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Each month the Tax Prophet collects these uncommonly sage answers to commonly asked tax questions here in the FAQ section.
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
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
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,
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.
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
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.
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:
The following questions involve the additional factors used in California:
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.