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IRS AUDIT SYSTEM

IRS AUDIT PROCEDURES

By: Robert E. McKenzie, Esq. ©2009

1. INDEPENDENT CONTRACTOR

1.10 Beginning in the mid 1980's the IRS began test programs in several Districts auditing employers whoallegedly misclassified their employees as "independent contractors." This program, called the SpecialCompliance Employment Tax Examination Program, began in 1984 in seven districts. It was later expanded to26 Districts. The Internal Revenue Service reported in 1988 that in the first year 92% of the taxpayers examinedon the issue of worker classification were confronted with additional tax assessments. As a result of the largerevenues generated by the IRS's test program, it has now expanded its employment tax examination program toinclude all districts. The program was originally called the Employment Tax Examination Program or ETEP.Later, the Internal Revenue Service changed the name of the program to the Office of Employment Tax andCompliance (OETAC).

1970's

1.20 During the 1970's, the Internal Revenue Service also stepped up its efforts in Employment Tax Audits. Asa result of complaints by taxpayers, however, Congress sought to rein the IRS in by passing IRC § 530 of the

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Revenue Act of 1978. That provision sought to provide relief for companies that were the subject of IRSEmployment Tax examinations. As a result of the passage of IRC § 530, the IRS suspended most of itsEmployment Tax examination efforts from 1978 to 1984. Section 530 was intended to be temporary to allowCongress to pass specific definitions of employees, but as a result of conflict among various industries, Congresswas unable to come up with a definition. Therefore, as of 1988, the IRS resumed its aggressive Employment TaxExamination Program. That program continues up through the date of this publication even though the IRS has aclassification settlement program which is discussed later in this Section. Section 530 was also amended by theSmall Business Jobs Protection Act which is also discussed later in this Section.

Effect of Reclassification

1.30 The financial impact of IRS reclassification of independent contractors can be disastrous. The stakes arevery high, in excess of 43% of payments to independent contractors. The IRS might also seek to impose personalliability pursuant to IRC § 6672 on corporate officers. Reclassification also leads to requirements that employeesbe included under state tax programs and under employee benefit programs.

Potential Liability

1.40 IRC § 3509 provides for assumed rates for FICA and withholding which would result in deficienciesbetween about 11% and 14% of a company's reclassified payroll. Section 3509 rates apply if the company didnot intentionally disregard worker classification rules. Absent application of IRC § 3509 rates, the IRS assumes arate for withholding of 28% of payments to reclassified workers. It also imposes liability for both employee andemployer FICA and Medicare for a total of 15.3% of payments. The employer also becomes liable for FUTA. Aredetermination for the three past years will normally destroy most labor intensive service businesses.

2. COMMON-LAW TEST

2.10 For purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act(FUTA), and income tax withholding, the term "employee" includes any individual who, under the usualcommon-law rules for determining the employer/employee relationship, has the status of an employee. [See IRC4§ 3121 (d), 3306(i), 3401 (c)]

Control and Direction

2.20 Under the common-law rules, a worker is an employee when the person for whom services are performedhas the right to control and direct the individual who performs the service. This control must reach not only theresult to be accomplished, but also the details and means by which the results are to be accomplished. Theemployer need not actually exercise control. It is sufficient that the right to do so exists. It is the substance ofeach particular relationship that governs; therefore, the employers may not simply contract away theiremployment tax liabilities.

Employees for FICA Purposes

2.30 The IRC §3508 also provides that certain individual occupation groups, who may not be employees undercommon-law rules, will be treated as employees for FICA purposes only. This category was originally referred toas "Statutory Employees" and identified under IRC § 3121 (d)(4) as agent drivers, traveling or city salesmen,full-time life insurance salesmen and homeworkers. It also includes corporate officers who receive remunerationfor services as corporate officers.

3. TWENTY COMMON-LAW FACTORS

3.10 Twenty common-law factors have been identified by the IRS for determining whether a worker is in factan employee. [See Rev Rul 87-41, 1987-1 CB 296] Unfortunately the degree of importance of each of thesefactors varies from case to case. Some factors do not apply to certain occupations and therefore, should not begiven any weight. Although 11 of the 20 factors may indicate employee status, this does not necessarily mean anemployer/employee relationship exists. Some of the factors may be inappropriate under the circumstances andsome may be more significant than others. The weight to be given and degree of importance of each factor variesdepending on the occupation and the reasons for its existence.

Factors

3.20 The following 20 common-law factors are used by the IRS. These factors are the basis of Form SS-8,which is used by the IRS to analyze the employee/independent contractor question:

(1) Compliance with instructions. A person who is required to comply with instructions about when,where, and how to work is ordinarily an employee. The control factor is present if the employer has theright to instruct, whether or not he in fact does so.

(2) Training. Training of a person by an experienced employer, by correspondence, by required attendanceat meetings, and by other methods indicates control because it shows that the employer wants theservices performed in a particular method or manner. This is especially true if the training is givenperiodically or at frequent intervals. Independent contractors ordinarily rely upon their own resources fortraining and receive no training from the purchasers of their services.

(3) Integration with business. Integration of the person's services in the business operations generallyshows that the person is subject to direction and control. In determining whether integration exists, it isnecessary to determine the scope and function of the business and whether the services of the individualare merged into it.

(4) Personal rendition of service. If services must be rendered personally, it indicates that the employer isinterested in the methods as well as the results. The employer is interested not only in getting a desiredresult, but also in who does the job. Lack of "employer"-type control may be indicated when anindividual has the right to hire a substitute without the employer's knowledge.

(5) Hiring, supervising and payment of assistants. Hiring, supervising, and payment of assistants by theemployer generally shows control over the workers on the job. Sometimes one worker may hire,supervise, and pay the other workers. This may result from a contract under which the worker providesmaterials and labor and is responsible only for the attainment of a result. In this case, the worker is anindependent contractor. On the other hand, if the worker hires, supervises, and pays other workers at thedirection of the employer, the worker may be acting as an employee in the capacity of a supervisor orrepresentative of the employer.

(6) The existence of a continuing relationship. The existence of a continuing relationship between anindividual and the person for whom the individual performs services is a factor tending to indicate theexistence of an employer-employee relationship. Continuing services may include work performed atfrequently recurring, though somewhat irregular, intervals. If the arrangement contemplates continuing orrecurring work, the relationship is considered permanent, even if the services are rendered on a part-timebasis, or the person actually works only a short time.

(7) Set hours of work. The establishment of set hours of work by the employer is a factor indicative ofcontrol. This condition bars the worker from being master of her own time, which is a right of theindependent contractor. Of course, an independent contractor often must work when facilities are opento her and must complete an entire job within a certain period of time. However, it is the flexibility withinthese necessary time restraints that separates the independent contractor from the employee. Wherefixed hours are not practical because of the nature of the occupation, a requirement that the worker workat certain times is an element of control.

(8) Exclusive full-time work. If the worker must devote full time to the business of the employer, theemployer has control over the amount of time the worker spends working. This implicitly restricts theworker from doing other gainful work. An independent contractor, on the other hand, may choose forwhom and when to work.

Full-time does not necessarily mean an eight-hour day or a five or six-day week. Its meaning may vary with theintent of the parties, the nature of the occupation, and the customs of the locality.

(9) Work on employer's premises. Doing the work on the employer's premises is not control in itself;however, it does imply that the employer has control, especially where the work is of such a nature that itcould be done elsewhere. A person working in the employer's place of business is physically within theemployer's direction and supervision. The use of desk space and of telephone and stenographic servicesprovided by an employer places the worker within the employer's direction and supervision, unless theworker has the option as to whether to use these facilities.

Work done off the premises does indicate some freedom from control; however, it does not by itself mean thatthe worker is not an employee.

(10) Sequence of work done. If a person must perform services in the order or sequence set by theemployer, it shows that the worker may be subject to control as the worker is not free to follow his ownpattern of work, but must follow the established routines and schedules of the employer. This is true ifthe employer retains the right to do so even if in fact he does not.

(11) Reports recruited. If regular oral or written reports must be submitted to the employer, it indicatescontrol in that the workers are compelled to account for her actions.

(12) Payment by hour, week, or month. An employee is usually paid by the hour, week, or month,whereas payment on a commission or job basis is customary where the worker is an independentcontractor. Payment by the job includes a lump sum, which is computed by the number of hours requiredto do the job at a fixed rate per hour.

The guarantee of a minimum salary or the granting of a drawing account at stated intervals with no requirementfor repayment of the excess over earnings indicates the existence of an employer-employee relationship.

(13) Expense account. Payment by the employer of the worker's business and/or traveling expenses is afactor indicating control over the worker. Conversely, a lack of control is indicated where the worker ispaid on a job basis and has to take care of all incidental expenses.

(14) Tools and materials supplied. The furnishing of tools, materials, etc., by the employer is indicative ofcontrol over the worker. Where the worker furnishes the tools, materials, etc., it indicates a lack ofcontrol; but in some occupational fields, it is customary for employees to use their own hand tools.

(15) Facilities-furnished. A significant investment in facilities by the person performing the services tends toshow an independent status. On the other hand, the furnishing of all necessary facilities by the"employer" tends to indicate the absence of an independent status on the part of the worker.

Facilities generally include equipment or premises necessary for the work, but not tools, instruments, clothing,etc., that are provided by employees as a common practice in their particular trade.

(16) Risk of loss. Individuals who are in a position to realize a profit or suffer a loss as a result of theirservices are generally independent contractors, while individuals who are employees are not in such aposition.

(17) Number of "employers." If a person works for a number of persons or firms at the same time it usually

indicates an independent status because in such cases the worker is usually free from control by any ofthe firms. It is possible, however, that a person may work for a number of people or firms and still be anemployee of one or all of them.

(18) Availability to general public. Workers who make their services available to the general public areusually independent contractors.

(19) Power to fire. The right to discharge is an important factor it: indicating that the person possessing theright is an employer. The employer exercises control through the ever-present threat of dismissal thatcauses the worker to obey instructions. Independent contractors, on the other hand, cannot be fired aslong as they produce results that measure up to their contract specifications.

Sometimes an employer's right to discharge is restricted because of the employer's contract with a labor union orthrough increasingly more liberal judicial decisions in favor of employees. Such restrictions do not weighunfavorably against the existence of an employment relationship.

(20) Termination damages. An employee has the right to end the relationship with the employer at any timethe employee wishes without incurring liability. An independent contractor usually agrees to complete aspecific job and is responsible for its satisfactory completion or is liable for breach of contract.

4. INTERPRETATION OF COMMON-LAW TEST

4.10 Because of the conflicting nature of the various tests, they become a weapon in the hands of IRSemployees. The author has found it almost impossible to convince front-line Revenue Officer Examiners (ROE's)and Revenue Agents (RA's) that a particular group of workers meet the common law test as independentcontractors. The Internal Revenue Service appears to have an inherent bias in favor of determiningemployee/employer relationship. Only at the Appeals Division does the putative employer have the potential tohave a fair consideration of the common-law test. Some taxpayers are forced to initiate refund litigation suits tofinally secure justice in employment tax disputes with the IRS.

Worker Agreement

4.20 One common misconception that many people have is that if there is a contract signed by the workeragreeing to independent contractor status, that creates such a relationship. That is not in fact the case. Thecommon-law test controls even if the worker has agreed to be an independent contractor. The Internal RevenueManual instructs its employees as follows:

When an employer-employee relationship exists, it is of no consequence whether the employee is designated as atrustee, agent, independent contractor, or other title. Additionally, signing a contract does not always indicate the

worker is self-employed. What does govern is the substance of a particular relationship, and consequentlyemployers cannot contract away their employment tax liabilities. [IRM 104.6.5.6]

State Tests

4.30 Even if a worker is an employee pursuant to state unemployment tax or worker's compensation laws, thatdoes not in fact mean that that worker is a worker for federal purposes. Many states impose a much harsher test,known as the ABC test, for determination of a worker's status. Therefore, a worker might be an independentcontractor for common-law test purposes and an employee for worker's compensation and state unemploymenttax purposes.

5. SECTION 530 OF REVENUE ACT OF 1978

5.10 In the early 1970's, the Internal Revenue Service stepped up its enforcement of the employment tax laws.As a result, many businesses faced the severe economic consequences of reclassification. Because of pressurefrom these businesses, Congress passed Section 530 of the Revenue Act of 1978 as an interim relief provision.Section 530 of the Revenue Act of 1978, as amended, is not part of the Internal Revenue Code (IRC). However,some publishers include its text after IRC § 3401(a). Unfortunately, Congress was not able to come up with adefinition of employee. In 1982, the Senate Finance Committee proposed a five-factor test which, if met, wouldprovide safe harbor for independent contractors. The five factors proposed by the Senate Finance Committeewere:

(1) Control of hours worked;

(2) Place of business;

(3) Investment or income fluctuation;

(4) Written contract and notice of tax responsibilities; and

(5) Filing of required returns.

This legislation was not passed by Congress. Congress was able to agree upon passage of IRC §§ 3508 and 3509,which are discussed later in this material. [See Sections 11-8 and 11-9]

Safe Harbor of § 530

5.20 Section 530 provides that "an individual shall be deemed not to be an employee for purposes ofdetermining tax liabilities, unless the taxpayer had no reasonable basis for treating such individual as anemployee." [Revenue Act of 1978 § 530(a)(1)] Section 530 further provides three statutory safe havens and onegeneral safe haven for meeting the reasonable basis requirement. Under Section 530, a taxpayer is deemed tohave a reasonable basis for not treating an individual as an employee where the taxpayer's treatment of theworker was in reasonable reliance on any of the following:

(1) Judicial precedents, published IRS rulings, technical advice memorandum, or private letter ruling ordetermination letter ruling directed to the taxpayer;

(2) A prior IRS audit of the taxpayer, not necessarily for employment tax purposes, in which there was noassessment attributable to the taxpayer's employment tax treatment of the class of workers whose presentstatus is at issue. The Small Business Jobs Protection Act of 1996 removes this protection for tax returnsfiled for years after 1996;

(3) A long-standing, recognized practice of a significant segment of the industry in which the taxpayer isengaged; and

(4) A general safe haven (any other reasonable basis). In addition to the three statutory methods set forthabove, the statute allows the taxpayer to demonstrate "reasonable basis" for its treatment of workers insome other manner.

Additional Requirements

5.30 Even though the taxpayer has satisfied one of the designated statutory safe havens, Section 530 relief willbe denied where the taxpayer fails to meet two additional requirements:

(1) The taxpayer must not have previously treated the individuals in question as an employee; and

(2) The taxpayer must have timely filed all required information returns for each worker consistent withclassification as an independent contractor (i.e., Form 1099).

Burden of Proof

5.35 The Small Business Jobs Protection Act provides that for post-1996 periods if a taxpayer establishes aprima facie Section 530 case, the burden of proof shifts to Internal Revenue Service.

Consistency Provisions

5.40 Under the "consistency provisions" [Revenue Act of 1978 § 530(a)(3)] relief is unavailable to thetaxpayer if the taxpayer (or predecessor) has treated any individual after December 31, 1977, holding asubstantially similar position as an employee for employment tax purposes. Under this section, relief would alsobe denied in the successor taxpayer's business. The author defended a client who met at least two of the SafeHarbors of Section 530, but the IRS claimed that there is inconsistent treatment. The taxpayer employed uniontruck drivers to drive company-owned trucks and contracted with independent drivers who owned their owntrucks to provide additional trucking resources. The Internal Revenue Service used the term "truck driver" todescribe both categories (union drivers and owner operators). Because both categories are truck drivers, the IRSrefused to grant Section 530 relief based upon its determination that there was inconsistent treatment. The authorbelieves such cases indicate bad faith of the IRS when negotiating the use of Section 530 Safe Harbors. The casewas settled in Appeals after three years of dispute with a full concession by the IRS, but to gain that victory thetaxpayer spent thousands of dollars for legal and accounting fees.

Treatment as Employee

5.50 The IRS has published guidelines in Revenue Procedure 85-18 for purposes of interpreting "treat." Ingeneral the word "treat" includes the following:

(1) The withholding of income tax or FICA tax from an individual's wage; or

(2) The filing of employment tax returns (i.e., Form 940, 941 or W-2).

[Rev Proc 85-18, 1985-1 CB 518]

Effect of Section 530 Relief

5.60 The IRS takes the position that a successful Section 530 defense does not change the status of anemployee to independent contractor for other purposes. The IRS Manual [IRM 104.6.5.5] provides as follows:

(1) It is important to remember that even if an employer is entitled to relief under Section 530, theemployees remain employees for other purposes of the Code. Section 530 only terminates the liability ofthe employer for the employment taxes but has no effect on the employee's status. It does not convertworkers from the status of employee to the status of self-employed (independent contractor). The Section530 employee is still considered an employee for income tax and qualified benefit plan eligibility

purposes. Therefore, the employer must consider the Section 530 employees as employees in determiningwhether its pension, profit-sharing, or stock-bonus plan satisfies the qualification requirements of Section401 (a).

(2) The Section 530 employee remains liable for the employee share of FICA tax with respect to all wagesreceived. The employee's share of FICA is reported on Form 8919, Uncollected Social Security andMedicare Tax on Wages,, by substituting the word "wages" for the word "tips." Revenue Procedure85-18, Section 3.08; Section 31.3102-1 (c). See also Revenue Ruling 86-111, 1986-2 CB 176.

(3) Where Section 530 employees have filed and paid their tax under the Self Employment TaxContributions Act (SECA), they may file a claim for refund for the difference between SECA tax and theemployee share of FICA.

(4) As an employee, the worker generally cannot deduct unreimbursed business expenses above the line onSchedule C, but must deduct them, if at all, as miscellaneous itemized deductions on Schedule A, Form1040, subject to the two percent limitation of IRC § 67. This sometimes results in liability for thealternative minimum tax. Further, the worker cannot adopt or maintain a self-employment retirementplan. Finally, certain benefits provided by the business to a worker as an employee may be excludablefrom income by the employee due to specific IRC exclusions provided only to employees (e.g., employerprovided accident and health insurance.

Judicial Interpretation

5.70 In Lambert Nursery and Landscaping, Inc. v, United States, the United States Court of Appeals ruled thatthe nature of the relationship and not the services performed, is a critical factor in determining if two groups ofworkers hold substantially similar positions. The Lambert Nursery test appears to be correct because it is clearthat attorneys, accountants and doctors and other persons who are historically independent contractors may beemployees even though the services they perform as either employees or independent contractors are identical.Therefore, the position requirement should be interpreted to relate to the relationship between the worker andthe business, not the nature of services performed. Once the consistent treatment requirement is met for theworker or group of workers, it should not be forfeited for that period. It may, however, be forfeited for futureperiods if inconsistent treatment is not maintained.

6. REASONABLE BASIS FOR INDUSTRY PRACTICE

6.10 Unfortunately for taxpayers, despite the direction of Section 530, the IRS has not liberally construed theindustry practice safe haven, In Technical Advisory Memorandum 8733004, the Service denied Section 530relief even though the taxpayers established that 60% of the companies providing associate dentists to dentalclinics in the geographic area have treated the associate dentists as independent contractors. In TAM 8749001,the Service restated the narrow interpretation of industry practice as set forth in TAM 8733004. Moreover, theService indicated that the safe harbor is wholly unavailable in the case of a new industry which did not exist atthe time of Section 530's enactment.

Impact of Small Business Jobs Protection Act

6.15 The Small Business Jobs Protection Act provides specific guidance on the industry practice safe harbor. Asignificant segment does not require a showing of more than 25% of the industry. The committee reports say thisrule is a ceiling only and a lower percentage may constitute a significant segment. The practice need not havecontinued for more than 10 years, as the IRS has argued in some cases.

Geographical Definition

6.20 Fortunately, most courts have rejected the Internal Revenue Service's narrow interpretation of industrypractice. In General Investment Corp. v. United States, the 9th Circuit held the determination of what constitutesa relevant industry practice should be liberally construed in favor of the taxpayer in light of the remedialcharacter of such since Section 530. Before the 9th Circuit, the government argued that in order to rely upon theindustry practice standard, General Investment Corporation should be required to prove the industry standard formining companies throughout the United States, or at least for small mining companies throughout the UnitedStates which process and extract ore. The 9th Circuit soundly rejected both arguments. It found that "Congressintended to protect employers who exercise good faith in determining that workers were employees orindependent contractors." The Court cited the legislative history of Section 530, which stated that "reasonablebasis" is to be construed liberally for the taxpayers.

Industry Cooperation

6.30 Historically, it has been very difficult for taxpayers to provide sufficient proof of relevant industrypractice, particularly because competitors, out of fear of an IRS audit, refuse to cooperate. Althoughunderstandable, an industry as a whole is generally both served and protected by cooperation in thisregard.

Application of Section 530 Relief

6.40 The Small Business Jobs Protection Act reversed the IRS' position that there must be a determination thatthe worker is an employer under common law standards before the taxpayer may use Section 530 safe harbors.The Act also provides that for post-1996 periods if a taxpayer wished a prima facie Section 530 case, the burdenof proof shifts to the Internal Revenue Service.

7. SUBSECTION D

7.10 Section 1706 of the Tax Reform Act of 1986, amended Section 530 with respect to "technical servicespecials" by adding Subsection D. Subsection D provides that the relief under Section 530 is not available withrespect to individuals referred to "Technical Service Specialists" whose services are engaged by a broker.Subsection D only applies to three party transactions involving, the worker (Technical Service Specialists), thebroker firm and the client who uses the service of the worker.

8. IRC § 3508

8.10 IRC § 3508 provides specific relief for certain industries from worker reclassification. Qualified realestate agents will be relieved from redetermination if the person is a licensed real estate agent and receives all ofher remuneration based upon sales or other output, rather than hours worked, pursuant to a written contract.Direct sellers will be relieved of recharacterization if they are engaged in a trade or business of selling consumerproducts (i.e., Avon, Amway) and receive substantially all of their remuneration based upon sales or otheroutput, rather than hours worked, pursuant to a written contract.

9. IRC § 3509

9.10 Congress passed IRC § 3509 in 1982 to provide for reduced employment tax liability to employers forcertain retroactive recharacterization of workers. The Act provided that if Forms 1099 were filed with respect tothe workers, then the following rates would apply:

(1) 1.5% of liability of total payments for income tax withholding; and

(2) The employers share of FICA plus 20% of the employees share of FICA. If no 1099's were filed with

respect to the workers, then the liability would be:

(3) 3% liability for income tax withholding; and

(4) The employer's share of FICA plus 40% of the employee's share.

FUTA Liability

9.20 IRC § 3509 is not applicable for FUTA tax liability, and no adjustment is available under IRC § 6205 withrespect to interest and penalties. The lower tax rates provided under IRC § 3509 do not apply where theemployer intentionally disregards reporting requirements. [See Ltr Rul 8415010]

10. INTEREST FREE ADJUSTMENTS — IRC § 6205

10.10 A special interest free adjustment is provided with respect to certain under-payments of FICA andwithholding tax liability. This rule does not apply with respect to FUTA taxes. The underpaid FICA and/orwithholding tax liability must be paid at the time that "error is ascertained." An error is ascertained when theemployer has sufficient knowledge of the error to be able to correct it. [See Rev Rul 75-465, 1975-2 CB 474 forspecial rules]

11. SPECIAL ABATEMENT RULES — IRC §§ 3402(D), 6511(D)(7) AND 6521

11.10 IRC § 3402(d)(1) provides that an employer has the ability to obtain relief from a retroactive assessmentof income withholding tax liability if an employer can demonstrate that the worker reported the income coveredby the assessment on his Form 1040 return. IRS Form 4669 is designed for this purpose. Forms 4669 aretransmitted to the IRS with Form 4670, IRC § 3402(d) relief is unavailable if the special tax rates of IRC § 3509apply.

Mitigation of the Statute of Limitations

11.20 IRC § 6521 provides mitigation of the effect of the Statute of Limitations on obtaining a refund of FICAand SECA taxes in situations involving retroactive recharacterization of workers. Under IRC § 6521, theemployer may obtain credit for her share of FICA taxes if the statute of limitations for the worker obtaining the aSECA refund has expired. Section 6521 relief is unavailable if the special tax rates of IRC § 3509 apply.

Refund Claims by Redetermined Employees

11.30 Under the prior law, the taxpayer was required to file a claim for refund of excess self-employment taxespaid after redetermination to be an employee within three years after the due date of the return, the return isfiled or two years after the tax was paid. The Taxpayer Relief Act of 1997 provided that a redeterminedemployee, may now file a claim for overpayment of self-employment taxes any time before the last day of thesecond year after the Tax Court decision becomes final in a Tax Court proceeding regarding redetermination. Inother words, the redetermined individual does not have to file a claim until after all proceedings by the putativeemployer have concluded before the United States Court.

12. CLASSIFICATION SETTLEMENT PROGRAM

12.10 The IRS announced in FS-96-5 that it will be testing procedures under an optional workers classificationsettlement program. The Classification Settlement Program (CSP) is also intended to ensure that the taxpayerrelief provisions of Section 530 of the Revenue Act of 1978 are properly applied. [IRM 104.6.6.1] Sinceannouncement the program as a test the IRS has now apparently made the program permanent by incorporatingit within the Internal Revenue Manual.

Training Manual

12.15 As part of its classification settlement program, the IRS has issued training materials to its employees.Those training materials require a much more liberal view of employment tax issues. The authors have noted thatin many instances the IRS is much more willing to discuss the issue in a manner more favorable to the taxpayerthan prior to the issuance of these training materials. [Training 3320-102 (10-96)]

Eligibility

12.20 Under the CSP, an examiner will develop the worker classification issue, including the business' eligibilityfor relief under Section 530. The examination group manager must then confirm the business' eligibility for aCSP settlement. If an offer is made and accepted by the business, a standard closing agreement provided by theIRS National Office will be executed.

Graduated Settlement Offers

12.30 A series of graduated settlement offers will be available. If the business meets the Section 530 reportingconsistency requirement but either clearly doesn't meet the Section 530 substantive consistency requirement orclearly can't satisfy the Section 530 reasonable basis test, the offer will be a full employment tax assessment forthe one year under examination, computed using IRC § 3509, if applicable. If the business meets the reportingconsistency requirement and has a colorable argument that it meets the substantive consistency requirement andthe reasonable basis test, the offer will be an assessment of 25% of the employment tax liability for the audityear, computed under Section 3509, if applicable. The business must agree to properly classify its workersprospectively. [IRM 104.6.6.13.1 ]

Section 530

12.40 If the requirements of Section 530 are fully met, no assessment will be made, and the business maycontinue to treat its workers as independent contractors. Furthermore, a business that wishes to treat its workersas employees may enter an agreement to begin treating its workers as employees currently or at the beginning ofthe next year. If it does so, the business will not give up its claim to Section 530 relief for prior years.

13. TAX COURT JURISDICTION

13.10 The Taxpayer Relief Act of 1997 allows the taxpayer, upon filing an appropriate pleading, to obtain TaxCourt review of an "actual controversy" involving an IRS redetermination as part of an examination, that: (1)one or more individuals performing services for the taxpayer are employees for employment tax purposes [IRC §7436(a)(1)], or (2) the taxpayer is not entitled to relief under Section 530(a) with respect to such an individual.The Code Section does not define actual controversy but the term is used in the federal court system to mean areal dispute between adverse parties involving substantial legal interests.

Party in Interest

13.20 A pleading before the Tax Court can only be filed by the person for whom the services are performed.[IRC § 7436(b)(1 )] The taxpayer must file a petition with the Tax Court within 90 days of the time the IRSissues a certified or registered mail notice to the taxpayer of its determination in an employment tax matter. Ifthere is a Tax Court proceeding, the change of employment tax treatment of any individual from that of anintended contractor to that of an employee, the treatment as an employee will not be taken into account by theTax Court. The assessment and collection of taxes is suspended while the matter is pending before the UnitedStates Tax Court.

All Case Procedures

13.30 If the amount of the employment tax dispute is $50,000 or less for each calendar quarter involved, thecase may be conducted under the rules of evidence, practice and procedures applicable to small income taxcases. [IRC § 7436(c)(1 )] Decisions entered under the small tax case rules will not be reviewed in any othercourt and will not be treated as precedent for any other case not involving the same petition and the samedeterminations. The Tax Court decision, together with a brief summary of the Court's reasons for its decision,will satisfy requirements for reports on Tax Court proceedings, hearings and determinations.

Effect of Tax Court Decision in Larger Cases

13.40 The Tax Court determination of an employment tax matter will have the same force and effect as anyother Tax Court decision. It is appealable in the same manner as any other Tax Court proceeding. The TaxpayerRelief Act of 1997 also amended the prohibition against suits to restrain assessment and collection of taxes withrespect to employment status cases. [IRC § 7421 (a)] Employment status cases are also eligible for awards ofadministrative and litigation costs pursuant to IRC § 7430.

Limits of Tax Court Jurisdiction

13.50 The Tax Court had previously held that IRC § 7436, which granted its jurisdiction to make certainemployment status determinations, didn't give it jurisdiction to decide the proper amount of employment tax and

income tax withholding due as a result of its status determination. The Code was amended in 2000 to read asfollows:

“IRC §7436(a)(2) such person is not entitled to the treatment under subsection (a) of section 530 of theRevenue Act of 1978 with respect to such an individual, upon the filing of an appropriate pleading, theTax Court may determine whether such a determination by the Secretary is correct and the properamount of employment tax under such determination. Any such redetermination by the Tax Court shallhave the force and effect of a decision of the Tax Court and shall be reviewable as such.”

Therefore the Court may determine liability the amounts due as a result of its determination.

14. TRUST FUND RECOVERY PENALTY — IRC § 6672

14.10 The liabilities imposed under IRC § 6672 are known as the Trust Fund Recovery Penalty (formerly 100%Penalty). There are two major tests to determine if someone is subject to provisions of IRC § 6672. The twoissues in question may be stated as follows:

(1) Whether the party against whom the penalty is proposed had the duty to account for, collect and payover trust fund taxes; and

(2) Whether he or she wilfully failed to perform this duty.

Personal Liability of Officers

14.20 In the context of employment tax examinations, IRC § 6672 poses a danger to officers of a companywhich is forced to cease operations as a result of a large employment tax deficiency. Although the InternalRevenue Service has a policy of not pursuing officers of companies for personal liability in cases where IRC §3509 rates have been applied, it has pursued officers of companies when the higher assumed rates of liabilitywere imposed. Obviously, once an assessment is made using the higher assumed rates of 20% for withholdingand the employee portion of FICA, a person who controlled the corporate taxpayer has significant risk ofliability pursuant to IRC § 6672. The controlling officer of the corporation would not have the defense that hewas not a responsible person. The sole defense available to the officer would be that his conduct was not willful.The word "willfully," as used in IRC § 6672, does not signify an act done with a fraudulent or evil purpose, butmerely knowingly or intentionally disregarding the statutory provision. The Seventh Circuit has definedwillfulness as follows:

An act is willful if it is voluntary, conscience and intentional. A responsible person acted willfully if heknowingly used available funds to prefer other creditors over the Internal Revenue Service.

Personal Fault

14.30 The Supreme Court has observed that "the fact that the provision imposes penalty and is violated only bywillful failure is itself strong evidence that it was not intended to impose liability without personal fault."

Lack of Knowledge

14.40 In the case of an Employment Tax Examination, an officer certainly might raise the defense that he wasunaware of the liability and therefore, should not be found to have been willful. Unfortunately for the taxpayerutilizing that defense, in order to use the higher rates, other than IRC § 3509 rates, there must be a finding thatthe taxpayer intentionally disregarded the rules for employment taxes. Obviously, that standard would relatedirectly to the willfulness standard of IRC § 6672. If the original tax deficiency was never litigated, then thetaxpayer retains the right to defend that the corporate entity did not intentionally disregard tax rules andtherefore, the potentially responsible person was not willful.

15. SUMMARY OF EMPLOYMENT TAX AUDITS

15.10 The stepped up employment tax examination process by the Internal Revenue Service has placed manytypes of businesses at risk of economic destruction by an IRS audit. Many industries rely upon independentcontractors as their primary service providers, and a large employment tax deficiency would destroy anindividual business. Many industries, such as the messenger industry, trucking companies, and some constructionbusinesses face economic destruction as a result of employment tax audits. Because the area of law is complex,the practitioner must defend each individual examination on a case by case basis. The IRS has failed to liberallyapply IRC § 530 as anticipated by Congress. In most instances, the original audit will result in a finding againstthe taxpayer. Although the CSP program has allowed the settlement of some employment tax exams at the fieldlevel, Appeals is still offering better deals than the field in most cases. If you think the IRS is wrong, appeal.

Form 8919

The Internal Revenue Service has developed a new form for employees who have been misclassified asindependent contractors by an employer. Form 8919, Uncollected Social Security and Medicare Tax on Wages,will now be used to figure and report the employee’s share of uncollected social security and Medicare taxes dueon their compensation.

Generally, a worker who receives a Form 1099 for services provided as an independent contractor must reportthe income on Schedule C and pay self-employment tax on the net profit, using Schedule SE. However,sometimes the worker is incorrectly treated as an independent contractor when they are actually an employee.When this happens, Form 8919 will be used beginning for tax year 2007 by workers who performed services foran employer but the employer did not withhold the worker’s share of social security and Medicare taxes.

In addition, the worker must meet one of several criteria indicating they were an employee while performing theservices. The criteria include:

The worker has filed Form SS-8, Determination of Worker Status for Purposes of Federal EmploymentTaxes and Income Tax Withholding, and received a determination letter from the IRS stating they are anemployee of the firm.

The worker has been designated as a section 530 employee by their employer or by the IRS prior toJanuary 1, 1997.

The worker has received other correspondence from the IRS that states they are an employee.

The worker was previously treated as an employee by the firm and they are performing services in asimilar capacity and under similar direction and control.

The worker’s co-workers are performing similar services under similar direction and control and aretreated as employees.

The worker’s co-workers are performing similar services under similar direction and control and filedForm SS-8 for the firm and received a determination that they were employees.

The worker has filed Form SS-8 with the IRS and has not yet received a reply.

By using Form 8919, the worker’s social security and Medicare taxes will be credited to their social securityrecord. To facilitate this process, the IRS will electronically share Form 8919 data with the Social SecurityAdministration.

In the past, misclassified workers often used Form 4137 to report their share of social security and Medicaretaxes. Misclassified workers should no longer use this form. Instead, Form 4137 should now only be used bytipped employees to report social security and Medicare taxes on allocated tips and tips not reported to theiremployers.

IRS may prepare substitute returns in worker classification cases

Chief Counsel Advice 200822026

A Chief Counsel Advice (CCA) has concluded that, in employment tax cases where worker classification issuesare present, revenue officers have authority under Code Sec. 6020(b) to prepare employment tax returns, but therequirements of Code Sec. 7436 must be met before assessment.

Background. Where there is an actual controversy involving a determination by IRS that one or moreindividuals performing services for the taxpayer are employees as part of an examination, Code Sec. 7436 givesthe Tax Court jurisdiction to determine certain “worker classification issues” (i.e., the proper amount of theadditions to tax, additional amounts, and penalties that relate to the employment tax with respect todeterminations of worker classification and whether the taxpayer is entitled to relief under § 530 of the RevenueAct of 1978). To meet Code Sec. 7436 's requirements, certain procedures must be followed before assessmentof employment taxes. They are spelled out in Notice 2002-5, 2002-1 CB 320. For example, Notice 2002-5provides generally that a taxpayer will first receive a “30-day” letter listing the proposed employment taxadjustments to be made and describing the taxpayer's right either to agree to the proposed adjustments or toprotest the proposed adjustments to the IRS's Appeals function (Appeals) within 30 days of the date of the letter.

If the taxpayer does not respond to the “30-day” letter by agreeing to the proposed adjustments or by filing aprotest to Appeals, the taxpayer will receive a Notice of Determination of Worker Classification (NDWC).The taxpayer may also receive the NDWC if the taxpayer files a protest with Appeals and the workerclassification issues are not settled in Appeals. As indicated in Notice 2002-5, under Code Sec. 7436(d)(1), themailing of the NDWC suspends the period of limitations for assessment of taxes attributable to the workerclassification issues for the 90-day period during which the taxpayer can bring suit and precludes IRS fromassessing the taxes identified in the NDWC before the expiration of the 90-day period during which the taxpayermay file a timely Tax Court petition.

If IRS erroneously makes an assessment of taxes attributable to the worker classification issues without firsteither issuing a NDWC or obtaining a waiver of restrictions on assessment from the taxpayer, the taxpayer isentitled to an automatic abatement of the assessment. However, under Notice 2002-5, once any proceduraldefects are corrected, IRS may reassess the employment taxes to the same extent as if the abated assessment hadnot occurred.

The amount of any tax imposed by the Code is to be assessed within 3 years after the return was filed, subject tocertain specified exceptions. (Code Sec. 6501(a))

Under Code Sec. 6020(b), if a taxpayer fails to file a return when required, IRS may prepare a return based on itsown knowledge and on information it obtains through testimony or other means. The failure-to-pay penalty

under Code Sec. 6651(a)(2) applies to the amount of tax shown on the return, including, under Code Sec.6651(g)(2) , any amount shown on a substitute return prepared by IRS. Absent the existence of a return underCode Sec. 6020(b), the Code Sec. 6651(a)(2) penalty doesn't apply to a nonfiler. [For discussion of recentlyissued regs on substitute returns, see Federal Taxes Weekly Alert 02/14/2008]

Facts. The Chief Counsel was asked to review a memorandum which addressed the issue of whether a revenueofficer has authority under Code Sec. 6020(b) to prepare employment tax returns on behalf of taxpayers who failto file such returns in a case in which worker classification issues are present and where the revenue officer didnot refer the case to the Employment Tax Program as required under the Internal Revenue Manual (IRM).

For the years at issue, the taxpayer took the position that certain workers were independent contractors forfederal tax purposes. However, for prior years, the taxpayer had treated the workers as employees. Afterreviewing the facts of the case, the revenue officer determined that the workers should have been treated asemployees and prepared Substitute for Returns (SFRs) under Code Sec. 6020(b).

The taxpayer objected to the preparation of the SFRs and requested an appeal. The appeals officer concludedthat the worker classification issue was undeveloped and that “the revenue officer did not have the authority toprepare Forms 941 under Code Sec. 6020(b) procedures because the IRM requires the issue to be referred to theEmployment Tax Program,” and recommended the government concede the case.

Analysis. The CCA observed that the taxpayer failed to file an employment tax return and did not submitevidence to establish that no employment tax return was due. The revenue officer determined that some of thetaxpayer's workers were employees and that an employment tax return should have been filed. The revenueofficer prepared returns under Code Sec. 6020(b).

The CCA said that, because the revenue officer failed to meet Code Sec. 7436 's requirements, an assessment ofemployment taxes based on the Code Sec. 6020(b) return prepared by him is improper. However, the CCA saidthat the facts do not indicate that the government is required to concede the case. The CCA said that, underNotice 2002-5 , once the procedural defects are corrected and Code Sec. 7436 's requirements are met,employment taxes may be assessed.

Overassessment (Excise or Employment Tax), and Form 2504-WC, Agreement to Assessment andCollection of Additional Tax and Acceptance of Overassessment in Worker Classification Cases(Employment Tax)) constitute adjusted returns. (Reg. § 31.6205-1)

Interest-free adjustments. The final Code Sec. 6205 regs set out the procedures for making interest-freeadjustments for underpayments of employment taxes. If a return is filed and less than the correct amount ofemployee or employer FICA or RRTA tax is reported, and the employer discovers the error after filing thereturn, the employer adjusts the resulting underpayment of tax by reporting the additional amount due on anadjusted return for the return period in which the wages or compensation was paid. The adjustment must bemade by the due date of the return for the return period in which the error is ascertained, and the amount of theunderpayment must be paid by the time the adjustment is made, or interest will begin to accrue from that date.An underpayment adjustment can only be made within the period of limitations for assessment. Forunderpayments of ITW where the incorrect amount was withheld, subject to limited exceptions, an adjustmentcan only be made for errors ascertained during the calendar year in which the wages were paid. (Reg. §31.6205-1(b)(2))

The final regs also provide for interest-free adjustments of underpayments of FICA tax, RRTA tax, and ITWunder certain circumstances where the underpayment arises because the employer failed to file an original returnor failed to report and pay the correct type of tax. (Reg. § 31.6205-1(b)(3), Reg. § 31.6205-1(c)(3))

The final Code Sec. 6413(a) regs set out the procedures for making interest-free adjustments for overpaymentsof employment taxes. If an employer ascertains an overpayment error within the applicable period of limitationson credit or refund, it's required to repay or reimburse its employees the amount of overcollected employeeFICA or RRTA tax before the expiration of that period. However, the requirement to repay or reimburse doesn'tapply to the extent that taxes weren't withheld from the employee or if, after reasonable efforts, the employercannot locate the employee. In such a case, the employer can make an adjustment for only the employer share ofFICA or RRTA tax. An interest-free adjustment for an overpayment cannot be made once a claim for refund hasbeen filed. (Reg. § 31.6413(a)-1)

Once an employer repays or reimburses an employee to the extent required, the employer may report both theemployee and employer portions of FICA or RRTA tax as an overpayment on an adjusted return. The employermust certify on the adjusted return that it has repaid or reimbursed its employees to the extent required.

Under the final regs, the reporting of the overpayment constitutes an interest-free adjustment if the overpaymentis reported on an adjusted return filed before the 90th day prior to expiration of the period of limitations oncredit or refund. Similar rules apply for making interest-free adjustments for ITW overpayments, except that aninterest-free adjustment can only be made if the employer ascertains the error and repays or reimburses itsemployees within the same calendar year that the wages were paid and reports the adjustment on an adjustedreturn. (Reg. § 31.6413(a)-2)

No repayment or reimbursement for interest-free adjustments of overpayments. Unlike in the proposed reg, inthe final regs the employer isn't required to repay or reimburse the employee or to adjust the overpayment by thedue date of the return for the return period following the return period in which the error is ascertained. (Reg. §31.6402-2(a)(1)) After reconsideration, IRS determined there was insufficient reason to impose a timingrestriction other than the period of limitations on credit or refund of taxes. (T.D. 9405, 06/30/2008)

Deposits, payments, and credits. An employer making an interest-free adjustment must pay the amount of theadjustment by the time it files an adjusted return. The timely payment satisfies the employer's deposit obligationsfor the adjustment. (Reg. § 31.6302-1(c)(7)) In determining the amount of accumulated taxes in an agriculturalemployer's lookback period (which determines the employer's deposit schedule), adjustments to tax liabilitymade under the filing of adjusted returns or refund claims aren't taken into account; new agricultural employersare treated as having employment tax liabilities of zero for any lookback period before the date the employerstarted or acquired its business. (Reg. § 31.6302-1(g)(4))

If the underpayment amount isn't paid when the adjusted return is filed, interest begins to accrue as of the datethe adjusted return is filed. (Reg. § 31.6205-1(b)(2))

The adjusted overpayment amount will be applied as a credit toward payment of the employer's liability for thecalendar quarter (or calendar year for annual returns being adjusted) in which the adjusted return is filed, unlessIRS notifies the employer that the credit will be applied to a different return period or that the employer isn'tentitled to the adjustment under applicable laws or procedures. (Reg. § 31.6413(a)-2(b)(2))

Refunds for overpayments. As in the prior regs, instead of making an interest-free adjustment for anoverpayment, employers can file a claim for refund for the amount of the overpayment. Furthermore, if anemployer can't make an interest-free adjustment for an overpayment because the period of limitations forclaiming a credit or refund for the overpayment will expire within 90 days or because IRS has otherwise notifiedthe employer that it's not entitled to the adjustment, the employer can recover the overpayment only by filing aclaim for refund. (Reg. § 31.6413(a)-2(d))

An employer can file a claim for refund of an overpayment of FICA or RRTA tax, but must certify that it hasrepaid or reimbursed the employee's share of FICA or RRTA tax to the employee or has secured the employee'swritten consent to allowance of the refund or credit. However, the employer isn't required to repay or reimbursethe employee or obtain the written consent of the employee to the extent that the overpayment doesn't includetaxes withheld from the employee or, after reasonable efforts, the employer cannot locate the employee or theemployee, once contacted, will not provide the requested consent. (Reg. § 31.6402(a)-2(a)) The final regs underCode Sec. 6414 set out similar procedures for filing a claim for refund of overpaid ITW, except that an employercan't file a claim for refund of an overpayment of ITW for an amount the employer deducted or withheld froman employee. (Reg. § 31.6414-1(a))

IRS intends to issue guidance to provide examples of how the final regs apply in different factual scenarios.(T.D. 9405, 06/30/2008)

[A&L1]

"REPRESENTING THE AUDITED TAXPAYER BEFORE THE IRS"

AND

REPRESENTATION BEFORE THE COLLECTION DIVISION OF

THE IRS

[A&L1] In 1996 Sec 2(b) was eliminated

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