The IRS and Department of Labor (DOL) recently updated the memorandum of understanding (MOU) on identifying and reporting employee misclassifications to include a new streamlined process for identifying and reporting wrongful employee classifications. The streamlined process includes a decision tree to help investigators and auditors with the DOL’s Wage and Hour Division understand when to refer cases to the IRS’s Small Business/Self-Employed operating division as part of the Joint Worker Misclassification Initiative.

While taxpayers are generally responsible for any unpaid tax obligations to the IRS, preparers of employment tax returns or claims for refund may be liable for penalties under §6694. These penalties are imposed on preparers for understatements of tax due to unreasonable positions or willful or reckless conduct.

When will cases be referred to IRS?
The MOU includes information on a standardized referral form and a decision tree for assessing whether a matter should be referred to the IRS. According to the MOU, the DOL is to decide whether a case should be referred to the IRS based on the answers to the following questions:

• Was there a determination of employee status? The IRS only wants referrals that involve a determination of worker status.
• Is the business still in operation? The IRS does not want referrals for businesses that are no longer going concerns.
• Does the business have an average dollar volume (ADV) of more than $500,000? Employers with an ADV of more than $500,000 are likely to pay at least $25,000 a quarter in wages.
• Were Forms 1099 issued? If no Form 1099 was issued, the IRS will treat it as a “Tier 1” referral because the business can’t claim the protection of the safe harbor relating to federal employee status under §530 of the Revenue Act of 1978. Because the IRS will not need to devote resources to addressing the §530 issue, it will not need to spend as much time developing its case. The IRS will consider these instances to be a “prime lead” and afforded priority status due to the likelihood that any tax adjustments would be enhanced.
• Were workers in the same class treated inconsistently? If the business treated some workers in a class as employees and others in the same class as independent contractors, the IRS will also treat it as a Tier 1 referral. Businesses can’t claim protection under the §530 safe harbor provisions for issues related to worker status, and there is also the potential for the IRS to find enhanced noncompliance.

If a business treated all workers in the same class as independent contractors and issued Forms 1099, the IRS may still be interested in the referral as a Tier 2 lead because the business may be able to claim protection under the §530 safe harbor rules. As a practical matter, Tier 1 referrals will be given priority over Tier 2 referrals.

Who is eligible for §530’s safe harbor?
Section 530 is a relief provision that terminates a taxpayer’s liability for employment taxes for individuals not treated as employees if the following three requirements are met:

• Reporting consistency: The taxpayer must have filed the information returns that are consistent with its treatment of a worker as a non-employee. For example, an employer claiming a worker as an independent contractor would need to have filed a Form 1099.
• Substantive consistency: A taxpayer who treated the worker, or a worker holding a substantially similar position, was treated as an employee at any time after Dec. 31, 1977, the taxpayer can’t claim relief under §530.
• Reasonable basis: The taxpayer must have reasonably relied on one of the following at the time employment decisions were being made for the period at issue:
  • Prior audit
  • Judicial precedent
  • Industry practice

The relief provided under §530 does not apply to the determination of whether a worker was an independent contractor. Instead, it provides relief from employment tax liabilities of the employer, regardless of whether its workers were properly classified.

If you need additional information on how to properly classify workers and independent contractors or how to correct worker misclassifications, check out our on-demand webinar: Classifying a Taxpayer’s Employment Status.

Each year, Jan. 27 is celebrated as annual EIC Awareness Day as a way to bring attention to the refundable earned income tax credit, which is severely underutilized by many taxpayers during filing season.

Around 20% of taxpayers eligible to claim and get the earned income tax credit (EIC) don’t apply it to their returns. The EIC is a financial boost for low- to moderate-income taxpayers that can help with everything from food and housing to building a saving’s account.

Here are five things you should know about the EIC in order to claim the credit:

1. There are six basic qualifications to be eligible for the EIC:

   • Have worked and earned income under $59,187
   • Have investment income below $10,300 in the tax year 2022
   • Have a valid Social Security number by the due date of your 2022 return (including extensions)
   • Be a U.S. citizen or a resident alien all year
   • Not file Form 2555, Foreign Earned Income
   • Meet certain rules if you are separated from your spouse and not filing a joint tax return

2. You don’t have to have a child to qualify for the EIC if you meet the following criteria. You (and your spouse if filing a joint return) must:

   • Meet the EIC basic qualifying rules (above)
   • Have your main home in the United States for more than half the tax year
     • The United States includes the 50 states, the District of Columbia and U.S. military bases. It does not include U.S. possessions such as Guam, the Virgin Islands or Puerto Rico
   • Not be claimed as a qualifying child on anyone else’s tax return
   • Be at least age 25 but under age 65 (at least one spouse must meet the age rule)

3. If you qualify for the EIC, you probably qualify for other credits, including:

   • Child Tax Credit and the Credit for Other Dependents
   • Child and Dependent Care Credit
   • Education Credits

4. Most EIC-related refunds are available in taxpayer bank accounts or on debit cards by March 1, if they choose direct deposit and there are no other issues.

5. If you qualify for EIC, you must file a federal income tax return and claim the credit to get it, even if you owe no tax or aren’t required to file a return.

Claiming the EIC on a return is an important step for many taxpayers each year. If you’re a preparer, make sure you know the ins-and-outs of this credit to avoid an audit. Taxpayers, work with a qualified preparer to maximize your refund amount and claim all the credits applicable to your financial situation.

Question: Larry is a long-time tax professional who, after hearing all the advertising hype regarding employee retention credit (ERC) refunds, has determined that one of his clients qualified for the ERC in both 2020 and 2021. The client is an S corporation, which kept its employees on the payroll during the qualifying time frame and met the other requirements for claiming the credit. Therefore, Larry plans to claim the ERC for his client. His question is: When is the ERC claimed? Is it when the money is received or is it claimed on the amended returns for the tax periods in which the ERC credit applies?

Answer: Larry will claim the ERC on amended tax returns for the tax periods in which the ERC applies and the client qualifies. ERC claims are made via filing Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund. The entity’s tax returns for the period being claimed must be amended to reflect the ERC as a reduction in payroll expense [Notice 2021-20; Notice 2021-49].

Claiming the ERC for 2020 and/or 2021 requires the filing of amended Forms 1120-S U.S. Income Tax Return for an S Corporation, which will decrease the payroll expense by the amount of the calculated ERC. The amended Forms 1120-S will then report an increase in the net profit (or a reduction in an originally reported net loss), causing amendments to the Schedules K-1, Shareholder’s Share of Income, Deductions, Credits, provided to each of the shareholders for the years the ERC is claimed.

Issuing amended Schedules K-1 will also require each of the shareholders to amend their personal Forms 1040, U.S. Individual Income Tax Return, for both 2020 and 2021. Filing these amended Forms 1040 will likely result in additional tax due since the originally reported net profit will be increased or an originally reported loss will have been reduced. It’s likely the IRS will assess interest to these same shareholders for the increased tax owed. While we recommend filing an appeal of these assessments, it’s unclear whether the IRS will consider these explanations as reasonable cause.