Employee vs. independent contractor status: the section 530 safe harbor.

Any practitioner who has advised a client on the status of a worker as an employee or an independent contractor under the 20-factor common-law test (now found in Rev. Rul. 87-41) has probably not recovered from the experience. It is difficult to imagine a more frustrating area of tax law; at least one professional described this as subjectivity, uncertainty and exposure all rolled into one. And with the extensive IRS audit efforts in this area, the key word is exposure.

As long ago as 1978, Congress enacted Section 530 of the Revenue Act of 1978 in an effort to relieve the nightmare of the 20-factor common-law test, by providing some objective guidance and protection for taxpayers faced with such a classification issue. Section 530 created a "safe harbor" for taxpayers classifying individuals as independent contractors; if certain requirements are met, an employer may treat an individual as an independent contractor for employment tax purposes without having to resort to an analysis of the 20-factor common-law standard.

As will become apparent, Section 530 provides limited relief for taxpayers; the requirements that need to be satisfied to obtain relief, while not, as nightmarish as the 20-factor test, are nevertheless difficult to apply; they are quite subjective, and are frequently difficult to satisfy. Moreover, Section 530 has no effect on the employee's employment and income tax responsibilities, nor does it address the potential excise tax exposure that may result from misclassification.

Rev. Proc. 85-18 sets forth the current guidelines for applying the provisions of Section 530. In general, if a taxpayer has a "reasonable basis" to treat a category of workers as independent contractors for all periods after 1978, and all employment and other Federal tax returns are properly filed consistent with classifying these workers, as independent contractors, the workers are deemed to be independent contractors for employment tax purposes. In addition, the employer must have treated all individuals holding "substantially similar positions" as independent contractors. If the Section 530 safe harbor rules do not apply, no presumption of employment status is made. Instead, the taxpayer and the Service must apply the 20-factor common-law test to determine whether the workers are employees or independent contractors.

What is a "reasonable basis"?

In enacting Section 530, Congress made it clear that the term "reasonable basis" should be construed liberally in favor of taxpayers. Congress provided that, if any of the following alternatives were met, the "reasonable basis" standard would be satisfied:

1. Classifying the individual as an independent contractor is supported by judicial precedent, published rulings, a technical advice memorandum issued with respect to the taxpayer, or a letter ruling issued to the taxpayer.

2. A past employment tax or other IRS audit resulted in no assessment of employment taxes for improperly classified employees in substantially similar positions.

3. The independent contractor classification is supported by a long-standing and recognized practice in a significant segment of the taxpayer's industry.

If none of these alternatives are satisfied, a taxpayer may still provide other evidence to establish that it meets the "reasonable basis" test.

Although the reasonable basis standard is arguably too subjective, the taxpayer's burden of proving that a reasonable basis exists for independent contractor status should be somewhat less than it is for proving correct treatment as an independent contractor under the 20-factor common-law test.

Consequence of treatment as an

employee

If at any time a taxpayer treats a particular individual as an employee, payments to that individual and all other individuals in substantially similar positions will generally not qualify for Section 530 relief. The IRS has held that merely withholding payroll taxes from a payment to an individual qualifies as employee treatment, even if the taxes are not paid over to the Service. Moreover, filing and employment tax return that includes a payment to an individual also qualifies as employee treatment, even if no taxes were withheld. However, filing an employment tax return as a result of an IRS compliance audit does not, preclude Section 530 relief for the period under audit, while continuing to treat the individual as an employee in subsequent years does.

Filing all required Federal

returns

As noted, Section 530 relief is unavailable unless all Federal tax returns are filed on a basis consistent with treating the individual as an independent contractor. The Service has ruled that a Form 1099 classifying the individual as an independent contractor must be filed time to qualify for Section 530 relief. Delinquent filing, or failure to file a Form 1099 for any payment $600, will generally disqualify the taxpayer for relief as to the unreported payment. It may also disqualify payments made to all others providing substantially similar services.

Consistency of treatment

Section 530 relief is not available for any individual who has been treated by the employer as an employee during any period after 1977. Section 530 relief is also precluded for individuals if any individual in a substantially similar position has been treated as an employee in the same or any prior period.

Substantially similar

positions

Individuals in substantially similar potions include those doing work of a substantially similar nature. It is very possible that Section 530 relief could be lost for a category of workers if any employee since 1978, including the owner, has performed duties that are substantially similar to one or more of the taxpayer's current independent contractors. Workers may be in a substantially similar position despite the existence of certain differences, such as the methods for determining compensation or requiring daily reports of some worker but not others.

Certain technical contractors

excluded

As a result of an amendment to the law in 1986, Section 530 relief is not a available for payments made by an employer to an individual contracted out by the employer to a third party, if the individual provides services as an engineer, designer, drafter, computer programmer, systems analyst or other similar work.

Example: Company A contracts with company D for drafting services. D pay E to provide the services to A and bills A direct for E's services. D does not qualify for Section 530 relief for its payments to E. Remember, however, that the failure to qualify E as an independent contractor under Section 530 does not preclude D from treating E as an independent contractor if the common-law test is satisfied. Also note that if E contracted himself directly to A, A could qualify for Section 530 relief.

Safe harbor for employer only

The provisions of Section 530 relate only to the employer's liability for employment taxes. The safe, harbor cannot change the worker's actual status. In fact, the IRS views workers who qualify for Section 530 relief as employees for other Federal tax purposes. For example, business expenses of Section 530 independent contractors could be claimed only as itemized deductions (i.e. they are not deductible on Schedule C).

What to do now

Employer should evaluate whether the requirement of Section 530 have been satisfied. Care must be taken to identify all worker potentially in substantially similar positions. If the Section 530 requirements cannot be satisfied, an effort must be made to document worker relationships under the 20-factor common-law test. If there is any doubt, a taxpayer can request an IRS determination of an individual's status as an employee or independent contractor for employment tax and withholding purposes by filing Forms SS-8.

It can be quite costly to have independent contractors reclassified as employees. Even the cost of defending appropriately classified contractor can be significant. Thus, for those businesses that can meet the Section 530 safe harbor, adherence must be documented. Job description for employees should be clearly spelled out to differentiate duties from those being done by independent contractor. As a general rule, no independent contractor should be taken on as an employee at a later date unless the duties will be very dissimilar from the services previously provided.