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.
Information included in this article is accurate as of the publish date. This post is not reflective of tax law changes or IRS guidance that may have occurred after the date of publishing. All taxpayer circumstances are different, and NATP recommends contacting research services if you have specific questions about your clients’ tax situations.