Fighting the IRS (and the California Employment Development Department) in Worker Classification Disputes

taylorlaw | 07/27/2016

employees

What do you do when the IRS (or the California EDD) shows up and wants to audit your payroll tax returns to determine if the people you are paying as independent contractors should be treated as employees for payroll tax purposes?  While you may be tempted to handle the audit yourself, that could get you into lots of trouble.

Representation by a competent professional who has experience in handling “worker classification” audits by the IRS (or the EDD)  is critically important. It is important that the person handling the audit for the taxpayer understand both the factors used by the IRS and EDD for determining whether a worker is  an independent contractor or employee and how IRS and EDD auditors go about their business. Even if these auditors may seem pleasant to deal with, their job is to look out for the interests of the government. These auditors thus may not be interested in looking for evidence that supports the conclusion that the workers you have treated as independent contractors are in fact independent contractors. Having a representative who not only understands the law but also is experienced at presenting the facts to IRS and EDD auditors is very beneficial. Failure to properly present evidence that is favorable to the taxpayer’s position can result in the IRS/EDD improperly reclassifying an independent contractor as an employee.

Understanding the “rules” regarding when a worker is an employee and when a worker is an independent contractor is not always easy. There can be “gray areas” where the answer is not completely clear.  While understanding how the IRS and EDD interpret the relevant rules is important, obtaining advice from an independent professional who is looking out for your interests is also important. You can read some of what the IRS has to say about when a worker is an employee and when a worker is an independent contractor at this link: https://www.irs.gov/publications/p15a/ar02.html#en_US_2016_publink1000169490

Here is the link to a questionnaire created by EDD to help putative employers determine when a worker is an independent contractor: http://www.edd.ca.gov/pdf_pub_ctr/de38.pdf

A reclassification of one or more workers from independent contractor status to employee status in an employment tax audit can have a significant adverse effect on a client’s business. Sometimes, a reclassification of a group of workers from independent contractor status to employee status can cause a company to go out of business.

There are also some important differences between the rules that apply to the IRS and the rules that apply to the EDD. For example, under federal law, a worker who might be considered an employee under the “common law factors” test can nevertheless be treated as an independent contractor if the requirements set forth in Section 530 of the Revenue Act of 1978  are met.  There is no equivalent of Section 530 under California law.  Thus, it is possible that a worker could be treated as an independent contractor for federal employment tax purposes and as an employee for California employment tax purposes.

As another example, California law provides that a person performing services in the construction industry who does not have a valid contractor’s license is deemed an employee of the contractor who holds a valid contractor’s license (or who is required to hold such a license).  That is so even if the subcontractor would otherwise be treated as an independent contractor under the applicable rules. Federal law does not have a similar provision.

What happens if the IRS or EDD auditor issues and audit report concluding that workers that you treated as independent contractors should be treated as employees? There are both administrative and judicial procedures available to challenge the conclusions reached in the audit report. An IRS audit report asserting additional employment taxes as the result of a worker reclassification audit can be challenged administratively in the Office of Appeals and can be challenged judicially either in the Tax Court or in a refund suit brought in District Court or the Court of Claims. An EDD audit report asserting additional employment taxes as the result of a worker reclassification audit can be challenged before the California Unemployment Insurance Appeals Board (CUIAB) and, if the CUIAB rules adversely, in Superior Court. Having a representative who understands these procedures and how to use them is also important.

Recently, our firm reached a favorable settlement in a Tax Court case in the case of SECC Corporation v. Commissioner. In that case, the IRS had asserted that the taxpayer was liable for approximately $1.5 million in additional employment taxes.  We were able to settle the case for about $25,000.  Before the case was settled, the Tax Court had issued an opinion in the case which significantly changed the rules governing when the Tax Court has jurisdiction to review an assertion by the IRS that a taxpayer owes  additional employment taxes as the result of a worker reclassification audit. An explanation of the Tax Court’s ruling, along with a  history of how this case started and worked its way through the IRS and the Tax Court,  can be read in a three part blog post at Procedurally Taxing:

Part 1: http://procedurallytaxing.com/secc-corporation-v-commissioner-how-it-started-how-it-ended-and-what-might-happen-going-forward/

Part 2: http://procedurallytaxing.com/secc-corporation-v-commissioner-how-it-started-how-it-ended-and-what-might-happen-going-forward-2/

Part 3: http://procedurallytaxing.com/secc-corporation-v-commissioner-how-it-started-how-it-ended-and-what-might-happen-going-forward-3/

When the Tax Man or Tax Woman comes calling, remember that your chances of a successful outcome increase if you have an experienced tax professional in your corner. Our office has handled many worker classification audits by the IRS and EDD. We have also handled many administrative appeals before the IRS and California Unemployment Insurance Appeals Board, and we have litigated worker classification disputes in U.S. Tax Court and U.S. District Court.

Article written by A. Lavar Taylor, Read Mr. Taylor’s bio here. 

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