IRS outlines conditions for employee vs. independent contractor

The IRS has attempted to clear up a dilemma that has perplexed businesses that desire to treat certain workers as independent contractors rather than employees.

Employers are generally required to withhold and pay employment taxes (FICA, FUTA and withheld income tax) on wages paid to employees. Under Section 530 of the Revenue Act of 1978, a business may treat an individual as an independent contractor for employment tax purposes, if the following conditions are met:

  • The business does not treat the individual as an employee for any period.
  • The business does not treat another person holding a substantially similar position as an employee.
  • All required federal tax returns are filed on a basis consistent with the company's treatment of the individual as a nonemployee.
  • The business has a reasonable basis for not treating the individual as an employee.

A business has a reasonable basis for not treating an individual as an employee if the business reasonably relied on one or more of the following safe harbors:

  • Judicial precedent or IRS rulings
  • A past IRS audit
  • A long-standing practice of a significant segment of the relevant industry
  • A business that cannot meet any one of the three safe havens may nevertheless be entitled to relief if it can demonstrate a "reasonable basis" for not treating the individual as an employee.

A key question for Section 530 purposes is whether the business must demonstrate that it reasonably relied on a safe harbor before engaging the worker to perform services. Some courts have held that the business must have relied on the authority at the time the employment decision was made.

In a Program Manager's Technical Advice (PMTA), the IRS says that an employer need not demonstrate that it reasonably relied on a Section 530 employment tax safe harbor before engaging a worker to provide services. If the IRS challenges a worker's employment tax status, it will be sufficient if the employer demonstrates reasonable reliance any time prior to the current employment period.

The PMTA also concludes that employers relying on industry practice for worker classifications must demonstrate that the "industry practice" was known to them before the time the decision regarding whether to treat the workers as independent contractors was made and that the "industry practice" was reasonably relied on for that decision.

Businesses classifying workers as independent contractors should document their rationale with specific reference to the safe harbor being used. The documentation should include evidence of the date on which the decision was reached.

Read the entire PMTA here.

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