an IRC section 7436 issue (discussed later), section 530 must be addressed.

Section 530 Relief is available to state and local government taxpayers for workers performing services included under a Section 218 Agreement for purposes of both FITW and FICA. The inclusion of a position or class of workers in a Section 218 Agreement does not equate to an employee determination for all workers holding that position. (CCA 202038010 PDF)

SSA is responsible for determining coverage of state and local government employees under a state’s Section 218 Agreement and modifications. SSA coverage determinations include an independent common law analysis to determine whether the workers at issue are employees. (IRM 4.75.21.11)

Section 530(e) provides that a worker does not have to be an employee of the business for relief to apply. The company doesn’t need to concede or agree that the workers are employees for section 530 relief to be available.

3. Three statutory requirements that must be met.

  • Reporting consistency – The taxpayer must have timely filed the requisite information returns consistent with its treatment of the worker as a non-employee. (For example, if the taxpayer claims the worker is an independent contractor, Forms 1099 must have been filed for the taxable years at issue). If no information return requirement exists, relief will not be denied on the basis that the return was not filed.  (For example, if the taxpayer claims the worker was a volunteer, no information returns would be required). (Rev. Proc. 85-18, 3.03(B); Rev. Rul. 81-224)
  • Substantive Consistency – If the taxpayer or predecessor treated the worker, or any worker holding a substantially similar position, as an employee at any time after December 31, 1977, the taxpayer will not be eligible for relief.  See: Section 530(e)(6); Rev. Proc. 85-18; Rev. Rul. 83-16, Rev. Rul. 84-161. This is a facts and circumstance determination. A review of the day-to-day services performed, and a comparison of the job functions must be done. The mere existence of similar job titles or categories alone is not sufficient.
  • Reasonable Basis – The taxpayer must have reasonably relied on one of the following three “safe harbors”: 1) prior audit; 2) judicial precedent; or 3) industry practice. The taxpayer must have relied on the alleged authority at the time the employment decisions were being made for the periods at issue. The statute does not allow ex post facto justification.

The taxpayer may demonstrate other reasonable basis. This requirement is to be liberally construed in favor of the taxpayer.  There are four general categories that can be used:

Prior Internal Revenue Service examination

  • After December 31, 1996, the audit must have included an examination for employment tax purposes of the status of the class of workers at issue or a substantially similar class of workers.
  • Before January 1, 1997, the IRS audit does not have to have been an audit for employment tax purposes as long as the audit entailed no assessment attributable to the taxpayer’s treatment, for employment tax purposes, of workers holding positions substantially like the position held by the workers whose treatment is at issue.

Federal judicial precedents and administrative rulings

  • The facts in the case must be similar to the situation of the taxpayer at hand.
  • The judicial precedent or published ruling must have been in existence at the time the taxpayer began treating workers as non-employees. One case is sufficient to establish a precedent that creates a safe haven. This is true even if case law can be found to support either side of the non-employee/employee issue.
  • State court decisions and rulings of agencies other than IRS do not constitute judicial precedent. (However, such reliance may fall under the other reasonable basis safe haven).

Industry practice

  • The taxpayer must show reasonable reliance on a long-standing recognized practice of a significant segment of its industry. An industry generally consists of firms located in the same geographic or metropolitan area that provide the same product or service and compete for the same customers.

Other reasonable basis

  • A taxpayer that fails to meet any of the three “safe havens” may still be entitled to relief if it can demonstrate that it relied on some other reasonable basis for not treating a worker as an employee. Examples may include advice from an attorney or accountant, state or non-tax federal law, and other determinations, as well as prior audits of a predecessor, private letter rulings (PLR) or tax advice memoranda (TAM) to a predecessor, or good faith.

Section 7436 relief

Section 7436 of the Internal Revenue Code (IRC) relates to tax issues primarily concerned with employment tax determinations, specifically worker classification (whether individuals are employees or independent contractors) and Section 530 relief (a provision discussed above that can provide relief to employers from employment taxes in certain circumstances). 

Here’s how Section 7436 relates to tax issues:

  • Tax Court Review: IRC 7436 grants the Tax Court jurisdiction to review certain employment tax determinations made by the IRS during an audit.
  • Controversies Reviewable by Tax Court: The Tax Court can review controversies involving IRS determinations that:
  • One or more individuals providing services for a taxpayer are employees.
  • The taxpayer is not entitled to Section 530 relief.
  • Determination of Employment Tax Liability: The Tax Court can also determine the correct amount of employment tax, including penalties and additions to tax, under these determinations.
  • Assessment of Employment Taxes: Any employment tax liability resulting from Section 7436 issues cannot be assessed unless the taxpayer has had an opportunity to seek Tax Court review.
  • Notice of Determination: The IRS will issue a “Notice of Employment Tax Determination Under IRC 7436” (Section 7436 Notice) when it has made a determination regarding worker classification or Section 530 relief and no agreement has been reached with the taxpayer.
  • Petitioning the Tax Court: Taxpayers can petition the Tax Court to review the IRS’s determinations in a Section 7436 Notice. Filing a timely petition is crucial for seeking Tax Court review.
  • No Assessment Pending Action: In a Tax Court proceeding under Section 7436, the IRS generally cannot assess or collect the disputed employment taxes while the case is pending. 

In summary, Section 7436 provides a pathway for taxpayers to challenge certain employment tax determinations made by the IRS through review in the Tax Court. This is particularly relevant when the IRS reclassifies workers or denies Section 530 relief. 

Voluntary Classification Settlement Program

The Voluntary Classification Settlement Program is an optional IRS program that provides businesses with an opportunity to reclassify their misclassified workers as employees for future employment tax purposes. This program offers partial relief from federal employment taxes for eligible businesses that agree to treat their workers as employees prospectively.

Businesses must meet certain eligibility requirements and apply by filing Form 8952, Application for Voluntary Classification Settlement Program (VCSP).  Eligible taxpayers accepted into the VCSP will enter into a closing agreement with the IRS to finalize the terms of the VCSP. They will simultaneously make full payment of any amount due under the closing agreement.

EDD vs. IRS Worker Classification: Key Differences

While both the California Employment Development Department (EDD) and the Internal Revenue Service (IRS) consider similar factors when determining whether a worker is an employee or an independent contractor, there are some crucial distinctions. 

Similarities:

  • Control over work: Both agencies consider the extent to which an employer has the right to control how, when, and where the work is performed as a primary factor.
  • Right of termination: Both look at whether the employer has the right to terminate the relationship at will.
  • Financial risk: Both consider whether the worker is in a position to realize a profit or loss from their services. 

Key Differences:

  • Tests used:
  • The IRS traditionally used a 20-factor test, though they have shifted to focusing on three main categories: behavioral control, financial control, and type of relationship.
  • The EDD generally uses the ABC test (especially after the implementation of AB 5 in California), which presumes a worker is an employee unless the hiring entity can satisfy all three strict conditions:
  • A: The worker is free from the hiring entity’s control and direction.
  • B: The worker performs work that is outside the hiring entity’s usual course of business.
  • C: The worker is customarily engaged in an independently established trade or business of the same type.
  • Safe harbor provision: The IRS has a safe harbor provision (Section 530 of the Revenue Act of 1978) that protects employers from retroactive reclassification if they consistently treated a worker as a contractor, fulfilled reporting requirements, and had a reasonable basis for the classification. The EDD does not have a similar provision.
  • Penalties and settlement programs: The IRS generally has reduced penalties and offers settlement programs (like the Voluntary Compliance Settlement Program) to mitigate liability for misclassification. The EDD does not offer such programs.
  • Audit triggers: An EDD audit is often triggered when a misclassified worker files for unemployment, while an IRS audit can result from various red flags in tax returns. 

In Essence:

Federal law (IRS) tends to be more lenient on businesses regarding worker classification than California law (EDD). This is largely due to California’s adoption of the stricter ABC test. 

Conclusion

If you are in business and wish to employ individuals to participate in your day-to-day business operations, seek professional guidance if you are contemplating hiring them as anything other than bona fide employees. The financial consequences of misclassifying a worker can be costly.