The IRS plans to audit 6,000 companies for employment tax compliance during the next three years. Its primary focus will be worker classification (i.e., whether workers are being properly classified as independent contractors rather than as employees), but it also intends to examine fringe benefits, backup withholding, Form 1099 compliance, and Code section 409A issues.

As part of this process, the IRS plans to send letters to selected taxpayers notifying them that they have been selected for a "compliance research examination." Although the audits are for research, the IRS will conduct them like traditional audits and may make assessments.

Our recent experience representing clients in employment tax audits suggests that the IRS is strongly biased toward the conclusion that workers are employees rather than independent contractors. Thus, companies using independent contractors must be prepared to mount a vigorous defense. Alternatively, if a company's legal position is tenuous, attractive settlement options may be available provided the company consistently issues Forms 1099 to independent contractors reporting their compensation.

A Common Law Test Is Used to Determine Worker Classification

The classification of a worker as either an employee or independent contractor is determined, in the first instance, under a common law analysis. The IRS looks at a number of factors organized into three categories.

Behavioral Control Over Worker

The first category includes factors relating to behavioral control: Does the business have the right to direct or control how the work is done, e.g., how the worker performs the specific task for which he or she is hired. The relevant factors include: (1) The extent to which the business gives instructions for how the work is to be performed (as contrasted with merely specifying the results to be achieved); and (2) The extent to which the business trains the worker (i.e., more training may suggest an employment relationship).

Control Over Worker's Provision of Services

The second category includes factors relating to financial control: Whether the business controls how the worker provides personal services. The relevant factors include: (1) Whether the worker can realize a profit or a loss; (2) The extent to which the worker makes an investment in equipment and facilities, and otherwise has unreimbursed expenses; (3) Whether the worker provides (or holds himself out as providing) services to more than one business; and (4) Whether the worker is paid like an employee (e.g., hourly or salaried) or instead is paid by the job (or a flat fee).

Relationship Between the Parties

The third category includes factors relating to the relationship between the parties. The relevant factors include: (1) Whether a written contract exists that describes the relationship the parties intend to create; (2) Whether the business provides the worker with employee benefits (health insurance, a retirement plan, vacation pay, etc.); (3) The length of the relationship; and (4) The extent to which the services performed by the worker are central to the regular business of the company.

As with any multifactor test, the common law worker classification test is sufficiently ambiguous as to permit either conclusion to be made. Thus, the IRS is likely to determine that a worker is an employee even if only a few factors favor that conclusion.

Section 530 Relief May Be Possible

In the Revenue Act of 1978, Congress enacted so-called Section 530 to provide relief to employers in certain situations where the IRS challenged the classification of workers as independent contractors. If the requirements are met, Section 530 precludes the IRS from assessing employment tax liability against a business. This applies to federal income tax withholding, FICA, and FUTA.

Consistency Tests

For Section 530 to apply, two so-called "consistency tests" must be met. Under the "substantive consistency" test, the business must (after 1978) have classified all workers holding substantially similar positions in the same manner. In other words, the business must not have treated some workers as employees while treating similar workers as independent contractors. There is also a "reporting consistency" test, which essentially means that the business must have filed information returns (e.g., Forms 1099) on a basis consistent with treating its worker as independent contractors.

If the two consistency tests are met, then the worker is deemed not to be an employee unless the business had no reasonable basis for treating the worker as an independent contractor.

Reasonable Basis Tests

A reasonable basis for treating the worker as an independent contractor can be established if there was reliance on: (1) judicial precedent, published rulings, technical advice with respect to the business, or a letter ruling to the business; (2) a past IRS employment tax audit of the business that resulted in no assessment with respect to workers in substantially similar positions; or (3) a long-standing recognized practice of a significant segment of the industry in which such individual was engaged.

These are not the exclusive ways of showing that the business had a reasonable basis. For example, the courts have consistently held that reliance on advice from an attorney (or other tax professional) that a worker may be classified as an independent contractor satisfies the Section 530 reasonable-basis requirement.

Although Congress intended that the reasonable-basis test be construed liberally in favor of taxpayers, the IRS often takes a different approach. For example, it will not recognize reliance upon the advice of counsel unless such advice was obtained when the business first started using independent contractors. It can also be difficult to convince the IRS that a business relied upon a longstanding industry practice. This is a particular problem if the industry is a relatively new one. The IRS formerly required a showing of at least 10 years of industry practice. Congress prohibited that, but the IRS still requires that the practice be more than a couple of years old.

What Are the Stakes?

The liability for worker misclassification may be substantial. First, there may be liability equal to 15.3 percent for FICA and Medicare tax up to the FICA limit ($106,800 for 2010). The Medicare tax (2.9 percent) continues to apply beyond that limit. There may also be liability for income tax withholding, resulting in an aggregate liability that may reach 40 percent of compensation. Interest and penalties may also apply.

However, provided that the business did not intentionally disregard the requirements to deduct and withhold taxes, Code section 3509 provides lower rates. If the business filed information returns as if its workers were independent contractors, then the income tax withholding rate is reduced to 1.5 percent of wages and the employee-share FICA/Medicare rates are equal to 20 percent of the full rates. If it did not file information returns, then the income tax withholding rate is reduced to 3 percent and the employee-share FICA/Medicare rates are equal to 20 percent of the full rates. In either case, the employer gets no reduction for the employer's share of FICA and Medicare.

There May Be Favorable Settlement Opportunities

If the IRS audits the business and determines the workers were improperly classified as independent contractors, it may offer the business the opportunity to participate in the so-called Classification Settlement Program (CSP). CSP offers can be very attractive, provided the business is willing to classify its workers as employees prospectively.

IRS agents are instructed to determine whether Section 530 applies before making CSP offers. If Section 530 applies, no employment tax assessment will be made. If the business wants to begin treating its workers as employees, the IRS will enter into an agreement allowing it to do so.

Types of CSP Offers

If Section 530 does not apply, IRS agents are instructed to consider making a CSP offer, but only if the business has met the reporting consistency requirement. In other words, the business must have filed Forms 1099 with respect to workers treated as independent contractors. Assuming it has done so, then there are two possible CSP offers. Which offer is available depends on how good a case the business has for Section 530 relief.

If the business has filed Forms 1099 but if it clearly cannot satisfy both the substantive consistency and reasonable basis tests—in other words, if Section 530 relief is clearly unavailable—then the CSP offer is: (1) full assessment of tax for the last year of the audit period (using Section 3509 if applicable); and (2) prospective treatment of the workers as employees. The incentive here is that the assessment applies for just one year rather than for all years open under the statute of limitations.

If the business has filed Forms 1099 and if it arguably has satisfied both the substantive consistency and the reasonable basis tests—in other words, if it has reasonable arguments for Section 530 relief but the agent is not fully persuaded—then the CSP offer is: (1) 25 percent of the full assessment of tax for the last year of the audit period (using Section 3509 if applicable); and (2) prospective treatment of the workers as employees.

Employers Should Review Practices

Although the use of independent contractors is completely legitimate, the IRS believes there is substantial abuse, and it is ramping up enforcement. Companies using independent contractors should review their practices so that, if the IRS does commence an audit, they will be in the best possible position to defend themselves under both the common law tests and Section 530.