2010 IRS Employment Tax Crackdown

Who Is in Control?

For federal employment tax purposes, the classification of a worker as an employee or independent contractor depends on the common law definition of “employee,” i.e., a worker whose work is subject to the direction and control of the employer, both in terms of the results of the work performed and the means and methods by which the result is accomplished. 26 U.S.C. ' 3121(d)(2); 26 C.F.R.
' 31.3401(c)-1. The IRS has fashioned a widely referenced “Twenty Factor Test” as an analytical device to help identify key factors it will use in applying the control test. Rev. Rul. 87-41, 1987-1 C.B. 296.

The following are the 20 factors in the IRS Twenty Factor Test: 1) training; 2) instructions; 3) integration; 4) services personally performed; 5) hiring, supervising, and paying assistants; 6) continuing relationship; 7) set hours of work; 8) full-time work required; 9) job location; 10) order or sequence of work; 11) oral or written reports; 12) method of payment by hour, week, or month; 13) payment of expenses; 14) furnishing tools and equipment; 15) significant investment; 16) realization of profit or loss; 17) work for multiple companies simultaneously; 18) services available to general public; 19) right to discharge; and 20) right to terminate.

The IRS has made clear that the Twenty Factor Test is not an exhaustive or exclusive test, as “every piece of information that helps determine the extent to which the business retains the right to control the worker is important.” See Department of the Treasury, Internal Revenue Service, Independent Contractor or Employee? Training Materials 3320-102 (10-96), at 2-4.

The IRS has grouped the most relevant factors of its control test into three main areas of inquiry: 1) the degree of “behavioral control”; 2) the degree of “financial control”; and 3) the “type of relationship” between the parties. The “behavioral control” inquiry focuses on whether a company retains the right to control the worker and the details of how his or her work is performed. To that end, the IRS will evaluate the amount and type of any instructions and training received by the worker, as well any evaluation system in place that measures how the work is performed.

In contrast, the “financial control” analysis examines the extent to which the company controls the finances of the putative independent contractor. For example, the IRS will consider whether the company reimburses the worker for expenses and the extent to which the company, rather than the worker, stands to make a profit or bears the risk of loss for services performed. In this analysis, the IRS may also evaluate whether the company is the worker's sole source of income, or instead, the worker performs services for multiple companies simultaneously or makes his or her services available to the general public on a consistent basis. Finally, the IRS will examine the relationship between the parties to assess whether it resembles that of an employer-employee relationship or that of an independent contractor relationship. The IRS will consider the parties' perception and intent to enter into an employer-employee relationship by reviewing any written contracts describing the relationship, determining whether the company provides employee-type benefits, and determining how permanent and integral the worker's services are to the company's business.

There is no bright-line test, as no single factor or combination of factors will yield dispositive evidence of the company's right to control its workers. Nevertheless, companies should be mindful of those factors the IRS deems significant and scrutinize their own payroll practices accordingly. This will assist companies in evaluating whether their independent contractors are in reality workers under the company's direction and control, and help avoid liability for improper classification.

The Tax Consequences of Misclassifying Workers

While employers are not responsible for withholding or paying taxes on amounts paid to independent contractors, they are responsible for paying federal income taxes, Social Security and Medicare taxes (“FICA” taxes), and unemployment taxes (“FUTA” taxes) on wages paid to employees. 29 U.S.C. ' 3401 et seq. Thus, employers may face substantial tax liability if they are found to have misclassified employees as independent contractors. The tax consequences include a penalty for failing to withhold income taxes from the misclassified worker's wages, the employer's and employee's share of required FICA taxes, the employer's unpaid FUTA taxes, and interest on the unpaid taxes. 26 U.S.C. ” 3403, 6601. If employers inadvertently misclassify workers, Section 3509 of the Internal Revenue Code provides a “back-tax” formula whereby employers are assessed 1.5% of the wages paid to the misclassified worker as a tax liability for unpaid income tax withholdings and 20% of the amount subject to the employee's FICA taxes; these percentages are doubled if the employer fails to meet IRS reporting requirements (i.e., filing the IRS “Form 1099-MISC” for the misclassified worker), and even higher if the employer is found to have intentionally misclassified workers. Additionally, employers will be responsible for any parallel state sanctions. For example, in California, the Employment Development Department (“EDD”) imposes penalties on employers for failing to withhold the required California income tax and state unemployment insurance contributions on behalf of misclassified employees. Cal. Un. Ins. C. ' 13020. The possibility of simultaneous or joint review by a state agency appears to be even greater since the IRS announced its “Questionable Employment Tax Practices” initiative in November 2007, which is an agreement between the IRS and participating state workforce agencies to share audit information and to conduct joint audits when appropriate.

Section 530 of the Revenue Act of 1978 provides a very narrow “safe harbor” provision that allows companies to seek a reduction of their federal tax liability if they are found to have improperly classified workers as independent contractors. To qualify for the safe harbor, the company must demonstrate: 1) “reporting consistency” (having filed the required federal tax returns on a consistent basis); 2) “substantive consistency” (having treated workers in substantially similar positions in the same manner); and 3) a “reasonable basis” for making the incorrect classification. A company demonstrates that it acted reasonably and in good faith if its improper classification was the result of an IRS ruling or case, the written advice by legal counsel or an accountant, a past IRS audit of the company in which payroll taxes were not assessed for workers in “substantially similar” positions, or proof that a “significant segment” of the industry classified the same type of workers as independent contractors.

Increased Exposure to Civil Liability

Notably, a determination by the IRS that employers have misclassified employees as independent contractors often results in increased civil litigation, which may be even costlier than the unpaid payroll taxes. Two well-known and hotly contested cases illustrate the potential risks that go hand-in-hand with an IRS audit and a ruling regarding the misclassification of employees as independent contractors.

The Microsoft case, Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997) (en banc), cert. denied, 522 U.S. 1098 (1998), which spanned almost a decade and involved a class of freelance computer programmers, began with an IRS tax audit in 1989 and 1990. In reviewing the company's employment tax practices, the IRS determined that Microsoft had improperly classified the freelancers as independent contractors and thus owed payroll taxes to the IRS. Microsoft subsequently paid the taxes and modified its payroll practices. This did not, however, prevent a group of the freelancers from filing a class action lawsuit in which they claimed that since they were employees who had been improperly classified as independent contractors, they were entitled to benefits that were available to Microsoft employees, including participation in Microsoft's pension and benefit plans. A district court initially granted Microsoft's motion for summary judgment, in part based on the language of independent contractor agreements, which expressly disavowed the workers' entitlement to such benefits. After multiple appeals, a court of appeal ultimately held that these agreements did not prevent the misclassified workers from recovering benefits owed to Microsoft employees. The court's decision emphasized the fact that the IRS had found the workers to be “employees” and that Microsoft had conceded that the workers were “employees” for purposes of the lawsuit. Before another appeal could be brought, however, Microsoft settled the case for over $96 million.

More recently, Federal Express Corporation (“FedEx”) has made headlines for its ongoing defense against myriad class action lawsuits brought by the company's delivery drivers. The drivers allege various wage claims as a result of being improperly classified as independent contractors. Like Microsoft, FedEx's troubles began with an IRS audit of its payroll taxes and subsequent class action litigation brought by allegedly misclassified workers. In California, a group of FedEx drivers filed a class action lawsuit and prevailed in showing that they were “employees” within the meaning of California Labor Code. Estrada v.
FedEx Ground Package System, Inc., 154 Cal. App. 4th 1 (2007). In Washington, however, a Seattle jury found that the company's drivers were independent business owners, and not employees who were entitled to alleged overtime and expense reimbursements. Anfinson v. FedEx Ground Package System, Inc., 2009 WL 2868681. Meanwhile, class action claims in other jurisdictions brought by FedEx drivers remain fiercely litigated, including a national class action pending in a federal court in the Northern District of Indiana. Even though the IRS has not assessed any tax penalties against FedEx for its initial audit of FedEx's 2002 payroll taxes that were based on the status of delivery drivers as independent contractors, the IRS continues to audit this issue with respect to other tax years at FedEx, and the various court battles wage on.

Conclusion

Although the difficulties inherent in classifying workers as employees or independent contractors are hardly new, as demonstrated by both the Microsoft and FedEx cases, the pending IRS employment tax audit should serve as yet another reminder to companies of the importance of properly classifying workers. Since the IRS has indicated that it will examine employment tax compliance with increased scrutiny in the near term, companies should exercise increased caution with regard to their current tax compliance practices and carefully review their decisions to classify workers as independent contractors.

Sherrard Lee “Butch” Hayes, a member of this newsletter's Board of Editors, is the Partner in Charge of the Austin, TX, office of Fulbright & Jaworski. Julie Chen is an associate in the firm's Los Angeles office.

In the summer of 2009, the Internal Revenue Service (IRS) unveiled its “Employment Tax National Research Project,” an initiative to review and audit comprehensively the employment tax practices of 6,000 randomly selected businesses across the country from 2010 to 2012. It is the first time since the 1980s that the IRS has implemented an employment tax audit of this magnitude. Accordingly, any business selected for this audit should expect an intense and detailed examination into their tax records, compliance, and reporting practices.

The stated purpose of the IRS audit is to collect data that will help the agency better understand the areas in which businesses most frequently fail to comply with employment tax laws and related reporting requirements. The IRS plans to use these audits to secure statistically valid information for computing the “Employment Tax Gap” (the difference between the amount of tax owed by taxpayers and the amount actually paid voluntarily and on time by taxpayers ' last estimated to be approximately $350 billion), and to determine compliance characteristics so that it can address the most noncompliant employment tax areas going forward.

The IRS has acknowledged that the focus of its audit will rest in four areas where it believes businesses frequently fail to comply with employment tax laws: 1) employee vs. independent contractor status; 2) fringe benefits; 3) expense reimbursements; and 4) executive compensation. Because it continues to be one of the most significant problem areas for employers, this article examines the first of these four areas ' the classification of workers as either employees or independent contractors. Specifically, this article: 1) reviews the approach the IRS will use to determine whether companies have properly classified workers; and 2) discusses the consequences from both a tax and potential civil liability perspective of misclassifying employees as independent contractors.

Who Is in Control?

For federal employment tax purposes, the classification of a worker as an employee or independent contractor depends on the common law definition of “employee,” i.e., a worker whose work is subject to the direction and control of the employer, both in terms of the results of the work performed and the means and methods by which the result is accomplished. 26 U.S.C. ' 3121(d)(2); 26 C.F.R.
' 31.3401(c)-1. The IRS has fashioned a widely referenced “Twenty Factor Test” as an analytical device to help identify key factors it will use in applying the control test. Rev. Rul. 87-41, 1987-1 C.B. 296.

The following are the 20 factors in the IRS Twenty Factor Test: 1) training; 2) instructions; 3) integration; 4) services personally performed; 5) hiring, supervising, and paying assistants; 6) continuing relationship; 7) set hours of work; 8) full-time work required; 9) job location; 10) order or sequence of work; 11) oral or written reports; 12) method of payment by hour, week, or month; 13) payment of expenses; 14) furnishing tools and equipment; 15) significant investment; 16) realization of profit or loss; 17) work for multiple companies simultaneously; 18) services available to general public; 19) right to discharge; and 20) right to terminate.

The IRS has made clear that the Twenty Factor Test is not an exhaustive or exclusive test, as “every piece of information that helps determine the extent to which the business retains the right to control the worker is important.” See Department of the Treasury, Internal Revenue Service, Independent Contractor or Employee? Training Materials 3320-102 (10-96), at 2-4.

The IRS has grouped the most relevant factors of its control test into three main areas of inquiry: 1) the degree of “behavioral control”; 2) the degree of “financial control”; and 3) the “type of relationship” between the parties. The “behavioral control” inquiry focuses on whether a company retains the right to control the worker and the details of how his or her work is performed. To that end, the IRS will evaluate the amount and type of any instructions and training received by the worker, as well any evaluation system in place that measures how the work is performed.

In contrast, the “financial control” analysis examines the extent to which the company controls the finances of the putative independent contractor. For example, the IRS will consider whether the company reimburses the worker for expenses and the extent to which the company, rather than the worker, stands to make a profit or bears the risk of loss for services performed. In this analysis, the IRS may also evaluate whether the company is the worker's sole source of income, or instead, the worker performs services for multiple companies simultaneously or makes his or her services available to the general public on a consistent basis. Finally, the IRS will examine the relationship between the parties to assess whether it resembles that of an employer-employee relationship or that of an independent contractor relationship. The IRS will consider the parties' perception and intent to enter into an employer-employee relationship by reviewing any written contracts describing the relationship, determining whether the company provides employee-type benefits, and determining how permanent and integral the worker's services are to the company's business.

There is no bright-line test, as no single factor or combination of factors will yield dispositive evidence of the company's right to control its workers. Nevertheless, companies should be mindful of those factors the IRS deems significant and scrutinize their own payroll practices accordingly. This will assist companies in evaluating whether their independent contractors are in reality workers under the company's direction and control, and help avoid liability for improper classification.

The Tax Consequences of Misclassifying Workers

While employers are not responsible for withholding or paying taxes on amounts paid to independent contractors, they are responsible for paying federal income taxes, Social Security and Medicare taxes (“FICA” taxes), and unemployment taxes (“FUTA” taxes) on wages paid to employees. 29 U.S.C. ' 3401 et seq. Thus, employers may face substantial tax liability if they are found to have misclassified employees as independent contractors. The tax consequences include a penalty for failing to withhold income taxes from the misclassified worker's wages, the employer's and employee's share of required FICA taxes, the employer's unpaid FUTA taxes, and interest on the unpaid taxes. 26 U.S.C. ” 3403, 6601. If employers inadvertently misclassify workers, Section 3509 of the Internal Revenue Code provides a “back-tax” formula whereby employers are assessed 1.5% of the wages paid to the misclassified worker as a tax liability for unpaid income tax withholdings and 20% of the amount subject to the employee's FICA taxes; these percentages are doubled if the employer fails to meet IRS reporting requirements (i.e., filing the IRS “Form 1099-MISC” for the misclassified worker), and even higher if the employer is found to have intentionally misclassified workers. Additionally, employers will be responsible for any parallel state sanctions. For example, in California, the Employment Development Department (“EDD”) imposes penalties on employers for failing to withhold the required California income tax and state unemployment insurance contributions on behalf of misclassified employees. Cal. Un. Ins. C. ' 13020. The possibility of simultaneous or joint review by a state agency appears to be even greater since the IRS announced its “Questionable Employment Tax Practices” initiative in November 2007, which is an agreement between the IRS and participating state workforce agencies to share audit information and to conduct joint audits when appropriate.

Section 530 of the Revenue Act of 1978 provides a very narrow “safe harbor” provision that allows companies to seek a reduction of their federal tax liability if they are found to have improperly classified workers as independent contractors. To qualify for the safe harbor, the company must demonstrate: 1) “reporting consistency” (having filed the required federal tax returns on a consistent basis); 2) “substantive consistency” (having treated workers in substantially similar positions in the same manner); and 3) a “reasonable basis” for making the incorrect classification. A company demonstrates that it acted reasonably and in good faith if its improper classification was the result of an IRS ruling or case, the written advice by legal counsel or an accountant, a past IRS audit of the company in which payroll taxes were not assessed for workers in “substantially similar” positions, or proof that a “significant segment” of the industry classified the same type of workers as independent contractors.

Increased Exposure to Civil Liability

Notably, a determination by the IRS that employers have misclassified employees as independent contractors often results in increased civil litigation, which may be even costlier than the unpaid payroll taxes. Two well-known and hotly contested cases illustrate the potential risks that go hand-in-hand with an IRS audit and a ruling regarding the misclassification of employees as independent contractors.

The Microsoft case, Vizcaino v. Microsoft Corp. , 120 F.3d 1006 (9th Cir. 1997) (en banc), cert. denied, 522 U.S. 1098 (1998), which spanned almost a decade and involved a class of freelance computer programmers, began with an IRS tax audit in 1989 and 1990. In reviewing the company's employment tax practices, the IRS determined that Microsoft had improperly classified the freelancers as independent contractors and thus owed payroll taxes to the IRS. Microsoft subsequently paid the taxes and modified its payroll practices. This did not, however, prevent a group of the freelancers from filing a class action lawsuit in which they claimed that since they were employees who had been improperly classified as independent contractors, they were entitled to benefits that were available to Microsoft employees, including participation in Microsoft's pension and benefit plans. A district court initially granted Microsoft's motion for summary judgment, in part based on the language of independent contractor agreements, which expressly disavowed the workers' entitlement to such benefits. After multiple appeals, a court of appeal ultimately held that these agreements did not prevent the misclassified workers from recovering benefits owed to Microsoft employees. The court's decision emphasized the fact that the IRS had found the workers to be “employees” and that Microsoft had conceded that the workers were “employees” for purposes of the lawsuit. Before another appeal could be brought, however, Microsoft settled the case for over $96 million.

More recently, Federal Express Corporation (“FedEx”) has made headlines for its ongoing defense against myriad class action lawsuits brought by the company's delivery drivers. The drivers allege various wage claims as a result of being improperly classified as independent contractors. Like Microsoft, FedEx's troubles began with an IRS audit of its payroll taxes and subsequent class action litigation brought by allegedly misclassified workers. In California, a group of FedEx drivers filed a class action lawsuit and prevailed in showing that they were “employees” within the meaning of California Labor Code. Estrada v.
FedEx Ground Package System, Inc. , 154 Cal. App. 4th 1 (2007). In Washington, however, a Seattle jury found that the company's drivers were independent business owners, and not employees who were entitled to alleged overtime and expense reimbursements. Anfinson v. FedEx Ground Package System, Inc. , 2009 WL 2868681. Meanwhile, class action claims in other jurisdictions brought by FedEx drivers remain fiercely litigated, including a national class action pending in a federal court in the Northern District of Indiana. Even though the IRS has not assessed any tax penalties against FedEx for its initial audit of FedEx's 2002 payroll taxes that were based on the status of delivery drivers as independent contractors, the IRS continues to audit this issue with respect to other tax years at FedEx, and the various court battles wage on.

Conclusion

Although the difficulties inherent in classifying workers as employees or independent contractors are hardly new, as demonstrated by both the Microsoft and FedEx cases, the pending IRS employment tax audit should serve as yet another reminder to companies of the importance of properly classifying workers. Since the IRS has indicated that it will examine employment tax compliance with increased scrutiny in the near term, companies should exercise increased caution with regard to their current tax compliance practices and carefully review their decisions to classify workers as independent contractors.

Sherrard Lee “Butch” Hayes, a member of this newsletter's Board of Editors, is the Partner in Charge of the Austin, TX, office of Fulbright & Jaworski. Julie Chen is an associate in the firm's Los Angeles office.