Friday, June 3, 2011

§409A Implications in IRS Worker Classification Audits?

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The IRS is conducting letter audits of corporate, tax-exempt and governmental entities on employment tax issues to obtain current statistical data for computing the employment tax gap (i.e., the lost tax revenue due to improper worker classification and related tax payments and withholding) and to determine key compliance issues in this area for future audits. In particular, the IRS is looking at worker classification, fringe benefits, payroll tax reporting, and executive or deferred compensation.

Section 409A would be expected to figure into these investigations due to its application to situations in which independent contractors are used. In this regard, the "unrelated services exception" under §409A would apply if during the taxable year in which the independent contractor obtains a legally binding right to the compensation (i.e., the year in which the compensation is deferred), the independent contractor is actively engaged in the trade or business of providing services (other than as an employee, director or any management services) and provides "significant services" to two or more service recipients that are not related to each other or to the independent contractor. Companies and other entities under these audits will have to figure out how to obtain the necessary information to decide if the unrelated services exception applies, because the significant services analysis requires information about the independent contractor's service arrangements with other service recipients.

If the independent contractor has entered into a deferred compensation arrangement with a “related” service recipient, the arrangement will be exempt from §409A only if it is a “bona fide agreement, method, program or other arrangement” arising in the ordinary course of the independent contractor's trade or business. Under this exemption, among other requirements, any independent contractor arrangement with a related party must be properly classified as such and cannot constitute a majority of the independent contractor's revenue for the taxable year. Additionally, the actual arrangement must be substantially similar to other arrangements the independent contractor has entered into with unrelated service recipients. Thus, for a related service recipient to make this determination, it will need to understand other arrangements the independent contractor has in place.

Perhaps the question is whether independent contractors are willing (and able) to provide this information at the risk of disclosing sensitive business information about other companies and the contractor's other business relationships. Information at risk might include worker classification issues such as behavioral control, financial control, and the relationship of the parties, which a service recipient will compare to those under its own arrangement.

--Mark C. Wolf, Tax Law Editor (Compensation Planning)    
 

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