What is a worker classification issue? When the Internal Revenue Service (“IRS”) believes that a taxpayer (i.e. employer or service recipient) is improperly treating workers as independent contractors instead of employees it will pursue the taxpayer by initiating an examination, more commonly known as an audit, where the taxpayer will likely receive a Letter 3850 (Rev 3-2006) in the mail providing them notice of the inquiry. A worker classification issue will usually start with an analysis of whether the worker should have been classified as an independent contractor or an employee. If it is determined that the workers should have been treated as employees, then a calculation must be prepared to determine how much the taxpayer (employer) owes the IRS.
Often, a taxpayer will resolve the tax liability generated from the worker classification audit through one of the IRS settlement programs (known as CSP or Classification Settlement Program) or through Section 530 of the Revenue Act of 1978. Also, a taxpayer who fails to withhold the required tax may be entitled to relief, under §§ 3402(d), 3102(f)(3), 1463 or Regulations § 1.1474-4, but they must show that the worker reported the payments and paid the corresponding tax. More simply stated, an independent contractor does not have any of its taxes withheld from a check it receives. However, if the independent contractor should have been classified as an employee, then the employer would be entitled to offset some of the tax liability it owes the IRS by proving that the misclassified worker still paid his or her taxes that should have been withheld.
In a recent Tax Court case, the Mescalero Apache Tribe (“Tribe”) won on a motion to compel discovery against the IRS. The Tribe was in the middle of a worker classification case. In dispute, was the reclassification of hundreds of workers as employees instead of independent contractor. The taxpayer, Tribe, has the burden of proof to show its worker paid income tax to reduce the amount it would owe the IRS. (Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11)