Understanding the Effects of an IRS Independent Contractor Reclassification Examination

Businessmen and women around the world—but especially in California—remember the strikes that have happened in recent years at the Ports of Los Angeles and Long Beach; they brought supply chains to a standstill, disrupted businesses globally, and cost Californians tens of billions of dollars.  These strikes are a very public example of how disputes about employee classifications can continue for years and years.  Because employers’ tax liabilities are very different for employees and independent contractors, the IRS regularly reviews employee classification during tax audits to ensure they are appropriate.

How does the IRS review classifications?

When the IRS opens a case to review an employer’s classifications of his or her workers, it assigns an agent known as an examiner to the case.  The examiner is generally responsible for managing the review, and has several specific tasks he or she is required to perform.  Those tasks include determining whether the employer is eligible for “Section 530 relief,” as well as making an offer under the Classification Settlement Program.  

What is Section 530 Relief?

When an employer has been classifying workers as something other than employees (such as independent contractors) and there is a question about whether that is appropriate, there is a law that creates a “safe harbor,” shielding employers from liability for past employment taxes.  This safe harbor is known as Section 530 relief.  To qualify for Section 530 relief, the employer must have had a reasonable basis for classifying the workers as non-employees.  If the employer had such a basis, filed all the required tax documents for the period in question, and was consistent in how he or she classified workers, the employer should qualify for Section 530 relief.  The IRS examiner is required to determine whether or not the employer is eligible.

What is the Classification Settlement Program?

The Classification Settlement Program (CSP) creates an opportunity for employers and the IRS to resolve issues regarding how the employer has classified his or her employees early in the review process, before it drags on for months or years piling up costs for both sides.  Under the CSP, employers who had been treating workers as independent contractors or other non-employees voluntarily agree to treat those workers as employees in the future.  In return, the IRS allows the employer to pay just 10% of the employment tax for those workers during the year in question, and the employer will not be liable for interest or penalties on that amount.  Additionally, the IRS agrees not to audit the employer for his or her classifications of those employees for years before the year in question.  Most employee classification cases qualify for the CSP, and the IRS examiner is required to determine whether each case is eligible.  For eligible cases, the examiner is required to make the employee a settlement offer under the CSP.

The process of having the IRS review or challenge your classifications of employees can be long and expensive, both in litigation costs as well as the potential for past employment tax liabilities, interest, and penalties.  Fortunately, federal law offers a variety of options for employers to resolve their classification cases quickly and with very limited costs.  But navigating federal laws and dealing with the IRS is complicated, so you should have the guidance of an experienced tax attorney.  Our firm specializes in representing employers in their tax cases, and our attorneys have helped hundreds of clients successfully resolve their employee classification cases.  If you have questions about being reviewed by the IRS and would like to speak with an attorney, contact us today to schedule a consultation.

Posted in: Tax Audit

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