U.S. District Court Finds Taxpayer Had Reasonable Basis for Classifying Workers as Independent Contractors

In an area IRS auditors are increasingly scrutinizing, a U.S. district court sided with the taxpayer in its claim for an employment tax refund on the grounds that the taxpayer had a reasonable basis for classifying its workers as independent contractors and thus was not liable for back employment taxes.  In Nelly Home Care, Inc. v. United States, the IRS asserted after an audit of a homecare services company that the company had misclassified its workers as independent contractors and assessed back employment taxes owed as a result of the misclassification.  Refund claims for employment taxes are within the jurisdiction of the U.S. district courts, so the taxpayer paid the taxes and filed a refund action in the U.S. District Court for the Eastern District of Pennsylvania.

The calculation of FICA and federal income tax withholding in reclassification cases is determined under the special rates of Section 3509 of the Internal Revenue Code when an employer incorrectly classifies an employee as an independent contractor but issues a Form 1099-MISC. The court noted that IRS auditors are increasingly relying on this section to scrutinize worker misclassifications.  However, Section 530 of the Revenue Act of 1978, which was never codified, provides a safe harbor for taxpayers that owe back employment taxes due to worker classification errors.  An employer may qualify for the safe harbor by showing that it had a “reasonable basis” to not classify workers as employees, provided the basis arose from reliance on one of four conditions: (i) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer; (ii) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment of workers in substantially similar positions to the workers at issue; (iii) longstanding recognized practice of a significant segment of the industry in which the worker was engaged; or (iv) any other factors that a court considers sufficient to establish a “reasonable basis.”

The taxpayer in Nelly Home Care argued unsuccessfully that it satisfied the second and third conditions as a basis for its reasonable belief. However, the court found that the record demonstrated that the taxpayer satisfied the fourth condition for demonstrating that it had a reasonable basis and, therefore, was relieved of the employer’s responsibility to withhold income taxes on and apply FICA taxes to the payments.  Specifically, the court considered the inquiries made of other companies’ practices, the personal experience of the taxpayer in the industry, and the IRS’s silence regarding the taxpayer’s classification during its audits of the owner’s personal tax returns.  Notably, the court warned that its decision “in no way endorses” the taxpayer’s classification of its workers as independent contractors.