Employers are generally required to withhold and pay employment taxes (FICA, FUTA, and withheld income tax) on wages paid to employees. An employee is someone who qualifies under the common law (case law) rules as such which for tax purposes falls under a “20 question” test. If you attempt to classify employees as independent contractors and then fail to withhold payroll taxes the IRS can retroactively reclassify them and assess significant penalties. Section 530 relief has been a key provision often used to avoid disaster in these erroneous classification situations. This allows a business to treat an individual as an independent contractor if all four following hurdles are cleared:
- It never treats the person as an employee;
- It does not treat any other person with a substantially similar position as an employee;
- All required federal tax returns and Forms 1099 show the worker as an independent contractor; and
- The business had a “reasonable basis” not to treat the person as an employee.
You can satisfy the fourth requirement by reasonably relying upon:
- Judicial precedent or IRS rulings;
- A past IRS audit; or
- A long-standing practice of a significant segment of the relevant industry.
In a recent Technical Advice, the IRS concludes that you have to demonstrate actual and reasonable reliance before the period for which employment decisions are made. This test is most clearly met when you can demonstrate actual and reasonable reliance on the asserted reasonable basis before taking on the workers at issue or substantially similar workers. That means before the initial employment decision being made. However, the IRS says you may be able to satisfy the reasonable basis requirement by establishing that you “actually and reasonably” relied on the asserted basis before making the employment decisions regarding the workers’ status for later periods. This seems to potentially take the epiphany factor out of defenses. There are developing cases that bear watching for their outcomes.