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Independent contractor safe harbors: not so safe.

Traditionally, employee versus independent contractor determinations have been decided based on 20 common law factors. These 20 common law factors are well established and recognized.(1) The importance of these determinations have focused on the taxes imposed by the Federal Insurance Contributions Act (FICA), the Self Employment Contributions Act (SECA) and the Federal Unemployment Tax Act (FUTA). However, new issues are now being raised by the IRS in the employee versus independent contractor determinations.

Employers prefer independent contractor status for their workers since it reduces the costly responsibility for paying these taxes along with the administrative costs. Workers favor being classified as an independent contractor because it allows them the opportunity to deduct certain expenses that would otherwise be disallowed or limited for an employee. The IRS is not as concerned with the classification as it is with the fact that it perceives independent contractors to be less likely to report their income and pay any taxes that are due. Administratively, it is easier for the IRS to audit and assess the employer. The IRS has often been overzealous in attempting to collect these lost revenues, not with the culprit--the non-reporting independent contractor--but with the company that employed the worker.

Section 530 of the Revenue Act of 1978(2) was passed to protect taxpayers who had made a reasonable determination that a given individual was an independent contractor rather than an employee. Although it is not a part of the Internal Revenue Code, Section 530 originated as a temporary provision and was made permanent in 1982.(3)

Current Developments

The IRS has once again stepped up the attack in the longstanding conflict of employee versus independent contractor status. One area the IRS has been closely examining is certain groups of professionals associated with business corporations. These professionals include doctors, dentists and optometrists who are subject to state regulatory licensing.

Rather than form their own professional corporation, these individuals conduct their practices at the facilities of a business corporation. The business corporation provides the facilities and support to the professional who is treated as an independent contractor by the business corporation. The business corporation is generally owned and managed by a non-professional. This precludes the business from forming a professional corporation.

The reason the business corporation treats the professional as an independent contractor as opposed to an employee is that the business corporation would be deemed as practicing as a licensed professional if the professional is treated as an employee (i.e., a license to practice medicine cannot be issued to a corporation). Both the business corporation and the professional would be in violation of state law in such a case.(4)

A recent district court case appears to support the Congressional intent that the reasonable basis requirement be construed liberally in favor of this type of taxpayer.(5) However, serious questions remain concerning the IRS's use of the safe harbor provisions of Section 530 against the taxpayer in issues outside the traditional area of employment taxes.

Safe Harbor Provisions

During the late 1960s, the IRS increased its enforcement activity in the area of employment taxes. The IRS aimed its activity at employers. If the IRS was successful in reclassifying the payments made to independent contractors, the employer would be liable for withholding, social security and unemployment taxes that had not been withheld nor paid to the Treasury.

Taxpayer dissent became very vocal, with complaints that the IRS was reversing previous private rulings and taking positions not raised in previous audits. Congress addressed this problem in 1976 by asking the IRS to postpone any changes in position or any newly stated positions until the Joint Committee on Taxation had an opportunity to study the issue. Congress followed with the passage of Section 530 of the 1978 Revenue Act.

Section 530 is a curative piece of legislation providing remedial relief for employers. Its purpose is to protect those employers who have made a good faith effort to classify their workers.(6) If an employer has a reasonable basis, has filed the required information returns and has not treated any other similar workers in a different manner, the employer will be protected from an IRS reclassification. By establishing a number of safe harbor provisions, this provision limits the IRS's ability to force employers to reclassify workers.

The three safe harbor provisions were established to provide protection from an unexpected assessment in the employers' liability for employment related taxes. If any of the three provisions are met, the IRS is prevented from making an assessment of the taxpayer for the employment taxes. First, if the taxpayer had a reasonable basis for treating the worker as an independent contractor, such as judicial precedent, published rulings, technical advice with respect to the taxpayer, a letter ruling, or a determination letter, the taxpayer would be protected. Judicial precedent and published rulings do not have to relate to the industry or business the taxpayer is engaged in to be relied upon. Secondly, the taxpayer can maintain that position if relying on a past IRS audit of the taxpayer. Finally, if the taxpayer can show such treatment coincided with a long-standing, recognized practice of a segment of the industry in which the taxpayer is engaged, the IRS is precluded from reclassifying the taxpayer's position.

The three statutory methods for establishing a reasonable basis for the treatment of a worker as an independent contractor are not exclusive. If a taxpayer can demonstrate a reasonable basis for the treatment in some other manner, the taxpayer will still be entitled to a termination of any assessed employment tax liability. However, the IRS does not extend these safe harbor provisions beyond the employment taxes.

The Queensgate Case

A recent district court case has appeared to provide some relief for licensed professionals, including doctors, dentists, optometrists, etc. In Queensgate Dental Family Practice, Inc.,(7) it was held that dentists working exclusively for a corporation that provided dental services were not employees for Federal employment tax purposes. The taxpayer qualified for relief from reclassification under Section 530 by establishing reasonable basis.

Reasonable basis was established by relying in good faith on advice given to the taxpayer by the state dental board's counsel, who advised that the dentists must be treated as independent contractors by the business corporation since any type of employment relationship would be considered illegal under state law.

In this case, a group of dentists had a full-time working relationship with a non-professional business corporation that operated facilities where the dentists conducted their practice. The president of the corporation was not a dentist; therefore, the business could not be formed as a professional corporation.

The IRS argued two main points. First, Queensgate Dental Corporation could have formed as a professional corporation. The establishment of a business corporation was merely one manner of business formation. The dentists could have been treated as employees by establishing a professional corporation rather than the business corporation that was established. The IRS felt that by using the existing structure, it was merely a matter of business convenience not to treat the dentists as employees even though they had the option to do so.

Secondly, the government contended that the Court should first determine if the dentists were employees or independent contractors based on the facts and circumstances before applying Section 530. Although this issue was rejected by the Court, it is very important to taxpayers in looking at future potential issues that may be raised.

Queensgate's defense was that they had relied on an opinion of the Pennsylvania Dental Board that stated it would be illegal under state law for the corporation to enter to an employer-employee relationship with the dentists. Therefore, the dentists had to be treated as independent contractors or they would be in violation of state law. For example, a nonprofessional corporation employing a licensed practitioner would be guilty of practicing a profession without a license.(8)

In holding for Queensgate, the Court concluded that Queensgate's reliance on the Dental Board's advice that a nonprofessional corporation could not enter into an employer/employee relationship with a licensed dentist was reasonable basis under the safe harbor provisions of Section 530 for treating the dentists as independent contractors and reclassification was not appropriate in such a situation.

The Court rejected both of the government's points. First, the Court stated that Congress did not intend that Section 530 require a taxpayer to structure a business in such a way to qualify workers as employees. Rather, Section 530 merely requires that the taxpayer's "beliefs and decisions" used to determine the treatment of individuals as either independent contractors or employees were "reasonable and made in good faith." Second, the Court believes the intent of Section 530 was to specifically eliminate the need for courts to become involved in examining the detail of complex factual issues necessary to determine whether under common law an individual is an independent contractor or an employee.

Far-Reaching Consequences for the Professional

While commentators have been citing this case as a victory for the taxpayer,(9) the consequences and issues unresolved by this case may be more far-reaching than would appear at first glance. Practitioners should be cautioned that unintended consequences could follow when representing similarly situated professionals. This would include doctors, dentists, optometrists and any other professionals who are regulated by state law, who are currently employed by a nonprofessional corporation and who are treated as independent contractors on the pretext of the advice of their state board as to an illegal employee-employer relationship serving as a safe harbor.

In Queensgate, the independent contractor status was established for the dentists by relying on Section 530 and not by the 20 common law factors. The IRS may interpret reliance on Section 530 as an admission that independent contractor status could not be established under the common law factors and attack those areas of the tax law not protected by Section 530.

The IRS has ruled that when a taxpayer has obtained safe harbor relief under Section 530, there is no change in the way the status, liabilities and rights of the worker are determined. Section 530(a)(1) terminates the liability of the employer for the employment taxes but has no effect on the workers. It does not convert individuals from the status of employee to the status of self-employed.(10) That is, the relief provided by Section 530 only terminates the liability of an employer for the employment taxes--it will not convert individuals from the status of employee to the status of self-employed for all purposes. The individual could be considered an employee for all other purposes.

This position could have severe consequences in the case of a professional who maintains tax qualified retirement and/or other employee benefit plans. In the Queensgate case, while it could be concluded that the employer's reliance on state law regarding the illegality of the employer-employee relationship would be a basis for safe harbor relief and therefore relieve the employer for payroll taxes, the individuals relying on this safe harbor provision could be classified as employees for other purposes. The taxpayer would then be placed in noncompliance with KEOGH-SEP requirements and for state regulatory licensing purposes.

While professional taxpayers may have won the battle involving FICA, Federal employment taxes and income taxes withheld, they could ultimately lose the war. If a professional relies on safe harbor relief in an earlier situation, all pension contributions could be recharacterized at a later date since the professional would be considered an employee, not self-employed.

While the IRS has not formally published an opinion, it has informally indicated that it intends to take the position that any taxpayer relying on the safe harbor provisions is in effect admitting that the affected workers are employees. Thus the taxpayer could be charged with violating state licensing board regulations regarding the unauthorized practice of the profession and could face both criminal charges and possible revocation or license suspension. Additionally, the self-employed status for KEOGH/SEP pension purposes could be lost.

In Queensgate, it appears the Court may have anticipated some of these problems, since the decision also examined the relationship between the dentists and the corporation and found that the dentists had met the common law factor test showing independent status as opposed to employee status.

Therefore, taxpayers such as optometrists, doctors, dentists and other similarly situated professionals who are controlled by state licensing laws should be very careful in structuring a response to an employee tax compliance audit. While Section 530 may protect the professional from employment tax deficiencies, the taxpayer could face increased problems concerning pension and employee benefit qualifications. The final question is if the IRS is successful in any of these attacks, would professionals be in violation of state law and subject to losing their licenses and other disciplinary proceedings?


While it may first appear that the Queensgate case represented a victory for the taxpayer, the underlying implications and unanswered questions of this case appear to pose many serious problems. Specifically, applying safe harbor status in such situations may have unintended consequences: the taxpayer who relies on Section 530 safe harbor provisions is in effect admitting that the worker is an employee. Thus, for purposes of pension plan funding, employee benefits and state regulatory licensing provisions, the taxpayer may face unintended consequences, including criminal charges.

In view of the potential fallout described in this article, taxpayers who face worker recharacterization audits should pay careful attention to how they formulate a response.


1 See Revenue Ruling 87-41, 1987-1 C.B. 296. The ruling summarizes cases and rulings to establish 20 factors or elements that determine if sufficient control exists to establish whether an individual is an employee. The 20 factors were designed only as a guide for making determinations.

2 Revenue Act of 1978, P.L. 95-600, 95th Cong., 2nd Ses., 530, as amended by P.L. 96-167, P.L. 97-248 and P.L. 99-514.

3 See 269(c) of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).

4. For example see John H. Michell v. Louisiana State Board of Optometry Examiners, 156 So.2d 457, 245 La. 1 (June 28, 1963).

5 See Queensgate Dental Family Practice, Inc. v. U.S., U.S. District Court, Middle Dist. of Pennsylvania (September 5, 1991), 68 AFTR 2d 91-5679.

6 See Donovan v. Tastee Freez (Puerto Rico), Inc., 520 F. Supp. 899, 903 (D.C. Puerto Rico 1981); United States v. MacKenzie, 777 F.2d811, 815, 57 AFTR2d 86-319, 2d Cir. 1985; and General Investment Corp. v. United States, 823 F.2d 337, 340, 60 AFTR 2d 87-5395, 9th Cir. 1987.

7 Queensgate Dental Family Practice, Inc. v. U.S., U.S. District Court, Middle District of Pennsylvania, 68 AFTR 2d 91-5679 (September 5, 1991).

8 For example see Neill v. Gimbel Brothers, Inc., 330 Pa. 213, 199 A. 178 (1938); Neill v. Bloch, 330 Pa. 222, 199 A. 182 (1938); Neill v. Stern and Company, 330 Pa. 224, 199 A. 182 (1938).

9 For example see "Dentists Practicing in Facilities Owned by Business Corporation Were Independent Contractors," The Practical Accountant, January, 1992, p. 8.

10 See Section 3.08 of Revenue Procedure 85-18, 1985-1 C.B. 518 (April 1, 1985).

Randall M. Miedaner, JD, CPA, CFP, is an attorney in Baton Rouge, Louisiana, who practices primarily in the areas of tax and business law. He received his law degree from Louisiana State University, where he currently holds an adjunct faculty position in the accounting department at the school of business.

Joseph M. Hagan, PhD, CPA, is an assistant professor at Louisiana State University and teaches primarily in the area of business entities. He has published articles in numerous professional journals.
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Author:Miedaner, Randall M.; Hagan, Joseph
Publication:The National Public Accountant
Date:Jul 1, 1993
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