Employee vs. Independent Contractor Tax Problems

New bill seeks to reduce worker misclassifications

H.R. 5804, 4/15/08 [Taxpayer Responsibility, Accountability, and Consistency Act of 2008]
Rep. James McDermott (D-Wash) has introduced legislation that would revise employee vs. independent contractor rules and increase information reporting penalties The legislation is called the “Taxpayer Responsibility, Accountability, and Consistency Act of 2008,” and it primarily focuses on Section 530 of the Revenue Act of 1978. Under Section 530, employers that meet the following three requirements are protected from potentially large employment tax assessments, even though they incorrectly categorized a worker as an independent contractor: (1) reasonable basis, (2) substantive consistency, and (3) reporting consistency. An employer can meet the “reasonable basis” requirement if judicial precedent, IRS rulings, a 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 (and any predecessor business) consistently treated the workers in question as independent contractors. The reporting consistency requirement is met if the employer has not classified the workers as employees on any required federal tax returns, including information returns.

New Rules. The new legislation would repeal Section 530 and replace it with a new Code section, IRC §3511, that would make it more difficult for employers to avoid employment tax liability if they misclassified a worker as an independent contractor. IRC §3511 would generally require employers to have a “reasonable basis” for classifying a worker as an independent contractor. The “reasonable basis” standard is met only if:

    (1) The employer classified the worker as an independent contractor based on: (i) a written determination (as defined in IRC §6110(b)(1)) that it received addressing the employment status of either the worker in question, or another individual holding a substantially similar position with the employer; or (ii) an employment tax examination of the worker, or another individual holding a substantially similar position with the employer, that did not conclude that the worker should be treated as an employee; and

    (2) The employer (or a predecessor) has not treated any other individual holding a substantially similar position as an employee for employment tax purposes for any period beginning after Dec. 31, 1977.

The new legislation would not allow an employer to rely on an examination commenced, or a written determination issued, more than seven years before the beginning of the period in question. For purposes of IRC §3511, the determination as to whether an individual holds a position substantially similar to a position held by another individual would be made in accordance with the Fair Labor Standards Act.

The IRS would issue its determination of worker status no later than 90 days after the filing of a petition with respect to employment status in any industry where employment is transient, casual, or seasonal (e.g., construction). The new statute would apply to services rendered more than one year after the date that the legislation is enacted. Section 530 would not apply to services rendered more than one year after the date that the legislation is enacted.

Increase in Information Reporting Penalties. Under current law, a taxpayer that doesn’t 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);
    • 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 concern whose average annual gross receipts for the three most recent tax years ending before the calendar year in which the returns are due (or for the entire period of its existence, if less than three years) are $5 million or less.

    Increase in penalties. Under the new law, a taxpayer that doesn’t 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).

      The new law would also increase the penalties for failure to furnish a correct payee statement, intentional disregard of the rules, and failure to comply with other information reporting requirements (see IRC §6723).

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