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Section 530 - The Federal Exception Preventing the IRS from Reclassifying Workers as Employees

In 1978, Congress mandated that the IRS stop reclassifying workers as employees provided the company had "any reasonable basis" for treating the worker as an independent contractor. Section 530 of the Revenue Act of 1978. Since it was intended to be a temporary measure, Sec. 530 was never codified as part of the Internal Revenue Code , but it has continued in effect since enactment. Because it was not part of the Internal Revenue Code, Section 530 does not apply to independent contractor status disputes with California. Despite an impressive string of taxpayer victories under Sec. 530, the IRS continued to insist on a restrictive interpretation of this exception.

As part of the Small Business Act, Section 1122, Congress clarified and expanded the scope of Sec. 530 (described below). Section 530 is available to companies that treated workers as independent contractors, if -

There are 3 express safe harbors associated with the reasonable basis standard -

The federal courts greatly expanded the reach of Section 530 and, recently, Congress followed suit. Unfortunately, California never adopted Section 530 and so the treatment of the same worker by the IRS and California could be inconsistent. It is California, rather than the IRS, that causes most of the tax problems for small companies in this difficult area.

Recent Federal Law Changes in the Independent Contractor Rules

As discussed above, as part of the Small Business Act, Section 1122, Congress clarified and expanded the scope of Sec. 530. In general, these changes benefit companies who classify their workers as independent contractors.


Under the original law, any audit, whether or not it involved employment tax issues, came within the prior audit safe harbor exception. The new law limits this exception to prior employment tax audits involving the particular worker, or workers performing similar jobs. Companies may rely on audits that began prior to 1977 under the old rules.


The IRS had incorrectly maintained that a long-standing practice safe harbor exception required a 10-year period or that the practice was in existence prior to 1979, thus preventing new industries from using this exception. Congress clarified this exception by stating that no fixed period of time will apply. This change will benefit new industries.


Congress stated that there is no fixed percentage needed to show reliance on this exception. A showing of 25% or more of the companies in an industry, excluding the taxpayer's company, is now deemed a significant portion of the industry for this standard. The IRS had maintained that a showing of more than 50% of the industry was required to meet this exception.

The change under this exception will assist many companies who treat their workers as independent contractors. Often, a trade publication, which polls its members as to practices in the industry, may be used as evidence of the practice in a significant segment of the industry.


Companies who rely on one of the three safe harbor exceptions will have to make a prima facie showing only. The company must cooperate with the IRS investigation to shift the burden. Previously, the IRS claimed that the taxpayer had the burden of proving the applicability of a safe harbor exception. Congress expressly stated that the change in this shift of burden does not imply that the IRS was correct in its interpretation; therefore, taxpayers may still argue the IRS has the burden of proof in cases arising before the change in the law.

The IRS must request information that is related to the taxpayer's position regarding reasonable basis, and compliance with the IRS must not be impracticable given the particular circumstances and relative costs involved. Once the burden of proof shifts to the IRS, it applies to all aspects under Section 530, including the consistency and filing requirements.

With respect to the consistency requirement (workers in substantially similar positions were treated as independent contractors), consideration of the relationship between a taxpayer and a worker includes the degree of supervision and control by the taxpayer. Note: This will permit separate treatment for the same general class of worker if the degree of supervision and control is different.

Note: The IRS Training Guide, issued in July 1996, evidently provides several pro-independent contractor interpretations that the IRS is supposed to use in an audit, including-


A company may classify a former independent contractor as an employee without jeopardizing the past classification under the consistency requirement of Section 530. Current classification of a worker as an employee will not be used as evidence of an improper classification for any year prior to the reclassification.


The IRS wrongly maintained that Sec. 530 only applied to workers who would have otherwise been considered employees under the traditional common-law tests under Revenue Ruling 87-41, 1987-1 CB 296. Congress makes it clear that Sec. 530 applies to the classification of workers, whether or not workers are considered independent contractors for other purposes.


Under prior law, reference to Section 530 was deceptively described or entirely hidden from the forms and publications most taxpayers and companies use to determine these issues. Now, the IRS is required to notify companies of their rights under Section 530 as soon as the issue of worker classification is raised in an audit.


These changes to Section 530 will apply for periods after December 31, 1996. The shift in the burden of proof rules will also take effect for disputes involving tax periods after December 31, 1996. The requirement that the IRS must give notice of Sec. 530 is effective for audits that begin after December 31, 1996.

California's "Form Over Substance" Analysis

Unlike the federal government which has been tilting towards finding an independent contractor relationship in the close cases, the California employment tax audits (Employment Development Department - "EDD") have maintained California's traditional paternalistic attitude of invariable finding an employment relationship in these cases. California continues to apply the traditional common-law tests to determine independent contractor status.

The EDD focuses on the "trappings of independence" shown by the worker, rather than engaging an intellectually honest analysis of the "control" issue. Therefore, it is crucial that the worker hold himself or herself out to the public as being in business.

While one can question the EDD's insistence over this prerequisite as being irrelevant to the control issue that governs the independent contractor status, compliance with EDD's requirements is not unduly difficult and can insulate both the company and the worker from the adverse tax consequences arising from a reclassification of the worker as an employee.

Since the focus of most EDD auditors is on the independent business aspects of the worker, the following should be considered by companies concerned about this issue -


Under Unemployment Insurance Code Section 656, there is a rebuttable presumption in favor of independent contractor status for those engaged in a professional practice, such as physicians, attorneys, accountants, engineers and architects. Scientists in the physical, chemical, biological and natural sciences also fall within this presumption. Note: Those involved in the social sciences do not enjoy the benefit of this presumption. If the presumption applies, then the burden of proof shifts to the state to prove that an employment relationship existed.


There is a new set of regulations and criteria for determining whether a "language interpreter" is an independent contractor. See Regulation 4304-9 of Title 22, California Code of Regulations. Language interpreters include translators of text and interpreters of conversations. This set of new regulations was enacted after extensive hearings and are generally favorable towards the classification of such workers as independent contractors.

Although seminar presenters are not literally within the definition of language interpreters, the criteria for determining independence is similar and these new regulations can be argued, by analogy, to apply to professionals in the social sciences that are performing similar work.

Traditional Independent Contractor vs. Employee Analysis

The traditional tests to determine whether a worker is an employee or independent contractor involve the concept of control: Are the services of the worker subject to the taxpayer's (company's) will and control over what must be done and how it must be done? In Revenue Ruling 87-41, 1987-1 CB 296, the IRS developed 20 factors used to determine whether a worker is an independent contractor under the common law. In general, at least 11 of these factors must show independent contractor status.


If Section 530 is not available, then the common-law factors test must be used. The following questions analyze the relationship between the company and worker under the traditional 20 common law factor test used by the Internal Revenue Service:

  1. Does the principal provide instructions to the worker about when, where, and how he or she is to perform the work?
  2. Does the principal provide training to the worker?
  3. Are the services provided by the worker integrated into the principal's business operations?
  4. Must the services be rendered personally by the worker?
  5. Does the principal hire, supervise and pay assistants to the worker?
  6. Is there a continuing relationship between the principal and the worker?
  7. Does the principal set the work hours and schedule?
  8. Does the worker devote substantially full time to the business of the principal?
  9. Is the work performed on the principal's premises?
  10. Is the worker required to perform the services in an order or sequence set by the principal?
  11. Is the worker required to submit oral or written reports to the principal?
  12. Is the worker paid by the hour, week, or month?
  13. Does the principal pay the business or traveling expenses of the worker?
  14. Does the principal furnish significant tools, materials and equipment?
  15. Does the worker have a significant investment in facilities?
  16. Can the worker realize a profit or loss as a result of his or her services?
  17. Does the worker provide services for more than one firm at a time?
  18. Does the worker make his or her services available to the general public?
  19. Does the principal have the right to discharge the worker at will?
  20. Can the worker terminate his or her relationship with the principal any time he or she wishes without incurring liability to the principal?


The following questions involve the additional factors used in California:

  1. Is the worker engaged in a separately established occupation or business?
  2. In this locality, is the work usually done under the direction of the principal without supervision?
  3. Is skill required in performing the services and accomplishing the desired results?
  4. Do the parties believe they are creating an employer/employee relationship?


The rules involving the classification of workers as independent contractors are complex and contradictory. It largely depends on whether the federal government or California is investigating the situation. In both situations, however, it is important to document the worker's status and to the extent possible, the worker should have a separate and independent business with all the usual business trappings, such as a fictitious business name, stationery, business cards and yellow page or similar ads announcing the business to the public.

Remember, there are relief provisions available if your worker paid taxes and the taxing authorities later conclude he or she was your employee. Taxing authorities cannot collect a twice for the same income, so you'll receive a credit for previous taxes paid, provided you comply with appropriate relief provisions.