How to survive an employment tax audit.

Once a clients has been selected for an employment tax audit examining whether its independent contractors should be reclassified as employees, what happens next? This article provides a blueprint to the Federal employment tax audit process and also offers guidance on correlative state tax audits.

The IRS estimates that more than one-half of the roughly five million Americans now working as independent contractors should be reclassified as employees.(1) Since establishing the Employment Tax Examination Program in 1988, the Service has assessed more than $670 million in penalties and back taxes and has forced businesses to reclassify over 430,000 independent contractors as employees.(2) Although tax advisers do not typically plan for or look forward to any type of tax audit, in particular, employment tax audits can become time-consuming, detailed and costly; however, preventive measures and steps can be taken to ensure adequate preparation.

This article prepares readers for employment tax examinations and highlights recent developments in this area. Employment tax audits may be successfully handled by:

* Obtaining a clear understanding of the facts and circumstances.

* Performing a "pre-audit" analysis.

* Knowing the areas of interest to the agent.

* Making a strong case at the compliance-check stage of the audit.

* Setting the stage for Revenue Act of 1978 Section 530 (RA '78 Section 530) relief.

* Resolving issues and negotiating a settlement early in the audit Process.

Understand the Facts and Circumstances

For employment tax review purposes, the Service may conduct a "compliance check" (i.e., a perusal of the client's Federal employment tax forms and a brief interview centering around the 20 factors in Rev. Rul. 87-41(3)) or a full-scale audit (i.e., an extensive and detailed examination of the client's books and records). On receiving notification from the Service that a client has been targeted for an employment tax audit or for a compliance check, it is imperative to begin to prepare a case by obtaining a clear understanding of the facts and issues relevant to the audit or compliance check.

The preliminary fact-gathering process is essential to the tax advisers understanding of relationships with workers, sheds light on the company's strengths and weaknesses and limits the possibility of surprises. Most importantly, however, the fact-gathering process prepares the adviser for the detailed questions that the IRS examiner will ask during the audit or compliance check. In today's high-technology world, agents have access to much of the information the client has reported in the past and usually have an idea or strategy in place at the outset. Obviously, the practitioner should know the filing base better than the agent before the first meeting; this will be critical to a successful outcome.

The agent may raise concerns regarding independent contractors. The practitioner will need to establish a listing of all workers, outside vendors and other entities used as contractors. A review of all Forms 1099 issued, as well as Forms W-2, should assist the practitioner in compiling this list. In addition, interviews with management, members of the human resources, payroll and legal departments, and with the workers should be conducted if necessary to determine whether the facts surrounding the work relationship support the company's classification scheme.(4)

All documents and filings relevant to the relationship between the worker and the company should be reviewed to determine whether the worker has been consistently classified from year to year.(5) Standard employment contracts and other retainer agreements between the company and all contractors should be scrutinized.(6) Any formal written policies, training materials, and other company literature relating to its worker classification policies should also be reviewed.

At the conclusion of the fact-gathering and investigative process, the tax adviser should have a clear understanding of the client's payroll positions and exposure points, and be armed with documentation and substantiation supporting these relationships.

Perform a Pre-Audit Analysis

Once an exhaustive list of all workers at issue has been compiled, a detailed review of each individual worker's job function and his relationship with the employer should be conducted. For employers with several workers performing the same function, a review of each job category or position will suffice.

The determination of whether a worker is an employee or an independent contractor is governed by guidelines set forth in Secs. 3121(d)(2) and Regs. Secs. 31.3121(d)-1(c),31.3401(c)-1 and 31.3306(i)-1. These regulations provide that an employer-employee relationship generally exists when the person for whom the services are performed has the "right" to direct and control the individual who performs die, services as to the result to be accomplished, and also as to the details and means by which the result is accomplished. It is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.

To assist in determining the proper classification of workers, the Service has identified 20 common-law factors in Rev. Rul. 87-41 that serve as guides for establishing whether sufficient control exists for validating the employer-employee relationship.(7) These 20 factors were developed based on an examination of case law and rulings. The client and the tax adviser must attack the fact-gathering process armed with these factors, which the IRS will consider in evaluating the client's classification schemes.

Once it has been determined which workers (if any) may potentially be reclassified, an extensive analysis of the potential tax exposure associated with these workers should be developed. This analysis should include a summary of amounts paid, the Federal (and, if applicable, state) income tax withholding, Medicare and social security taxes associated with these amounts and any penalties and interest that may be assessed.(8) At the conclusion of the pre-audit analysis, the adviser win have a clearer picture of the magnitude and seriousness of the client's potential tax exposure. Similar work-ups should be performed for other payroll issues, such as fringe benefits or cafeteria plans, which may have been targeted by the agent for review.

It is important to protect and limit access to this information and the related analysis by avoiding their widespread circulation. The danger is that an agent will request this information because he has inadvertently discovered its presence and may take it out of context. Legal advisers should be consulted if there are concerns about retaining privilege over confidential matters.

Know the Agent's Areas of Interest

In targeting responses to the agent's requests, it is critical to know his areas of interest. The agent should be asked the purpose of any requested meeting or document. Once the areas of interest have been ascertained, the practitioner should familiarize himself with the agent's procedures regarding the issue, particularly whether the workers at issue belong to a particular class or industry targeted for review by the Service on a national basis. News columnists and freelance reporters in the news industry and various workers in the trucking industry, for example, have most recently been the targets of increased scrutiny by the Service.

In August 1996, the Service released a new training manual for agents/examiners evaluating worker classification schemes.(9) This manual is an extremely important document that assists agents in evaluating evidence presented in worker classification disputes. The Service has prioritized the 20 factors discussed in Rev. Rul. 87-41 into three broad categories of evidence: behavioral control, financial control and relationship of the parties.

Individuals within the client's organization who have hiring authority should familiarize themselves with this training manual. The manual provides insight on the manner in which the IRS expects its agents to investigate certain issues and provides an important inside view of which inquiries will be made.(10)

Make a Case at the Compliance-Check Stage

Although a compliance check is typically the first level of review, it should be taken seriously. The tax adviser must make his case convincingly at the compliance-check stage to decrease the likelihood of a compliance check advancing to a full-scale audit.

The practitioner should cooperate with the agent by timely responding to all requests for information. Arguments and documentation supporting the treatment of issues should be presented in a clear, concise and well-organized manner. Some experts advise inundating the agent with information, records and documentation during the compliance-check stage, arguing that it is better to give an agent more information than he requests.(11) On the other hand, many agents now request data in an electronic format and have access to Programmers who can assess large volumes of data. Suggested samplings may help to better control the progress of the review. Cooperating with the agent during the compliance-check stage may successfully avoid a full-scale employment tax audit.

Set the Stage for RA '78 Section 530 Relief

If the examining agent determines that a class of workers should be reclassified as employees, the first weapon in combating any deficiency is RA '78 Section 530. RA '78 Section 530 provides employment (but not income) tax relief to employers who, in good faith, have mistakenly classified workers as independent contractors and, as a result, have failed to pay the Federal employment taxes associated with them.

RA '78 Section 530 was enacted in 1978 to combat what Congress perceived to be overly aggressive tactics used by the Service to reclassify workers and pursue collection of employment taxes. RA '78 Section 530 relieves an employer from Federal employment tax liability when it can demonstrate that (1) it did not treat an individual as an employee for any period (RA '78 Section 530(a)(1)(A)), (2) in the case of periods after 1978, it filed all Federal tax returns (including information returns) on a basis consistent with the workers being treated as independent contractors (RA '78 Section 530(a)(1)(13)), (3) it did not treat any worker holding a substantially similar position as an employee for employment tax purposes for any period beginning after 1977 (RA '78 Section 530(a)(3)) and (4) it had a reasonable basis for not treating the worker as an employee (RA '78 Section 530(a)(1), flush language).

RA '78 Section 530 offers three nonexclusive standards as safe harbors in determining whether a taxpayer had a reasonable basis for not treating a worker as an employee. The statute provides that a taxpayer may reasonably rely on (1) Judicial precedent, a published ruling, a letter ruling, technical advice or a determination letter issued to the taxpayer, (2) a prior IRS audit resulting in no assessment attributable to the treatment of the individual whose status is at issue and (3) a long-standing, recognized practice of a significant segment of the taxpayer's industry.(12) Employers may also rely on any other reasonable basis for not treating a worker as an employee, such as the advice of an attorney or accountant,(13) prior state administrative action (e.g., workers' compensation decisions)(14) or other Federal determinations (e.g., determinations under the Fair Labor Standards Act).(15)

Notably, the Service has been restrictive in its interpretation of the RA '78 Section 530 safe harbors, imposing burdensome and stringent requirements on taxpayers seeking to invoke such relief. In response, Congress issued amendments to RA '78 Section 530 in the Small Business Job Protection Act of 1996 (SBJPA). The congressional intent in passing the amendments was to clarify the guidelines for relief by further easing the burden of proof required by taxpayers.

The SBJPA

SBJPA Section 1122(a) substantively amended RA '78 Section 530, generally for periods after 1.996. The most significant amendments are:

* Taxpayers may not rely on RA '78 Section 530 relief for nonemployment tax audits commencing after 1996.

* A significant segment of the taxpayer's industry means a practice used by 25% of the industry.

* To be considered a long-standing industry practice, it is not necessary for the practice to have existed for more than 10 years.

* The Service does not have to determine that an individual is the taxpayer's employee before RA '78 Section 530 may apply.

* For disputes involving periods after 1996, the burden of proof shifts to the IRS once the taxpayer establishes a prima facie case of reasonableness under the three statutory safe harbors.(16)

RA '78 Section 530 was intended to be applied liberally in favor of taxpayers and to grant administrative relief to taxpayers who had a reasonable basis for treating workers as independent contractors. Therefore, by conforming with the RA '78 Section 530 relief provisions to the greatest extent possible in advance of any IRS examination or compliance check, the tax adviser will be in a better position to negotiate the lowest possible settlement for the client if and when the IRS challenges the classifications.(17)

Resolve Issues and Negotiate Settlement

In an effort to ease the administrative burden associated with resolving employment tax audits, the Service has developed the Early Referral to Appeals and Classification Settlement Programs ("CSP") as taxpayer incentives. These programs encourage resolution of classification issues as early in the administrative process as possible.

Managing an audit is a process of negotiation that involves identifying, prioritizing and resolving issues raised by the agent. Caution is advised, however, in settling an issue too early in the process when other issues have yet to be explored and further potential adjustments could occur. Timing is important when negotiating a settlement; the resolution of an early issue may be a trade-off or counterpoint to a later one. The tax adviser has a right to see the whole before settling on a part. Once the timing concerns have been resolved, use of the Early Referral and CSP processes can lead to favorable results.

Early Referral to Appeals

Rev. Proc. 96-9(18) sets forth a process that allows taxpayers to refer any unagreed issue arising from an examination (subject to certain exceptions) that has been developed and is under the district director's jurisdiction. Any issue whose resolution would reasonably be expected to result in quicker resolution of the entire case and that both the taxpayer and the district director agree should be referred would be considered appropriate for early referral.(19)

Sec. 3509

Sec. 3509 provides relief for employers who have failed to deduct and withhold the appropriate amount of income tax and the employee's share of FICA tax for reclassified workers who were previously treated as nonemployees.(20) If it can be shown that there was no intentional disregard of the requirement to deduct and withhold taxes from the employee's wages and that the reporting requirements of Secs. 6041(a), 6041A and 6051 have been met, the liability under Sec. 3509(a)(1) for Federal income tax withholding purposes will be limited to 1.5% of wages paid to the employee. Under Sec. 3509(a)(2), the employer's liability for the worker's share of FICA taxes will be 20% of the amount that otherwise would be imposed without the application of Sec. 3509. If, in the alternative, the worker misclassification was not due to intentional disregard, but the employer failed to satisfy the reporting requirements without reasonable cause, liability will double under Sec. 3509(b)(1) to 3% of wages for income tax withholding and 40% of the employee's share of FICA taxes that otherwise would have been due. No relief is provided for the employer's share of FICA and FUTA.

While Sec. 3509 may present tremendous tax savings and settlement incentives, the relief provision does not apply in all circumstances. For example, according to Sec. 3509(d)(2) and Regs. Sec. 31.3509-1(d)(2), Sec. 3509 does not apply to wages for which the employer deducted and withheld income taxes, but failed to deduct and withhold the employee's share of FICA taxes. Thus, while Sec. 3509 provides incentives, there are restrictions. If the employer qualifies for Sec. 3509 protection, however, it will more than likely produce positive results. This provision should also be kept in mind when searching for a reasonable offer of settlement, even if the literal terms of the statute are not met; however, the agent may refuse the settlement offer.

CSP

The CSP gives employers who have erroneously treated workers as independent contractors the option to resolve their case and face a reduced employment tax assessment under Sec. 3509. The CSP was established by the Service as an optional settlement program for resolution of worker classification cases earlier in the administrative process and for much lower amounts than possible under normal procedures.(21) Because worker misclassification has emerged as a hot issue for IRS examiners, it is important that organizations with exposure to assessment of tax and penalties recognize CSP as an invaluable tool for reducing that exposure. If settlement is desired, the CSP would limit the time and cost associated with taking the case to court or to appeals. However, the income tax effect of reclassification (e.g., the qualification of the employer's benefit plans) must be considered.

Under the CSP, the client can enter into a closing agreement with the IRS limiting the amount owed to either 25% or 100% of the employment tax assessed for the most recent year under audit.(22) The 25% rate will apply if the reporting and substantive consistency requirements are met and the reasonable basis tests enunciated in RA '78 Section 530 are satisfied. If the reporting consistency requirement of RA '78 Section 530 is not met, the client will not be eligible to participate in the CSP.(23) The examiner, under the CSP, must determine RA '78 Section 530 eligibility and whether the client is eligible for a CSP offer. Examiners have the option of offering a CSP settlement. Participation in the CSP is entirely voluntary; a CSP settlement offer may be accepted at any time during the examination process. By declining a CSP offer, however, an employer does not waive its right to a conventional administrative appeal or to judicial review.

The CSP is currently available to any taxpayer with an open case in either the examination or appeals divisions of the IRS on March 5, 1996, and to anyone who has initiated a case during the two-year period thereafter (i.e., through March 5, 1998). The pro gram was originally implemented on a two-year basis and has been extended indefinitely.(24) If the tax adviser determines that it would be administratively advantageous to settle the case, the CSP may be an invaluable tool that actually benefits both the client and the Service.

State Tax Audits

Employment Taxes

Federal employment tax audits often trigger state employment tax audits, because the Service shares data with state taxing authorities. Although most states follow the Federal rules, they are not bound by them and may provide their own guidelines and procedures for determining contractor status and analyzing other employment tax issues. Certain states, for example, may not adhere to the 20-factor test set forth by the Service, and may instead follow a 10-factor analysis for determining independent contractor status. For this reason, although states typically reclassify all workers reclassified for Federal tax purposes, they may also reclassify additional workers and may even classify workers differently than they were classified for Federal tax purposes.

Another significant issue is the withholding on and treatment of multistate contractors and employees. Because these workers typically perform services in several states, each state may expect withholding, payment and deposit of applicable state payroll taxes.

State employment tax audits should be handled using the same approach discussed above for Federal audits. If a client becomes the target of a state employment tax audit, the state regulations should be consulted.

Unemployment Tax

State unemployment tax audits have many of the same characteristics as audits by other payroll tax jurisdictions; thus, the employer guidelines offered for audits of other payroll taxes should be applied to state unemployment audits. Some key issues unique to state unemployment tax audits are discussed below.

Unemployment claims are the leading triggers for federal, state and local payroll tax audits. Employee versus independent contractor issues trigger audits because of the following state unemployment process.

States collect quarterly listings of employee wage data from employers with their state unemployment tax returns. These quarterly wage listings are loaded into massive state databases that contain the quarterly earnings history for all employees of all employers doing business in each state. When individuals file claims for unemployment benefits, they tell the state where they worked and why they lost their Jobs; the state scans its wage database to confirm the earnings history for the identified employer.

If the state does not find a record of wages for the claimant reported by the employer, it investigates. For an auditor, there is no more compelling evidence of a problem than when an individual considered himself an employee (as evidenced by an unemployment claim) and the employer did not. Once an auditor approaches the employer regarding one such incident, the employer should prepare to defend its position on every independent contractor used.

Another issue unique to state unemployment audits is that each state has the ability to define employee versus independent contractor status. Most states refer to the Federal definitions, but some do not. A practitioner confronted with an unemployment audit on this issue should check the state regulations. At any rate, state unemployment tax audits should be handled in the same mariner outlined above for Federal payroll tax audits.

Conclusion

A thorough review of the client's employment tax classifications prior to meeting with any auditor will prepare the tax adviser to answer the agent's inquiries. Armed with a full understanding of the potential tax exposure involved, the practitioner should work diligently during the compliance-check stage to document and establish the reasonableness of the client's classifications. By satisfying the requirements of the RA '78 Section 530 relief provisions to the greatest extent possible before the audit begins, the tax adviser will be in a better position to negotiate the lowest possible settlement after referring open items to appeals and evaluating any CSP offers.

Author's note: Special editorial comments were provided by Debra Heikkinen, Senior Tax Manager, Deloitte & Touche LLP, Stanford, CT.

(1) Haupt, "Heading Off an IRS Audit," 84 Nation's Business 42 (March 1996).

(2) Wood, "A Roadmap for Employment Tax Audits," Legal Guide to Independent Contractor Status (John Wiley & Sons, Inc., 2d ed., 1997 Supp.) (hereinafter, "Wood"), p. 15, citing Bouard, "The IRS V. the Self-Employed," The Wall Street Journal (4/7/93), p. B-3. See also Selz and Mehta, "Small Businesses Get Big Bills as IRS Targets Free-Lancers," The Wall Street Journal (8/24/95), p. B-1.

(3) Rev. Rul. 87-41, 1987-1 CB 296.

(4) Wood, note 2, p. 15, n. 6.

(5) See id.

(6) It is important to communicate with the company's legal department or outside counsel administering these documents.

(7) See Tax Clinic, "Employee versus Independent Contractor Status," 18 The Tax Adviser 525 (July 1987); Burns and Freeman, "Avoiding IRS Reclassification of Workers as Employees," 27 The Tax Adviser 102 (Feb. 1996).

(8) This should be compared with potential tax assessments at full Sec. 3509 rates (discussed below).

(9) Training 3320-102 (Rev. 10-96), TPDS 842381 (issued 3/4/97).

(10) The manual can be accessed via the Web at http://www.irs.ustreas.gov or requested in writing to: Internal Revenue Service, Freedom of Information Reading Room, P.O. Box 795, Ben Franklin Station, Washington, D.C. 20044.

(11) Haupt, note 1, at p. 42.

(12) See Rev. Proc. 85-18, 1985-1 CB 518, superseding Rev. Proc. 81-43, 1981-2 CB 616.

(13) See In re Edward W. McAtee, 115 BR 180 (D.C. Iowa, 1990)(66 AFTR2d 90-5739, 90-1 USTC [paragraph] 50,242); Bonnie G. Overeen, D.C. Okla., 1991 (71 A AFTR2d 93-4557, 91-2 USTC [paragraph] 50,459); Smoky Mountain Secrets, Inc., D.C. Tenn., 1995 (76 AFTR 2d 95-6974, 95-1 USTC [paragraph] 50,573); the latter is discussed in Gee, "Smoky Mountain's Secret to Successfully Claiming Workers to Be Independent Contractors," 27 The Tax Adviser 370 (June 1996).

(14) See Queensgate Dental Family Practice, Inc., D.C. Pa., 1991 (68 AFTR2d 91-5679, 91-2 USTC [paragraph] 50,536).

(15) However, a determination that a worker was an independent contractor for state employment tax purposes does not preclude the Federal government from challenging the worker's status for Federal employment tax purposes if it was not a party to the action or in privity with the state; see Spicer Accounting, Inc., 918 F2d 90 (9th Cir. 1990)(91-1 USTC [paragraph] 50,103).

(16) See Jackson, Gee and Knight, "How to Shift the Burden of Proof to the IRS on Independent Contractor Status," 28 The Tax Adviser 642 (Oct. 1997).

(17) Veilleux and Martin, "Readying your Organization For an Employment Tax Examination: Your Chances for a Settlement just Got Better," 13 Exempt Org. Rev. 615 (April 1996).

(18) Rev. Proc. 96-9, 1996-1 CB 575.

(19) The Service outlined rules for applying Rev. Proc. 96-9, id., in Ann. 96-13, IRB 1996-12, 33. Although initially introduced on a test basis, the Early Referral program was extended in Ann. 97-52, IRB 1997-21, 22, to May 27, 1998.

(20) Wood, note 2, p. 50.

(21) See Ann. 96-13, note 19.

(22) See note 17.

(23) Stratton, "IRS Officials Clarify Scope of Worker Classification Initiatives," 71 Tax Notes 451 (4/22/96).

(24) See Notice 98-21, IRB 1998-15.

RELATED ARTICLE: EXECUTIVE SUMMARY

* Employment tax audits may be successfully handled by: obtaining a clear understanding of the facts and circumstances; performing a "pre-audit" analysis; knowing the agent's areas of interest; making a strong case of the compliance-check stage; setting the stage for RA '78 Section 530 relief; and resolving issues and negotiating settlement early in the process.

* Timing is important when negotiating a settlement; the resolution of an early issue may be a trade-off or counterpoint to a later one.

* Federal employment tax audits often trigger state employment tax audits, because the Service shares data with state taxing authorities.