On April 15, 2008 – the due date for income-tax returns for individuals and pass-through entities – House Ways and Means Committee Member Jim McDermott (D-WA) introduced a bill, H.R. 5804, that would repeal Section 530 of the Revenue Act of 1978 (“Section 530”), a venerable safe-harbor provision that the Congress enacted to protect taxpayers against what was then characterized as “overzealous” actions by the Internal Revenue Service (“IRS”) in reclassifying independent contractors to employee status. The Taxpayer Responsibility, Accountability, and Consistency Act of 2008 would replace Section 530 with a new safe-harbor provision that fewer taxpayers could satisfy and whose protections would be largely illusory.
I. Executive Summary
H.R. 5804 would repeal Section 530 and replace it with a new safe harbor that would enable, rather than repel, a gradual conversion of independent contractors to employees.
The bill’s provisions are in many respects an infusion of labor-law concepts into the tax law, as it would overtly tilt the scales in favor of workers being reclassified as employees by (i) eliminating a key safe-harbor provision that protects qualifying businesses in all industries against IRS reclassifying workers to employee status, and (ii) creating a new process for IRS to issue worker-status determinations that mandates appeal rights only from determinations that workers are independent contractors.
While the bill would help those workers who want to be employees but are working as independent contractors, it would harm the self-employed individuals who want to expand their business and attract new clients, as the bill would significantly increase the financial risks associated with purchasing services from independent contractors.
II. Section 530 – Current Law
By way of background, Section 530 currently provides qualifying taxpayers with permanent protection – both prospective and retrospective – against the IRS reclassifying covered workers from independent-contractor status to employees for federal employment-tax purposes. In short, a taxpayer who satisfies Section 530 is assured that the independent-contractor status of covered workers will be respected for purposes of federal employment taxes forever, so long as the taxpayer takes no action that would violate Section 530’s requirements.
A business satisfies the requirements of Section 530 with respect to a worker if the business:
1. (including any predecessor of the business) since 1978 has consistently treated the worker (and all other workers holding “substantial similar” positions) as nonemployees for federal employment-tax purposes (the substantive consistency requirement),
2. for the tax year at issue, reported on a Form 1099 the amount of compensation paid each worker at issue during the year (of at least $600) (the Form 1099 requirement), and
3. treated the workers as nonemployees in reliance on a reasonable basis.
For these purposes, reasonable basis can be established by showing that the classification of the workers was in reasonable reliance on any of the following:
- acceptable precedent, Section 530(a)(2)(A);
- a prior IRS audit, Section 530(a)(2)(B); or
- a long-standing industry practice, Section 530(a)(2)(C).
In addition, the legislative history accompanying Section 530 and Rev. Proc. 85‑18, 1985‑1 C.B. 518, make clear that reasonable basis can also be demonstrated “in some other manner.” In Rev. Proc. 85‑18 the IRS acknowledges the congressional intent that reasonable basis should be construed liberally in favor of the taxpayer.
As noted, H.R. 5804 would repeal Section 530.
III. Proposed New Safe Harbor
The proposed new safe harbor would be incorporated into the Internal Revenue Code of 1986 (the “Code”) as new Code section 3511. A taxpayer satisfying the requirements of the proposed new safe harbor would be protected against IRS reclassifying covered workers to employee status only until the first tax period beginning after the date that the Taxpayer receives notice of a determination that the covered workers are employees.
The requirements of the proposed new safe harbor parallel in form, but differ materially in substance, the requirements of Section 530. Its requirements are that the business:
1. (including any predecessor of the business) since 1978 has consistently treated the worker (and all other workers holding “substantial similar” positions) as nonemployees for federal employment-tax purposes (the new substantive consistency requirement),
2. for the tax year at issue, reported on a Form 1099 the amount of compensation paid each worker at issue during the year (of at least $600) (the new Form 1099 requirement), and
3. treated the workers as nonemployees in reliance on a reasonable basis.
A taxpayer could establish a reasonable basis for purposes of the proposed new safe harbor in only two ways, namely, by reasonable reliance on –
(i) a written determination (as defined in Code section 6110(b)(1)) issued to the taxpayer addressing the employment status of such individual or another individual holding a substantially similar position with the taxpayer, or
(ii) a concluded IRS examination (for employment tax purposes) of whether such individual (or another individual holding a substantially similar position) should be treated as an employee of the taxpayer, with respect to which there was no determination that such individual (or another individual holding a substantially similar position) should be treated as an employee.
The bill would restrict the reasonable basis criteria even further by disregarding any examination that commenced, or a written determination that was issued, more than seven years before the beginning of the period in which a taxpayer seeks to claim reliance for purposes of the safe harbor.
A determination of whether two positions are “substantially similar” for purposes of the new substantive consistency requirement would be made in a manner consistent with the Fair Labor Standards Act of 1938 (“FLSA”).
Finally, the bill would reverse the changes made to Section 530 in the Small Business Job Protection Act of 1996, which imposed the burden of proof with respect to material aspects of Section 530 on the IRS, by imposing on a taxpayer the burden of demonstrating that it satisfies all requirements of the new safe harbor by a preponderance of the evidence.
The repeal of Section 530 and its replacement by Code section 3511 would be effective one year following the date of enactment.
IV. Other Provisions Contained in H.R. 5804
In addition to the proposed replacement of Section 530 with a new safe harbor, the bill also would require the Treasury Department to develop a new procedure for workers to petition IRS for a determination of their status for federal employment-tax purposes relative to a taxpayer for whom the worker performs services. The new procedure would permit such a petition by the worker personally, by a “designated representative” or by an attorney. For industries in which IRS deems employment to be transient, casual or seasonal (the bill cites as an example the construction industry), a determination would need to be provided within 90 days following the filing of a petition. The bill mandates appeal rights following a determination that an individual is an independent contractor, but is silent on a right to appeal a determination that an individual is an employee. IRS would be required to notify the U.S. Department of Labor about any workers whom IRS reclassifies as employees.
The bill would introduce to the tax law an anti-retaliation provision, which would prohibit a taxpayer from discharging, refusing to contract with or otherwise discriminating against an individual on account of the filing by or on behalf of the individual of a petition seeking a determination of worker status.
The Secretary of the Treasury would be required to issue an annual report on worker misclassification that describes its enforcement efforts, the results produced by such efforts and the outcomes of petitions filed seeking worker-status determinations. The report also would be expected to include estimates of the magnitude of worker misclassification and its impact on the federal tax system.
Finally, the bill would increase to draconian levels the penalties imposed on taxpayers for failing to comply with information-reporting requirements. For example, the proposed penalty for failure to file a complete Form 1099 on time or for failure to include all or correct information would increase fivefold from $50 to $250 per return, and the maximum imposed per person per calendar year would increase from $250,000 to $3 million. The penalty increases would be effective with respect to Forms 1099 required to be filed after December 31, 2008.
V. Co-sponsors
As of this date, H.R. 5804 already has 23 co-sponsors – all Democrat. The cosponsors are Rep. Shelley Berkley* (D-NV), Rep. Robert A. Brady (D-PA), Rep. Joseph Crowley* (D-NY), Rep. Elijah E. Cummings (D-MD), Rep. Artur Davis* (D-AL), Rep. Rosa L. DeLauro (D-CT), Rep. Lloyd Doggett* (D-TX), Rep. Rahm Emanuel* (D-IL), Rep. Raul M Grijalva (D-AZ), Rep. Phil Hare (D-IL), Rep. Brian Higgins (D-NY), Rep. Michael M. Honda (D-CA), Rep. Steve Kagen (D-WI), Rep. Sander M. Levin* (D-MI), Rep. John Lewis* (D-GA), Rep. George Miller (D-CA), Rep. Richard E. Neal* (D-MA), Rep. Bill Pascrell, Jr. * (D-NJ), Rep. Linda T. Sanchez (D-CA), Rep. Allyson Y. Schwartz* (D-PA), Rep. Fortney Pete Stark* (D-CA), Rep. Betty Sutton (D-OH) and Rep. John F. Tierney, (D-MA).
* Denotes a Member of the House Ways and Means Committee.
VI. Analysis
H.R. 5804 is similar in many respects to the Independent Contractor Proper Classification Act of 2007, S. 2044, that Senator Barack Obama (D-IL) introduced on September 12, 2007. Like S. 2044, Rep. McDermott’s bill is a tax bill with significant influence from labor law. For example, both bills contain anti-retaliation provisions that while common for labor laws are generally not found in tax laws. Moreover, H.R. 5804 explicitly incorporates FLSA principles for determining whether two positions are “substantially similar” for purposes of the new safe harbor. Finally, evidencing a clear weighting of the scales in favor of workers being reclassified as employees, the bill would mandate appeal rights from IRS determinations that workers are independent contractors, but it is conspicuously silent on the availability of appeals from determinations that workers are employees. While such weighting of the scales is not uncommon for labor laws, it is uncommon for the tax law.
A significant aspect of the new safe harbor is that an IRS written determination or IRS examination would constitute a reasonable basis for purposes of the new safe harbor for only a limited time period, namely, seven years. At the end of seven years it would be as though the determination or examination never occurred for purposes of the new safe harbor.
The substantive protections provided by the new safe harbor are largely if not entirely illusory. The only way a taxpayer can qualify for the new safe harbor is for the taxpayer to obtain an affirmative determination from IRS that confirms the independent-contractor status of covered workers. A taxpayer that receives such a determination and satisfies the other safe-harbor requirements can rely on that determination until the earlier of (i) the expiration of seven years, or (ii) IRS determining that the covered workers are employees. The bill would expressly permit what Section 530 explicitly proscribes, namely, IRS examining a company’s relationship with independent contractors, confirming the correctness of that treatment, and subsequently examining that same relationship and reclassifying the workers as employees.
Moreover, the bill is not clear as to the type of “determination” that could invalidate safe-harbor protection, as the bill states that only “a written determination (as defined in Code section 6110(b)(1))” can constitute a reasonable basis, but states that a determination will invalidate safe-harbor protection. Thus, the type of determination that can constitute a reasonable basis is defined narrowly, with precision, while the type of determination that can invalidate safe-harbor protection is vague. For example, it is not clear whether safe-harbor protection could be invalidated by a determination by a state agency or by the U.S. Department of Labor.
An important (but unstated) consequence of the bill’s explicit repeal of Section 530 is its removal of Section 530’s statutory prohibition against IRS or the Treasury Department issuing precedential guidance clarifying the status of individuals for federal employment-tax purposes. Thus, if H.R. 5804 were enacted, IRS could commence promulgating regulations and issuing revenue rulings setting forth precedential guidance applying the common-law test to specific fact patterns.
The proposed dramatic increase in penalties for information-reporting failures would certainly create a powerful financial incentive for clients of independent contractors to accurately and timely comply with their Form 1099 reporting obligations. The increased penalties might also discourage some companies from purchasing services from independent contractors, in order to avoid the draconian consequences associated with making an administrative information-reporting error.
Finally, the proposed expansion of Form 1099 reporting requirements to include payments to corporations appears overly broad. If enacted, this provision would likely deluge IRS with Forms 1099, as it would apply to corporate payees of all size.
