IRS Safe Harbor Stops Misclassification Penalties

IRS steps

Employers that treat workers as independent contractors have a means of avoiding penalties in the event of an Internal Revenue Service audit, payroll practitioners said May 15.

The reasonable basis test under Section 530 of the 1978 Revenue Act provides a safe harbor for employer that treat workers as independent contractors if certain conditions are met, said Emily Rook, CPP, a consultant with Circle Financial Services. Rook and Karen Salemi, FLMI, CPP, with Pepperell Payroll Professionals, spoke at the American Payroll Association's annual conference in National Harbor, Md.

Section 530 excuses employers from employment tax liability, regardless of a worker status determination under the common-law test, if they have a reasonable basis for treating a worker as an independent contractor and if they meet substantive consistency and reporting consistency requirements.

The common-law test looks at three factors: behavioral control, financial control, and the type of relationship. Behavioral control examines the employer's right to direct and control the worker, financial control, among other things, examines how the worker is paid and the extent of the worker's investment, and the relationship factor looks to see whether it's permanent or temporary and whether the worker is receiving any employee-type benefits.

Employers have a reasonable basis if they depend on court decisions and IRS rulings on similarly situated workers, Rook said. Employers also can depend on a longstanding recognized practice in a significant segment of the employer's industry and opinions from outside counsel or certified public accountants, she said.

Consistent treatment of workers is required and employers must file all appropriate tax and information returns, Rook said.

In an IRS audit, the examiner must give the employer written notice of the availability of Sec. 530 safe harbor protections, Rook said. The examiner should broadly construe reasonable basis claims and consider them even when they are not raised by the employer, she said.

The reasonable basis test covers an employer's past conduct, and the IRS must tell you what to do going forward, Rook said.