Discussion:State U/C audit

Although he came out unscathed, this is an issue that isn't going to go away. With the new partnership between IRS & the states, we think the state will ramp up the number of auditors, and we expect every one of our business clients to be audited within the next 10 years on this issue. With the states hurting so bad for money, they see this a great way to get revenue.

If you have clients who have "independent contractors", and who doesn't, you might want to fire off CYA memos on a regular basis.

Comments, anyone?

You are going to being hearing about this a lot more. Do I hear a summertime project warming up?

We feel that this is a major client/accountant relationship threat. If our clients do not conform, we will seriously consider disengaging them. We think it's that serious.

A travel agency almost lost on this issue, even though 1099s were issued and the workers absolutely qualified as independent contractors under federal rules. In the end, the travel agency prevailed by showing that the work was not done on their premises because the office where the workers were located had a separate entrance!

I'm thinking that in these cases, we should inform the client of the disparity, plus advise that they consult with an employment attorney.

Some clients may, in fact, opt to take their chances on the issue, which may be a reasonable business decision, but we want to make it perfectly clear that they are fully informed of the risk they are taking and won't blame us if they lose on the issue.

There a couple of tests to determine employee status.

First there is the 20 factor right of control test used by the IRS and most, if not all state tax authorities.

Then there is the broader economic realities test used by the Fed DOL and by many states for labor law purposes.

It is entirely possible to have a person be an IC for the feds, but an EE for certain state functions.

I can't answer for all states, but CA has provisions for submitting w-2 information when it differs from the IRS.

Now, practically speaking, there is one thing that you can do to ensure that it's a rare problem: Do not have checks made or endorsed to an individual. That's how they perform the audit, by examining the checks and the endorsements. Rubber stamped company-made checks pass scrutiny.

Congress is considering new legislation called the “Taxpayer Responsibility, Accountability, and Consistency Act of 2008,” which if enacted would revise the employee versus independent contractor classification rules. The proposed legislation would repeal §530 of the Code. Currently §530 protects an employer who incorrectly categorized a worker as an independent contractor from potentially large employment tax assessments if the employer meets all three of the following requirements: (1) reasonable basis, (2) substantive consistency, and (3) reporting consistency. An employer meets the “reasonable basis” requirement if there is judicial precedent, IRS ruling, past IRS audit, or industry practice supports the classification of a worker as an independent contractor. An employer meets the “substantive consistency” requirement if it consistently treated the worker in question as an independent contractor. The “reporting consistency” requirement is met if the employer never classified the worker as an employee on any federal tax return.

The proposed legislation creates a new Code section, IRC §3511, which would make it more difficult for an employer to avoid employment tax liability if it misclassified a worker as an independent contractor. The proposed §3511 would redefine “reasonable basis” by requiring an employer to establish: (1) The employer classified the worker as an independent contractor based on: (i) a written determination that it received addressing the employment status of the worker in question or an individual holding a substantially similar position; or (ii) an employment tax examination of the worker or an individual holding a substantially similar position, that did not find that the worker should be treated as an employee; and (2) the employer never treated the worker or an individual holding a substantially similar position as an employee for employment tax purposes.

           The proposed law would also significantly increase information reporting penalties.  Under current law, a taxpayer that does not file a correct information return may be subject to the following penalties: a $15 per return penalty if corrected within 30 days after the due date, up to a maximum total penalty of $75,000 a year ($25,000 for small businesses); a $30 per return penalty if corrected later than 30 days after the due date but before August 1, up to a maximum penalty of $150,000 a year ($50,000 for small businesses); and a $50 per return penalty if not corrected by August 1 (or if a return is not filed at all), up to a maximum penalty of $250,000 a year ($100,000 for small businesses).  A “small business” is defined as a business with average annual gross receipts for the three most recent tax years of $5 million or less. 

           Under the new law, a taxpayer that does not file a correct information return would be subject to the following penalties: a $50 per return penalty if corrected within 30 days after the due date, up to a maximum total penalty of $500,000 a year ($175,000 for small businesses); a $100 per return penalty if corrected later than 30 days after the due date but before August 1, up to a maximum penalty of $1,500,000 a year ($500,000 for small businesses); a $250 per return penalty if not corrected by August 1 (or if a return is not filed at all), up to a maximum penalty of $3,000,000 a year ($1,000,000 for small businesses). 

Please keep in mind that this is only a summary of pending legislation. If you would like more details about this, please do not hesitate to call our office.

What does that mean? Is the IRS going to be issuing determinations for employers?

Just a minor nitpick with the attorney's email, but it's §530 of the Revenue Act of 1978, not the Internal Revenue Code. IRC §530 is for Coverdell Savings Accounts.

Besides, aren't §530 cases really tough to win, even with the industry practice provision?