IRS Worker Classification Audits: Navigating Clients to the Section 530 Safe Harbor
An oft forgotten weapon in a taxpayer’s armory for resolving federal tax worker classification audits is the Section 530 safe harbor. Originally enacted in 1978 in response to the Internal Revenue Service (IRS) aggressive approach to these audits, it remains a powerful shield against a worker classification exam. The IRS has softened its approach since 1978, but there is anecdotal evidence that worker classification is once again a hot button issue. Thus, for those that qualify, a Section 530 determination is the fastest and cheapest resolution to a worker classification audit. Moreover, unlike the various federal amnesty programs, it grandfathers the taxpayer’s classification of the workers as independent contractors.
To qualify under Section 530 a taxpayer must have procedural and substantive compliance, as well as a reasonable basis to rely on the safe harbor. To meet procedural compliance, a taxpayer must have filed all the returns required for the workers and the returns need to be consistent with nonemployee status. To meet substantive compliance, a taxpayer must have treated its workers (and any individuals holding a substantially similar position) as nonemployees for employment tax purposes. Lastly, the taxpayer must have a reasonable basis for relying on the safe harbor.
THE PROCEDURAL CONSISTENCY REQUIREMENT
Procedural consistency means that the taxpayer filed all information returns regarding its workers. Although Section 530 and its accompanying legislative history do not address whether such returns must be filed timely, the IRS’s position is that taxpayers must file Forms 1099 timely to qualify for Section 530 relief. See e.g. Rev. Rul. 81-224, Rev. Rul. 85-18 and Technical Advice Memoranda (TAM) 8251012 (Sept. 7, 1982), TAM 8302008 (Sept. 28, 1982), TAM 8322005 (Feb. 21, 1983), TAM 8403002 (Sept. 9, 1983), TAM 8424005 (Feb. 24, 1984) and TAM 8703002 (Aug. 27, 1986).
However, the Tax Court in Medical Emergency Care Associates, S.C. v. Commissioner, 120 T.C. 436 (U.S. Tax Ct. 2003) expressly rejected the IRS’s position that untimely filed Form 1099s bar Section 530 relief. The Tax Court held that the Commissioner has a variety of penalties that it can impose for late filers, but that denying Section 530 relief was not one of the penalties available. Id. at 444.
THE SUBSTANTIVE CONSISTENCY REQUIREMENT
Substantive consistency means that the taxpayer must treat similarly situated workers consistently. Thus, two individuals cannot perform the same tasks where one worker is an employee and the other is an independent contractor.
THE REASONABLE BASIS REQUIREMENT
With regard to the third requirement, Section 530 provides three safe harbors for establishing reasonable basis. Specifically, Section 530(a)(2) provides that reasonable basis is established “if the taxpayer's treatment of such individual for such period was in reasonable reliance” upon any of the following:
- Judicial precedent, published rulings, or technical advice or letter ruling to the taxpayer;
- A past federal employment tax audit in which no assessment was made on account of improper classification of workers holding substantially similar positions; or
- A long-standing recognized practice of a significant segment of the industry in which the worker worked (the “Long Standing Practice Prong”).
At first blush, the reasonable basis requirement seems straightforward. However, most audits turn on the IRS’s interpretation of this requirement. For instance, under the Long Standing Practice Prong, the IRS demands that the taxpayer show that they were aware of both (1) the safe harbor and (2) the long-standing practice in a significant segment of the industry. Thus, although the IRS may agree that such a practice exists in a significant segment of the taxpayer’s industry, they will still deny the relief if the taxpayer cannot show that it knew of such practice and the safe harbor for the tax years in question. Proving this knowledge can be difficult. For that reason, it is recommended that taxpayers have a Section 530 memorandum written by qualified counsel to foreclose this typical audit technique.
Section 530 is one of the strongest defenses in a worker classification audit. Yet, it is often forgotten. The IRS manual specifically states that the first step of any audit involving worker classification is to determine whether Section 530 applies. Even so, the IRS and many practitioners often fail to raise it as an initial defense. Once the IRS builds momentum in a worker classification audit, the tide can be difficult to turn. Thus, it is important to have experienced tax counsel to navigate the stormy waters of a worker classification audit, including the Section 530 Safe Harbor.
Mr. Valentine is an associate in Jennings Strouss & Salmon’s tax practice. Paul’s practice emphasizes structuring corporate, partnership and real estate transactions, counseling medium and small businesses and tax-exempt organizations in tax matters, litigating tax cases in federal courts, and handling administrative controversies before the IRS. Paul’s experience with Arizona State and City tax controversy includes income tax, sales tax, and commercial rent tax. Before joining Jennings, Strouss & Salmon, Mr. Valentine was a Tax & Bankruptcy Junior Partner at Arboleda Brechner where he managed clients’ tax collection and controversy matters.