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.

IRS to Receive Automatic Notice of Missed Employment Tax Payments

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March 7, 2016

As of September 2015, unpaid employment tax reported on voluntary returns amounted to $59 billion, a number the IRS hopes to decrease by preventing employers from accruing the substantial employment tax deficits currently plaguing the system. Darren Guillot, a director in the IRS Small Business/Self-Employed Division, announced that the IRS intends to take a more “proactive” approach to employment tax situations, part of which will involve an update to the Electronic Federal Tax Payment System (EFTPS) that will enable the system to alert the IRS within 2-3 days after an employer misses an employment tax deposit. This change serves as an improvement to the current system, which can take over three months to notify the IRS of missed employment tax. By that time, a business has often fallen into significant arrears.

Employers who fall behind on employment tax payments and are identified by the new alert system can expect outreach to begin December 2016. The outreach will at first come in various forms, as the IRS plans to examine which forms of outreach are most effective and which employers will react more favorably. From a practical perspective, this represents a much needed and proactive compliance move. Taxpayers that fall into a pattern of nonpayment for trust fund taxes (e.g., payroll taxes, backup withholding, withholding under Chapter 3 and Chapter 4 of the Code) often are using the withholdings to pay other creditors. When this happens, personnel known as “responsible persons” under the law may become personally liable for the nonpayment of tax. By delaying contact with taxpayers regarding the nature of severity of the situation, taxpayers and those responsible persons who make these decisions often create financial burdens from which they may never recover.

Limitations on Cash Reimbursements for Transit Benefits Apply to Retroactive Increase in Transit Limits

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March 2, 2016

In a technical advice memorandum (PMTA 2016-01), the IRS Office of Chief Counsel stated that a retroactive increase in transit benefits paid in a cash lump sum is only excludable to the extent a transit pass or voucher is unavailable.  This ruling clarifies that these retroactive increases are subject to the same rules as other transit benefits.  This issue arises from Congress’s decision to increase the amount of transit benefits excludable from income in 2012, 2014, and 2015 (e.g., the limit in 2015 was increased from $130/month to $250/month), which has led employers to inquire about the tax treatment of lump sum payments made to compensate employees for transit payments made by the employees in those years that exceeded the limits in place at the time.  The IRS states that it will deem such lump sum payments income and subject to withholding and reporting if transit passes or vouchers are “readily available.”

If transit passes or vouchers are not “readily available,” employers may provide cash reimbursements, so long as employees incur and substantiate their expenses pursuant to an accountable plan.  Accordingly, most employers are unable to allow employees to take advantage of the retroactive increase.  If an employer allowed employees to exceed the pre-tax limit and purchase transit passes with after-tax dollars (or provided the employees with transit passes and imputed taxable income for amounts in excess of the pre-tax limit), it could provide amended Forms W-2 and file Forms 941-X removing the after-tax amounts from wages (for both FITW and FICA purposes).  However, given that the difference for each employee is only $1450 per year, some employees may not wish to file amended income tax returns to recover any excess tax paid.  In addition, the cost savings for employers may not be sufficient to justify the expense of preparing the amended returns.