Employee misclassification ruling has major implications for businesses that use contractors

Misclassifying employees can be a costly mistake for your business. The IRS has been particularly aggressive in its pursuit of worker misclassification in recent years, putting you at real risk if you have misclassified employees as contractors.

If the IRS reclassifies your contractors as employees, you’re responsible for paying the taxes you did not withhold from them, as well as interest and penalties – likely a sizable bill. To date, it’s typically been difficult for businesses to refute IRS reclassification of employees. However, a recent U.S. Tax Court ruling could give businesses significant recourse in cases of employee misclassification, potentially saving them substantial tax liability on workers’ earnings.

The new ruling allowed an employer access to its reclassified workers’ individual tax returns, which could reveal that they had already paid income tax on their earnings, thereby reducing the employer’s liability for withholding taxes.

The case details

The case involved a Native American tribe with hundreds of workers whom it treated as independent contractors. The IRS audited the tribe and ultimately reclassified many workers as employees. The agency sought about $550,000 in unpaid withholding taxes on those individuals plus approximately 20 percent interest from the tribe.

In its defense, the tribe turned to Section 3402 of the Internal Revenue Code (IRC), which lets an employer escape tax liability if it can show that workers who had been misclassified as contractors paid income tax on their earnings. After all, while employers are liable for withholding taxes on the wages they pay, the taxes are really a credit against the taxes employees owe on their income. If an employee actually paid the tax on his or her income, even though it wasn’t withheld, the employer is off the hook.

With Sec. 3402 in mind, the tribe asked each reclassified worker to complete IRS Form 4669, “Statement of Payments Received.” The IRS normally accepts the form as evidence that a worker filed an individual tax return and paid the income tax due, relieving the employer of withholding tax liability.

However, the tribe was unable to locate 70 of the workers, so it asked the Tax Court to order the IRS to search the workers’ records to determine if they had reported their Form 1099 income and paid their tax liabilities. The tribe asserted that this information would likely lead to a rapid settlement of the underlying misclassification case one way or another.

The general rule — and an important exception

Prior to this case, the Tax Court had never considered the question of whether an employer can use trial discovery to access its workers’ IRS records in order to reduce its own tax liability under Sec. 3402. The IRS argued that the IRC prohibits it from disclosing the workers’ tax return information to the tribe. The Court acknowledged that Sec. 6103(a) of the code provides a general rule that returns and the information on returns — including a taxpayer’s payments — should be kept confidential. But, the Court pointed out, the general rule comes with several exceptions.

For example, a return or return information may be disclosed in a judicial or administrative proceeding related to taxes if the return or return information directly relates to a transactional relationship, between someone who is a party in the proceeding and the taxpayer, and directly affects the resolution of an issue in the proceeding. As the Court noted, the federal courts of appeal have split on the question of whom information can be disclosed to under this exception.

The Fifth Circuit U.S. Court of Appeals has held that return information can be disclosed only to officials of the Department of the Treasury or the Department of Justice. The Tenth Circuit, on the other hand, has rejected that position and found disclosure proper in judicial and administrative tax proceedings in general.

According to the Tax Court, most courts have followed the lead of the Tenth Circuit. Moreover, this case, if appealed, would likely land in the Tenth Circuit because the tribe is located in New Mexico, which is part of that circuit. The Tax Court, therefore, held that third-party tax return information can be disclosed in tax proceedings to persons other than government officials — as long as the relevant exception’s other requirements are met.

The exception applied

The Court found that “transact,” as used in the phrase “transactional relationship,” means simply “to carry on business.” As such, it concluded, the relationship between an employer and its worker qualified as a transactional relationship.

The Court then turned to the question of whether the return information that the tribe requested “directly relates” to that relationship. It determined that whether the tribe’s workers paid their tax liabilities in full tends to show whether they considered themselves independent contractors or employees and thus directly related to their relationship with the tribe.

Finally, the Court considered whether the return information directly affects the resolution of an issue in the case. It found that how the workers viewed themselves, as employees or contractors, is a factor in worker classification cases. Whether their workers paid their income tax liabilities as contractors would tend to prove or disprove the tribe’s case, directly relating to the resolution of one of the issues in the case. If the tribe’s workers did indeed pay their taxes, the tribe’s Sec. 3402 defense would be proved and entirely resolved.

Having determined that the tribe satisfied the exception to the general rule against disclosure of returns and return information, the Tax Court ruled that the tribe was entitled to obtain the workers’ return information from the IRS.

The implications

Though it’s sometimes a difficult determination, it’s important for businesses to correctly classify workers as contractors or employees. As the Tax Court observed in this case, an employer can get hit with a big tax bill if it misclassifies employees as independent contractors and fails to collect and pay withholding taxes on their earnings.

But if the IRS does determine that you misclassified workers, this Tax Court ruling could potentially give you the benefit of the Sec. 3402 defense, even if you are unable to obtain Form 4669 from all of the reclassified workers. It could get you off the hook for misclassification altogether, as the payment of taxes by workers who were treated as contractors weighs against the existence of an employment relationship. This result could save you substantial money, not only in unpaid taxes, but also minimum wages and overtime, penalties, Social Security and Medicare contributions, unemployment and workers’ compensation premiums, and employee benefits. If you have any questions about worker classification, please contact your KraftCPAs tax advisor.

See this related article “Independent contractor status remains a hot spot for IRS attention” for more information on how to determine if workers should be classified as employees or may be classified as contractors.

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