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IRS must reveal workers’ tax return information in misclassification case

June 7, 2017

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An IRS redetermination of employment tax status of service providers can have devastating effects upon a business. However, a recent unanimous ruling by the U.S. Tax Court could make it easier for some employers whose workers have been reclassified as “employees” by the IRS to avoid income tax liability on the workers’ earnings. This ruling allowed an employer access to IRS records (consisting of the employer’s reclassified workers’ individual tax returns), which could reveal that workers had already paid income tax on their earnings, thereby reducing or eliminating the employer’s liability for failing to withhold income taxes. This article details the implications of the Tax Court case, and serves as an important reminder to all businesses to ensure that they are properly classifying workers. This article also highlights the importance of obtaining proper representation, should the IRS seek to reclassify independent contractors as employees.

The consequences of misclassifying independent contractors

Should an employer incorrectly classify workers as independent contractors instead of employees, potential devastating consequences can occur. First and foremost, under federal tax law, employers who fail to properly classify independent contractors as employees are liable for payment of Social Security (FICA) and Medicare taxes on both the employer’s and employee’s portion of the tax, as well as income tax withholding on payments to service providers. The Internal Revenue Service has broad statutory authority to reclassify independent contractors as employees, regardless of the wishes of the business and the service provider.

State and local taxing authorities may also impose tax liability upon an employer who misclassifies workers and fails to withhold taxes. And, in addition, an IRS reclassification of worker status may have collateral effects upon other aspects of the business-service provider relationship. For example, an independent contractor may also obtain benefits under workers’ compensation law (with the corresponding requirement that the business repay the benefits), or be entitled to minimum wages or overtime pay.

The Mescalero Apache Tribe Tax Court litigation

This recent Tax Court case illustrates the problems with reclassification, but may provide businesses with some relief. In Mescalero Apache Tribe v. Commissioner of Internal Revenue, a Native American tribe  treated hundreds of service providers as independent contractors. The IRS audited the tribe, and ultimately reclassified many of those workers as employees. As a result,the IRS sought about $550,000 in unpaid withheld income taxes  and approximately 20% interest from the employer. Additionally, the employer would be liable for penalties and interest associated with the failure to pay, withhold and remit employment taxes, as well.

In its defense, the employer turned to Section 3402 of the Internal Revenue Code (IRC), which allows an employer to avoid income tax withholding liability if it can show that workers who had been misclassified as contractors paid income tax on their earnings. The reasoning behind Section 3402 makes sense while employers are liable for withholding income taxes on the wages they pay to employees, the taxes are allowed as a credit against the income tax liability of those employees. The employer is not required to pay the employee’s income taxes when the employee has already paid those taxes. Proving that the employee paid income tax on the earnings, however, can be difficult. In connection with the audit and accompanying litigation, the employer 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 income tax withholding liability. However, the employer was unable to obtain completed Form 4669 from approximately 70 of its workers, so it asked the Tax Court to order the IRS to search the IRS’s  records to determine if the workers had reported their earnings as income, and paid income taxes upon such income. The employer argued that obtaining this information directly from the IRS would be the best evidence on this issue.

The general rule — and an important exception

Until this case, the Tax Court had never considered the specific 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 Internal Revenue Code prohibited it from disclosing the workers’ tax return information to the employer. The Tax 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 — must 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 what information can be disclosed under this exception. For example, 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. In Mescalero Apache Tribe, the Tax Court determined that an appeal of its decision would be heard by the Tenth Circuit Court of Appeals, and therefore, it was obligated to follow Tenth Circuit precedent. Once it determined that in the jurisdiction of the Tenth Circuit disclosure was appropriate, the Tax Court turned to the issue of whether the specific information was disclosable and discoverable.

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 employer requested “directly relates” to that relationship. It determined that whether the employer’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 employer.

Finally, the Tax 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 they paid their income tax liabilities as contractors would tend to prove or disprove the employer’s case, directly relating to the resolution of one of the issues in the case. If the employer’s workers did indeed pay their taxes, the employer’s Sec. 3402 defense would be proved and resolved in the employer’s favor on the income tax withholding liability issue.

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

The implications of misclassification of service providers and the Mescalero Apache Tribe Tax Court litigation

The IRS has been particularly aggressive in its pursuit of misclassified employees in recent years, putting employers at real risk if they employ service providers classified as independent contractors. As the Tax Court observed in this case, an employer can incur significant liability if it misclassifies employees as independent contractors, and fails to collect and remit withheld income and employment taxes on the employees’ earnings.

If the IRS determines that an employer misclassified workers, this Tax Court ruling could give that employer the benefit of discovery from the IRS to prove the Sec. 3402 defense, even if the employer cannot obtain Forms 4669 from all of the reclassified workers. It could relieve the employer for misclassification altogether, as the payment of taxes by workers who were treated as independent contractors weighs against the existence of an employer-employee relationship. That could save the employer substantial money, not only in unpaid income withholding taxes, but also Social Security and Medicare taxes, unemployment taxes, workers’ compensation premiums, and employee benefits. Additionally, the determination of an employer-employee relationship could subject an affected employer to liability under the Fair Labor Standards Act for minimum wages and overtime pay, plus penalties.

The best practice is to avoid the possibility of litigation regarding service provider classifications in the first place. Contact an experienced CPA firm who can help with this determination, as well as generate the proper determination to sustain such determination in an audit. If the IRS or another taxing authority decides to audit, contact an experienced CPA firm to represent your company in connection with the audit. And, if litigation results, ensure your representative takes full advantage of the rule set forth in Mescalero Apache Tribe to develop the best litigation posture possible.

If you have any question about whether your business is properly classifying workers or if your business is challenged in connection with such classification, contact us immediately.

© 2017

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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