At yesterday’s seminar–“From an HR Perspective: What To Expect From an IRS Audit” (mentioned here)–both of our speakers from the IRS, one from the employment tax division and the other from the employee plans division, discussed how in an audit IRS agents will most always examine worker classification issues, i.e. to determine whether individuals who should be classified as “employees” have been wrongly classified instead as “independent contractors.” Reclassifying the individual as an employee can not only have unpleasant consequences for the employer, but also for the individual who is no longer being treated as an independent contractor. The impact of reclassification on the individual can be seen in this recent Tax Court decision–Levine v. Commissioner, T.C. Memo 2005-86–in which the IRS was seeking to deny an individual a deduction for a SEP contribution, claiming the individual was an employee of the State Department and not an independent contractor. The Tax Court sided with the individual, holding the individual was indeed an independent contractor.
One of the interesting aspects of the case, however, was the discussion of benefits and how the “[r]eceipt of employee benefits is an important factor in determining whether an employer-employee relationship exists” (citing Packard v. Commissioner, 63 T.C. at 632). The court pointed out that the State Department’s provision of annual leave for the individual as well as reimbursement for 50% of the individual’s health insurance costs pointed towards “employee” status, while the absence of retirement benefits, or other employee benefits, e.g., death benefits or transit checks, was indicative of an “independent contractor” relationship.
Two things to note here:
(1) Employers should beware of reclassifying employees as “independent contractors” just to avoid coverage under benefit plans. Such actions can lead to ERISA section 510 claims as well as problems with the IRS in an audit, which can impact both the employer as well as the individual being reclassified.
(2) An individual or a business may ask the IRS to determine the whole matter of employment status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. If a worker or a business files for the determination, the IRS will then contact “all parties who could be affected by a determination of employment status” in an attempt to get information.
Also, as was discussed in our seminar, even the IRS finds it difficult sometimes to determine the proper worker classification of an individual. Nevertheless, the IRS has a couple of resources which employers may find useful as they try to make a determination regarding worker classification which will hopefully hold up in an audit: