Jason J. Galek is a tax attorney certified as a specialist in taxation law by the California State Bar Board of Legal Specialization. Jason represents individuals and business entities in tax controversy and planning matters before the Internal Revenue Service, California Franchise Tax Board, and Board of Equalization. Jason has an LL.M. in Taxation from Golden Gate University School of Law and is adjunct professor at Golden Gate University School. Jason is a member of the San Francisco Tax Club, and San Francisco Bar Association Taxation Section’s Executive Committee. Jason was previously Treasurer of the San Francisco Barristers Board of Directors and a member of the Bay Area Young Tax Lawyers executive committee.

Jason J. Galek Galek Law 100 Pine Street, Suite 1250 San Francisco, CA 94111 415-429-4175 galek-law.com [email protected]

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Perils and Solutions Arising From Misclassification of Employees

Topics  Common situations involving employee misclassification  Penalties and other Adverse Consequences  Abatement and Safe Harbor under the Internal Revenue Code  Voluntary Classification Settlement Program (VCSP)

INTRODUCTION

We all know, employees receive W2, and independent contractors receive 1099s. But the question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is intensely factual and complex.

What many employers do not know how to make the decision whether their workers are employees subject to FICA, FUTA, and federal income tax withholding, or independent contractors who are not.

As the title suggests, many employers find themselves in a Prince Hamlet situation when evaluating this situation, very often letting savings on employment taxes operate to guide their decision. Today, while we will discuss the factors that go into determining whether a worker is an employee or an independent contractor, and preventative measures, we will primarily be addressing the penalties tax consequences under the Internal Revenue Code for deliberately or inadvertently misclassifying workers as independent contractors instead of employees.

Broadly, a worker is either an employee (who is included) or an independent contractor (who is not included) within the definition of an employee for FICA, FUTA, and federal income tax withholding purposes. The classification of a worker under either classification changes the tax responsibilities of both the employer and the workers.

Why Is Classifying Employees So Complicated?

There are four separate independent categories of “employees” subject to FICA, FUTA, and federal income tax withholding: common law employee, corporate officer, statutory employee, or covered by an arrangement under the Social Security Act. IRC § 3121(d)).  Common law employee (Treas. Reg. 31.3121(d)–1(c)). Under common law, a worker is an employee when the person for whom the services are performed has the right to control and direct the individual who performs the services. This control reaches not only the result to be accomplished, but also the details and means by which that result is to be accomplished. Control must be present, but need not actually be exercised. Courts have held that the degree of supervision necessary to demonstrate control is only “such supervision as the nature of the work requires.” McGuire v. United States, 349 F. 2d 644, 646 (1965 9th Cir.). o Control is determined on a case‐by‐case examination of the total facts and circumstances. must be examined. Ask questions about the relationship between the worker and the taxpayer to ascertain control. Rev. Rul. 87‐41 lists 20 factors that may be informative but are not determinative.  Corporate officer (IRC § 3121(d)) is included within the definition of an employee for FICA, FUTA, and federal income tax withholding purposes. See IRC 3121(d)(1), IRC 3306(i), and IRC 3401(c). The common law standard is not applicable. o The regulations provide that generally an officer of a corporation is an employee of the corporation, but an officer is not considered to be an employee of the corporation if two requirements are met: . The officer does not perform any services or performs only minor services, and . The officer is not entitled to receive, directly or indirectly, any remuneration. (Treas. Reg. 31.3121(d)‐1(b))  Statutory employee (IRC § 3121(d)) includes agent‐drivers or commission‐drivers, full‐time life insurance salespersons, home workers, and traveling or city salespersons. These workers are employees for FICA purposes even if they do not satisfy the common law test. Some key differences between common law employees and statutory employees: o Workers cannot be a statutory employee if that employee is a common law employee. IRC § 3121(d)(3). o Employers are not permitted to deduct trade and business expenses for statutory employees. are sometimes treated as employees for FICA, and sometimes employees for FUTA, but not income tax withholding. Rev. Rul. 90–93.  Employees Under Section 218 of the Social Security Act beginning in 1951, states could enter into voluntary agreements with the Federal Government to provide social security coverage to public employees under Section 218 of the Social Security Act. IRC § 3121(b)(7)(E).  Further adding to the confusion, Statutory Non‐Employees are not treated as employees for FICA, FUTA, or federal income tax withholding purposes o Qualified real estate agents (IRC § 3508(b)(1)) o Direct sellers (IRC § 3508(b)(2)) o Companion sitters (cf. household employees) (IRC § 3506)

What’s an Independent Contractor?

Generally, any worker that is not an employee. Employers have a strong incentive to hire an “independent contractor" rather than a W2 wage employee because employers must withhold federal income and payroll taxes, pay the employer’s share of FICA on the wages plus any FUTA tax, and often provide the worker with fringe benefits. None of these apply if the worker is an independent contractor, who also are not subject to minimum wage and overtime requirements.

SOME PREVENTATIVE MEASURES AND TIPS

 Under certain circumstances, Employers may request the IRS to rule whether a worker is an independent contractor or employee (Form SS‐8). California has a similar procedure. See, Determination of Employment Work Status for Purposes of State of California Employment Taxes and Personal Income Tax Withholding (DE 1870).  Always report amounts paid on employment taxes on either W2 or Form 1099 (if it amounts to $600 or more). Failure to properly report amounts paid may prevent relief for the employer. Required for section 530 and VCSP  Workers who believe that they are misclassified can file Form 8919 to calculate and report the employee’s share of uncollected social security and Medicare taxes due on their compensation.  At minimum, the employer should evaluate if relief is available under section 3402(d).

POTENTIAL PENALTIES

Federal

Misclassification of employees as independent contractors has severe penalties. Generally, the employer is liable for the employee portion of the tax (in addition to the employer portion of the tax) despite if the tax is collected from the employee. IRC § 3102(b).

Section 3509 offers a reduction of the amounts required to be paid by the employer. For unintentionally failing to withhold federal income tax, the penalty is 1.5 percent of the wages paid. IRC § 3509(a)(1). The penalty is doubled to 3 percent if the employer did not file a Form 1099‐MISC for the worker with the IRS. IRC § 3509(b)(1)(A), (b)(2).

The penalty for unintentionally failing to withhold the employee’s share of Social Security and Medicare taxes is 20 percent of the employee's share of the tax. IRC § 3509(a)(2). The penalty is doubled to 40 percent if the employer did not file a Form 1099‐MISC for the worker with the IRS. IRC § 3509(b)(1)(B).

If the misclassification was intentional, or if statutory employees are misclassified, the employer is liable for the full amount of both the federal income tax that should have been withheld as well as the employee's and employer's share of Social Security and Medicare taxes. IRC §§ 3102(b); 3509(c), (d)(3).

If an employer has failed to withhold and deduct income taxes from an employee's wages because of a misclassification of the employee, and the section 3509 rules do not apply, the only mitigation available for the employer is provided by section 3402(d), providing that if an employer fails to deduct and withhold income tax from an employee's wages, and the tax against which the withholding may be credited is later paid, the withholding tax that the employer should have deducted and withheld is not to be collected from the employer. But the employer is not relieved from liability for any penalties or additions to tax that are otherwise applicable because of the failure to deduct and withhold the income tax.

Other penalties, such as the failure to file, the failure to deposit, the accuracy‐related penalty, penalty for a willful failure to collect and pay over withholding taxes. Criminal penalties may also apply.

California

California also imposes penalties for misclassifying workers. These penalties include repayment of back payroll taxes, subject to interest and a 15 percent penalty on the unpaid taxes. See, UIC § 1112, 1135. The EDD will abate the delinquency penalty under UIC section 1135, in addition to the personal income tax, if a worker was improperly treated as an independent contractor and reported the income on a California individual tax return, or payments to employees were misclassified and the EDD assessed PIT.

California Labor Code section 226.8, effective January 1, 2012, also imposes severe penalties on employers that willfully misclassify workers as independent contractors. Willful misclassification is defined as “voluntarily and knowingly misclassifying that individual as an independent contractor.” Section 226.8 is enforced by the Labor Commissioner of the California Labor and Workforce Development Agency. The Labor Commissioner may investigate complaints by workers and, if necessary, initiate either a civil suit or a hearing before the Labor Commissioner pursuant to California Labor Code Section 98. In addition to other penalties, section 226.8 imposes fines between $5,000 and $15,000 per violation. This amount increases to $10,000 and $25,000 per violation if the employer engages in a pattern or practice of violating the classification law.

Criminal penalties may also apply.

The difficulty with section 3402(d) relief is proving that the employees have in fact paid the income tax. In a recent case, involving whether workers were independent contractors or employees of an Indian Tribe/employer, disclosure of amounts of federal income tax paid by the workers on their tax returns was proper under Code Sec. 6103(h)(4)(C). The tribe was attempting to apply section 3402(d). The Tax Court held that (1) the employer/worker relationship is a “transactional relationship” since it pertains to the carrying on of business; (2) the determination of whether the Tribe's workers paid their tax liabilities tended to show how the workers viewed their employment status (directly relating to their relationship with the Tribe); and (3) the disclosure of the return information affected the resolution of the case, since if the Tribe's workers had paid their liabilities, then the Tribe's Code Sec. 3402(d) defense would be proved and entirely resolved. Mescalero Apache Tribe v. Commissioner, 148 TC No 11. (2017).

SECTION 530 OF THE 1978 REVENUE ACT

Section 530 relief has three requirements: reporting consistency, substantive consistency, and reasonable basis.

Reporting Consistency

The employer must have timely filed all required federal tax returns (including information returns) consistent with the employer’s treatment of each worker as not being an employee. Workers must have received a Form 1099‐MISC if paid $600 or more. Relief is not available for any year and for any workers that the employer did not file the required information returns.

Substantive Consistency

The employer must have treated the workers, and any similar workers, as independent contractors. If the employer treated similar workers as employees, this relief provision is not available.

Reasonable Basis

The employer must have had a reasonable basis for not treating the workers as employees. If the employer did not have a reasonable basis for treating the workers as independent contractors, the employer does not meet the relief requirements. An employer meets the reasonable basis test if the employer placed reasonable reliance for the action upon at least one of the following four bases:  The employer reasonably relied on a court case about federal taxes or a ruling issued to it by the IRS  The employer was audited by the IRS at a time when it treated similar workers as independent contractors and the IRS did not reclassify those workers as employees.  The employer treated the workers as independent contractors because the employer knew and can demonstrate that the employer followed a long‐standing recognized practice of a significant segment of the industry in which such individual was employed for similar employees  Some other ground for reasonable basis. For example, the employer relied on the advice of a business lawyer or accountant who knew the facts about the employer’s business.

For example, an employer obtained summary judgment on the ground that it had a reasonable basis for classifying its medical directors as independent contractors because of long‐standing practices in the rehabilitation industry were cited. The employer also had a “corporate practice of medicine doctrine,” which was listed as an independent reasonable basis for the independent contractor treatment of the medical directors. In Western Neuro Residential Centers, Inc. v. U.S., 2002‐1 USTC ¶50,368 (C.D. Cal. 2002.

Another example, adult entertainment operator’s booth performers were held to be employees rather than tenants or independent contractors for employment tax purposes. After denying relief under Section 530 of the Revenue Act of 1978, the court used the traditional 20‐factor test to find that the performers were employees. The Second Circuit reversed on the Section 530 holding, without discussing the trial court’s findings on the status of the workers. 303 West 42nd Street Enterprises Inc. v. U.S., 181 F.3d (2d Cir. 1999).

VOLUNTARY CLASSIFICATION SETTLEMENT PROGRAM (VCSP)

VCSP allows employers who erroneously treated workers as independent contractors to reclassify the workers as employees. As the name indicates, VCSP allows employers to voluntarily past worker classification issues without undergoing an audit.

VCSP is available to taxpayers who have consistently treated their workers (or a class or group of their workers) as independent contractors and now want to begin treating them as employees. Employers must have filed all required 1099s for the workers for the previous three years within six months of the 1099 due dates (including extensions).

No Previous or Current Audits

Employers under IRS audit, Department of Labor audit, or state taxing authority examination are not eligible for VCSP, but employers that are compliant with the results of audits are not barred from future participation in VCSP. Being contacted by the IRS for information following the filing an SS‐8 does not disqualify an employer from VCSP because the SS‐8 determination is not an audit. Corporate parents, subsidiaries, or other members of consolidated groups under audit will prevent the employer from individually participating in VCSP.

VCSP Terms

Employers must agree to treat the class of workers as employees for future tax periods, and to allow IRS an extra three years to assess employment taxes.

The employer in turn pays only 10 percent of the employment tax liability on compensation paid to the workers for the most recent tax year, determined under reduced rates on the compensation paid to the reclassified workers in the most recently completed tax year, determined at the time the VCSP application is filed. The 2016 reduced rate is 10.68 percent of compensation up to $118,500 (the 2016 Social Security wage base). and 3.24% of compensation above $118,500. The VCSP payment is 10 percent of tax under the reduced rate.

In addition, the employer will not be liable for interest and penalties on the employment taxes and will not be subject to an employment tax audit for the classification of the workers for prior years. Once an employer chooses to reclassify certain workers as employees, it must treat all workers in the same class as employees.

Employers apply to participate in VCSP by filing Form 8952 with IRS at least 60 days before the date the employer wishes to treat the workers as employees. No payment is submitted with the form. A closing agreement is required for employers accepted into VCSP; full payment is due when returning the signed closing agreement to the IRS.

SETTLEMENT PROGRAMS DURING AUDIT

Classification Settlement Program (CSP)

CSP was designed to allow taxpayers and examining agents to resolve worker classification issues as early as possible in the administrative process. IRM 4.23.6 (04‐22‐2014). The examining agent reviews whether the employer erroneously misclassified a worker as an independent contractor, including if relief is available under Section 530. Under CSP, the IRS will offer settlement if the employer agrees to classify workers as employees prospectively.

If an employer generally satisfies the requirements of Section 530, the CSP offer will be a full employment tax assessment for the one taxable year under examination. If the employer meets the reporting consistency test, and has an argument that it satisfies the substantive consistency and reasonable basis, the CSP offer will be an assessment of 25 percent of the employment tax liability for that year. If the employer clearly meets all three of the requirements, no assessment will be made and the taxpayer may choose to continue treating its workers as independent contractors. In this latter situation, the employer may, at its option, treat the workers as employees prospectively.

Early Referral Program

If an employer finds a CSP offer unacceptable, or does not agree with the IRS’s position on the availability of Section 530 relief, the employer can seek an early referral of the case to the IRS Appeals Office. Rev. Proc. 99‐28, §4.03. CSP will address  Whether a worker is an employee or independent contractor under the common law standards;  Whether a worker is a statutory employee or statutory non‐employee  Whether Section 530 relief is available  Whether an employer is entitled to a reduced rate assessment under section 3509  Whether the employer qualifies for an interest‐free adjustment  Whether the employer is liable for the employment taxes  Whether a payment constitutes “wages”  Whether the services at issue constitute “employment”

CALIFORNIA SETTLEMENTS

California does not have any settlement programs comparable to what is available on the federal level. The EDD is permitted to settle civil employment tax disputes. UIC §1236. The EDD will only consider a settlement offer when the assessment or denied refund claim is under petition with the CUIAB or before a civil court. The main consideration for employers is whether the misclassification was “willful misclassification” for which a willfulness penalty will be imposed, in addition to other assessments, penalties.

The willfulness penalty is

 $5,000 to $15,000 for each violation (a single misclassified individual); and  $10,000 to $25,000 for each violation if the Labor Commissioner, or a court, determines there is a “pattern and practice” of these violations. (Labor Code §226.8)

The statute also authorizes these penalties, against both the employer and the paid adviser, if the employer charges a worker who has been “willfully misclassified” as an independent contractor a “fee or makes any deductions from their compensation, for any purpose, including goods, materials, space rental, services, government licenses, repairs, equipment maintenance, or fines arising from the individual’s employment.” (Labor Code §226.8(a)(2))

IRS PUBLICATIONS  Publication 15, Circular E, Employer’s Tax Guide  Publication 15‐A, Employer’s Supplemental Tax Guide (Supplement to Circular E)  Publication 15‐B, Employer's Tax Guide to Fringe Benefits  Publication 1779, Independent Contractor or Employee Brochure  Publication 1976, Do You Qualify for Relief Under Section 530?  Publication 3114, Compliance Checks  Publication 3953, Questions and Answers About Tax Court Proceedings for Determination of Employment Status Under IRC Section 7436  Publication 4341, Information Guide for Employers Filing Form 941 and 944 ‐ Frequently Asked Questions About the Reclassification of Workers as Employees  Notice 989, Commonly Asked Questions When IRS Determines Your Work Status is “Employee”

EDD PUBLICATIONS

 Employment Determination Guide (DE 38) – EDD  California Employer’s Guide 2017 (DE 44) – EDD  Determination of Employment Work Status for Purposes of State of California Employment Taxes and Personal Income Tax Withholding (DE 1870) – EDD  Report of Independent Contractor(s) (DE 542) – EDD To W2 or Not To W2 Perils & Solutions Arising From Misclassification of Employees Topics • Common situations involving employee misclassification • Penalties and other Adverse Consequences • Abatement and Safe Harbor under the Internal Revenue Code • Voluntary Classification Settlement Program (VCSP)

Why is Classifying Employees So Complicated? .Common Law Employee (right to control and direct) 20-factor test .Corporate Officer .Statutory Employee .Employees Under Section 218 .Statutory Non-Employees What’s An Independent Contractor?

Not an employee Some Preventative Meausres & Tips

.May ask IRS or EDD to determine status .When advising a client, always instruct to report on W2 or 1099-MISC because federal settlement generally require reporting. .Workers themselves may report misclassification. .Some kind of relief should be available under federal law. .Correction under Federal Law may create other potential problems under state law or other federal laws, such as the Affordable Care Act provisions on a small business. Potential Penalties (Federal)

.Employee portion of the tax (in addition to the employer portion of the tax) despite if the tax is collected from the employee. IRC § 3102(b). .Reduction may be available under section 3509 or 3402(d). .The penalty for unintentionally failing to withhold the employee’s share of Social Security and Medicare taxes is 20 percent of the employee's share of the tax. IRC § 3509(a)(2). The penalty is doubled to 40 percent if the employer did not file a Form 1099-MISC for the worker with the IRS. IRC § 3509(b)(1)(B). .Other penalties will still apply. Potential Penalties (California)

.Repayment of back payroll taxes, subject to interest and a 15 percent penalty on the unpaid taxes. See, UIC § 1112, 1135. The EDD will abate the delinquency penalty under UIC section 1135, in addition to the personal income tax, if a worker was improperly treated as an independent contractor and reported the income on a California individual tax return, or payments to employees were misclassified and the EDD assessed PIT. .California Labor Code section 226.8 also imposes severe penalties on employers that willfully misclassify workers as independent contractors. In addition to other penalties, section 226.8 imposes fines between $5,000 and $15,000 per violation. This amount increases to $10,000 and $25,000 per violation if the employer engages in a pattern or practice of violating the classification law.

Practical Problems

Proving employees paid income tax. Mescalero Apache Tribe v. Comm’r, 148 TC No. 11 (2017). Section 530 of the 1978 Revenue Act

Section 530 relief is available to employers for misclassifying workers if three requirements are satisfied: .Reporting consistency .Substantive consistency .Reasonable basis. VCSP and Other Federal Programs

.VCSP .CSP .Early Referral Program .Note no California program equivalent to VCSP, main deterrent is willfulness penalty. IRS Publications

.Publication 15, Circular E, Employer’s Tax Guide .Publication 15-A, Employer’s Supplemental Tax Guide (Supplement to Circular E) .Publication 15-B, Employer's Tax Guide to Fringe Benefits .Publication 1779, Independent Contractor or Employee Brochure .Publication 1976, Do You Qualify for Relief Under Section 530? .Publication 3114, Compliance Checks .Publication 3953, Questions and Answers About Tax Court Proceedings for Determination of Employment Status Under IRC Section 7436 .Publication 4341, Information Guide for Employers Filing Form 941 and 944 - Frequently Asked Questions About the Reclassification of Workers as Employees .Notice 989, Commonly Asked Questions When IRS Determines Your Work Status is “Employee”

EDD Publications

.Employment Determination Guide (DE 38) – EDD .California Employer’s Guide 2017 (DE 44) – EDD .Determination of Employment Work Status for Purposes of State of California Employment Taxes and Personal Income Tax Withholding (DE 1870) – EDD .Report of Independent Contractor(s) (DE 542) – EDD