Sen. John Kerry (D-Mass) has introduced legislation that, if enacted, likely will require businesses to classify more workers as employees rather than as independent contractors, by among other things, repealing Section 530 of the Revenue Act of 1978 – a provision he characterized as a “loophole.” Senators Durbin, Harkin, Schumer, Brown, Menendez and Kirk are co-sponsoring this legislation.
For more than 30 years, Section 530, which was enacted in response to the financial hardship imposed on small businesses when the IRS reclassified their workers as employees, has provided a “safe harbor” to businesses with a reasonable basis for classifying a worker as an independent contractor.
Moreover, it generally has prohibited the IRS from publishing any regulation or revenue ruling with respect to the employment status of any individual for purposes of employment taxes. Arguably, this moratorium has prevented the IRS from reacting to changes in the workplace by adapting or modifying its long-standing guidance on worker classification (the employee versus independent contractor issue).
In addition to eliminating the Section 530 safe harbor, the proposed legislation would: (1) require businesses that pay any amount greater than $600 during the year to corporate providers of property and services to file Forms 1099 for such payments; and (2) significantly increase the penalties for failing to file Forms 1099. Forms 1099 are not required for payments to corporations under existing law, except in limited cases.
Sen. Kerry cited lost revenue due to misclassifications of workers, an increase in worker misclassifications, record federal and state budget challenges, leveling the playing field for businesses that play by the rules, and ensuring that American workers receive the protections and pay they deserve as reasons for the proposed legislation.
The legislation is significant because determining whether a worker is an employee or independent contractor is not always obvious under the current common law test. If a business is eligible for relief under Section 530, it can continue to treat a worker as an independent contractor, even if that worker is an employee under the common law test.
To receive protection under Section 530, businesses are required to satisfy three requirements: (1) the business must have a reasonable basis for treating the worker as an independent contractor; (2) the business must have treated the worker and similar workers as independent contractors; and (3) the business must have filed all required federal tax returns (including Forms 1099) consistent with its treatment of each worker as not being an employee.
A business will have a “reasonable basis” for treating a worker as an independent contractor under Section 530 if it can show one of the following:
- The business reasonably relied on a court case involving federal taxes or an IRS-issued ruling.
- The business 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. A business may not rely on an audit commenced after Dec. 31, 1996, unless such audit included an examination for employment tax purposes of whether the individual involved (or any other individual holding a substantially similar position) should be treated as the business’ employee.
- The business treated the worker as an independent contractor because it knew that was how a significant segment of its industry treated similar workers.
- The business relied on some other reasonable basis, i.e., it relied on the advice of a business lawyer or accountant who knew about its business.
However, Section 530 relief is not available in the case of a worker who, pursuant to an arrangement between the business and a client, provides services for that client as any of the following: engineer, designer, drafter, computer programmer, system analyst, or other similarly skilled worker engaged in a similar line of work.
The proposed legislation would add a new section to the Internal Revenue Code that would replace Section 530’s protections with a much narrower safe harbor for businesses that classify workers as independent contractors.
Under this proposed safe harbor section, if: (1) a business did not treat an individual as an employee for any period; and (2) for taxable periods after 1978, all federal tax returns (including Forms 1099) required to be filed by the business with respect to each such individual are filed on a basis consistent with the business’s treatment of the individual as an independent contractor, then the individual will not be treated as an employee unless the business had no reasonable basis for not treating the individual as an employee.
What constitutes a “reasonable basis” under the proposed safe harbor section of the Code is also much more restricted than what constitutes reasonable basis under Section 530. Under the proposed section, a business is treated as having a reasonable basis for not treating an individual as an employee if the IRS has determined (either through a written determination issued to the business or an employment tax examination) that the individual (or another individual holding a substantially similar position) is not an employee.
A business no longer would be able to rely on a specific court case, IRS rulings (other than a written determination issued to the business), industry practice, or some other reasonable basis. Moreover, a business must establish its entitlement to relief under the proposed section by “a preponderance of the evidence.”
The amendments made by the proposed legislation would apply to services rendered more than one year after enactment of the legislation, at which time Section 530 would no longer apply. The proposed safe harbor section further mandates that “not later than one year after the date of enactment of this section, [the IRS shall] prescribe such regulations as may be necessary and appropriate to carry out the purposes of this section.” Thus, the moratorium on the issuance of IRS regulations and rulings regarding worker classification, which has been in effect for more than 31 years, would also be lifted.
The history of Section 530 illustrates the difficulty of the worker classification issue. It was originally enacted to give Congress one year to address the complex issue of worker classification. When Congress was unable to address the issue within one year, the provision was extended and then made permanent in 1982.
Although not perfect, the current state of the law appears to give the IRS sufficient tools to address the worker classification issue, notwithstanding the Section 530 safe harbor. The IRS is actively conducting worker classification examinations and successfully reclassifying many workers.
While Section 530 does permit some workers to be treated as independent contractors who might be classified as employees under the common law test, this is likely a relatively small percentage of workers. The more significant aspect of the proposed legislation, if enacted, may well be the strong bias it demonstrates toward classifying workers as employees, and the increased reporting of payments to independent contractors by including corporations as recipients of Forms 1099 and significantly increased penalties for failing to file Forms 1099.