RS 02101: Employer-Employee Relationship - Policies and Procedures
TN 18 (08-13)
A. Section 530 of the Revenue Act of 1978
An independent contractor is a person, business, or corporation that provides goods or services to another entity under terms specified in a contract or within a verbal agreement. Unlike an employee, an independent contractor does not work regularly for an employer but works as and when required. Independent contractors are usually paid on a freelance basis.
In the United States, any company or organization engaged in a trade or business that pays more than $600 to an independent contractor in one year is required to report this to the Internal Revenue Service (IRS) as well as to the contractor, using IRS Form 1099-MISC. This form is merely a report of the money paid; independent contractors do not have income taxes withheld from their pay as regular employees do. Independent contractors are responsible for their own self-employment tax.
The IRS conducts audits of businesses to insure compliance with federal taxing statutes. If the IRS determines that an employer incorrectly treated a worker as an independent contractor rather than an employee, it can assess the employer for all unpaid taxes with respect to that worker, and other workers performing similar services.
The IRS may make the assessment retroactively, subject to the IRS' time limitation for assessment and refund of taxes, which is similar to SSA's time limitation for correcting earnings records. Therefore, an IRS assessment involving many workers can include significant amounts of money.
Some employers object to these assessments. They argue that the common-law control test used to determine employment relationships is too subjective to permit them to determine a worker's employment status with any certainty. Consequently, employers may, based on their own interpretation of the common-law rules, feel justified in treating workers as independent contractors (non-employees).
Section 530 of the Revenue Act of 1978 (Pub. L. 95-600) provides businesses with some relief from these assessments. The Small Business Job Protection Act of 1996 (Pub. L. 96-541) amended Section 530 to extend its effective date until July 1, 1982, and Pub. L. 97-248 extended its effective date indefinitely. However, the Tax Reform Act of 1986 (P.L. 99-514) provides that Section 530 does not apply in certain cases.
Section 530 provides businesses, not workers, with relief from federal employment tax obligations if businesses meet certain requirements. It also clarifies that the first step in any case involving worker classification is to determine if the business meets the requirements of Section 530. If the business meets the Section 530 requirements, the business is not liable for employment tax for the workers at issue.
B. Exceptions to Section 530 of the Revenue Act of 1978
Section 1706 of the Tax Reform Act of 1986 amends Section 530 to state that relief from federal employment tax obligations is not available in the case of a worker who provides services (according to an arrangement between the business and the worker) as a:
computer programmer,
designer,
drafter,
engineer,
systems analyst, or
other similarly skilled worker engaged in a similar line of work.
The Congressional intent was to classify workers who provide technical services for businesses under the common-law rules, without regard to Section 530 of the Revenue Act of 1978. The amendment applies to remuneration paid and services rendered after December 31, 1986.
In passing Section 1706, Congress explained that some technical services firms assigned workers to clients of the firms, and treated these workers as independent contractors or as employees of personal service corporations that the worker organized and controlled. For example, an engineer retained by a technical services firm to provide services to a manufacturer cannot avoid the amendment by organizing a corporation that he or she controls and then claim to provide service as an employee of that corporation. The individuals are employees or self-employed without regard to Section 530.
C. Section 530’s consistency requirement
For periods after December 31, 1978, the federal employment tax relief applies only if the employer:
files all required IRS Forms 1099 (Miscellaneous Income) for all workers on a basis consistent with the employer's treatment of the worker as an independent contractor (reporting consistency) unless the worker earned less than $600, and
after December 31, 1977, treats all workers in similar positions the same (substantive consistency). Substantive consistency is when a business treats the independent contractor workers the same as all employee workers that hold substantially similar positions.
D. Section 530’s reasonable basis requirement
To qualify for tax relief under section 530, an employer must also have a reasonable basis for not treating the workers as employees.
In accordance with IRS Revenue Procedure 85-18, consider an employer to have a reasonable basis for not treating workers as employees if the employer relied on any one of the following safe havens or other reasonable basis:
1. Industry practice safe haven
An industry practice safe haven is when an individual is engaged in a long-standing recognized practice of a significant segment of the industry. An industry is a group of businesses that provides the same product or service and competes for the same customers. To establish if an employer relies on industry practice:
examine business records (corporate minutes or unanimous consents in lieu of directors’ meetings) to decide if any written record exists showing the reason the employer treated workers as independent contractors, and
interview the workers and ask what reason the employer gave them that established their worker status as an independent contractor.
2. Judicial precedent safe haven
A judicial precedent safe haven exists when the employer demonstrates reliance on a judicial precedent such as:
a published IRS ruling,
technical advice memorandum,
private letter ruling, or
a determination letter relating to the business.
The facts in the case:
do not need to be identical;
must be similar to the business’ situation;
the judicial precedent or published ruling relied upon must have been in existence at the time the business began treating workers as independent contractors; and
the precedent relied upon does not need to deal with exactly the same industry as the employer’s.
3. Past audit safe haven
A past audit safe haven is the reliance on past IRS audits (after December 31, 1996) of the employer for employment tax purposes, where the IRS did not assess employment taxes based on services performed by an individual holding a position similar to that of the individual whose status is under consideration. A business may continue to rely on an audit that began before January 1, 1997 even though the audit was not related to employment tax matters. The prior audit safe haven does not apply if the relationship between the business and the worker(s) is substantially different from that which existed at the time of the audit.
4. Other reasonable basis
A business which fails to meet any of the three safe haven requirements in RS 02101.808D may be entitled to relief, if the business can demonstrate some other reasonable basis for not treating the worker as an employee. Reliance on the advice of an attorney or accountant may constitute a reasonable basis.
NOTE: Meeting the consistency and reasonable basis tests gives businesses relief from employment taxes with respect to the workers whose status is in question. Lack of worker social security numbers (SSN) is not a reasonable basis for not treating workers as employees. Section 530 relief is unavailable to employers who failed to treat illegal aliens as employees because they did not have SSNs.
E. Internal revenue procedures
Revenue Procedure (Rev. Proc.) 85-18, Section 3.03(B), I.R.B. 1985-13 April 1, 1985 provides instructions for implementing Section 530, as amended. Section .02 emphasizes the necessity of the filing of returns.
1. Filing returns
If the business does not timely file the required Forms 1099 with respect to the workers for the period involved; for periods after December 31, 1978, relief under Section 530(a)(1) will not apply, even if the taxpayer has met the “safe haven” rules of paragraph 3.01 of this revenue procedure.
Revenue Ruling 81-224, 1981-2 C.B. 197 provides that businesses who:
do not file timely Forms 1099 consistent with their treatment of the worker as an independent contractor, may not obtain relief under the provisions of Section 530 for that worker for that year; and
mistakenly file the wrong type of Forms 1099 (in good faith) do not lose Section 530 eligibility.
2. Status and treatment of workers
Section 530 of the Act does not change the status, liabilities, and rights of the worker whose status is at issue. Section 530(a) (1) terminates the liability of the employer for the employment taxes, but has no effect on the workers. It does not convert workers from the status of employee to the status of self-employed (independent contractor). Misclassified employees are responsible for the employee share of FICA rather than tax under the Self-Employment Contributions Act (SECA).
Section 31.3102-1(c) of IRS regulations provides, with respect to the collection and payment of the employee's share of the FICA tax, that “until collected from him (by the employer) the employee is also liable for the employee tax with respect to all wages received by him.” Therefore, if an employer's liability under Section 3102 of the Internal Revenue Code for the employee's share of the tax imposed by Section 3101 terminates under Section 530(a) (1) of the Act, the employee remains liable for that tax. Employees who incorrectly paid the self-employment tax (Section 1401 of the Code) may file a claim for refund; however, the amount of the self-employment tax refund will offset the amount of the employee's share of the tax imposed on the employee as a result of the application of Section 31.3102-1(c) of the regulations.
Accordingly, Section 530 has no substantive effect on SSA determinations involving employer-employee relationships. Continue to make such determinations in accordance with the instructions in RS 02101.020. Correct the earnings record via the Earnings Modernization Item Correction (ICOR) System as appropriate in MSOM EM 022.001 through MSOM EM 022.004.
F. Prohibition against regulations and rulings on employment status
Congress prohibited the IRS from issuing regulations or rulings clarifying the employment status of individuals. The purpose was to maintain the status quo until Congress studied the matter. However, this prohibition does not apply to those individuals noted in RS 02101.808B.
Section 1706 of the Tax Reform Act of 1986 lifted the prohibition in Section 530 against the issuance of regulations and rulings concerning employment tax status with respect to workers to whom the amendment applies. The IRS reacted by issuing Revenue Ruling 87-41, 1987-1 C.B. 296.
G. Effect on IRS and SSA coordination procedures
When developing a coverage or wage issue, you may obtain information indicating that the provisions of Section 530 apply (e.g., an “employer” states he or she did not report wages for a worker on the basis that the employer was not liable for social security taxes due to the provisions of Section 530). In these cases, the employer did not issue a Form W-2 (Wage and Tax Statement) since non-issuance of Form W-2 is one of the conditions for the employer to receive social security tax relief under Section 530. The employer should have issued a Form 1099 NEC (Nonemployee Compensation) to the worker for the year(s) in question. You may use Form 1099 NEC as evidence of covered wages paid to the worker, in lieu of Form W-2, if you establish that the worker was an employee.
Add the worker’s earnings, as appropriate, via the Earnings Modernization Item Correction (ICOR) System. See MSOM EM 010 for instructions. Annotate Remarks or the Rationale Screen in ICOR indicating that the provisions of Section 530 apply. Also, explain what Section 530 means for documentation purposes for any potential future review of the action taken.