To defend against tax liability, employers may be allowed to access the individual tax returns of its independent contractors whom the IRS have reclassified as “employees”. Those returns could reveal that the employees had already paid income tax on their earnings, thereby reducing the employer’s liability for withholding taxes. This access is all thanks to a recent U.S. Tax Court ruling that stemmed from a New Mexico case.
The Case and the Arguments
The case involved a Native American tribe which had hundreds of workers it treated as independent contractors. The IRS audited the tribe and ultimately reclassified many of these workers as employees.
The IRS sought about $550,000 in unpaid withholding taxes on those individuals plus approximately 20% interest from the tribe.
The tribe sought to escape tax liability by showing that the “misclassified” workers already paid income tax on their earnings. After all, while employers are liable for withholding taxes on the wages they pay, the taxes are really a credit against the taxes employees owe on their income. If an employee paid the income tax, even though it wasn’t withheld, the employer is off the hook.
Keeping with this defense, the tribe asked each reclassified worker to complete Form 4669, which the IRS considers acceptable evidence that a worker filed an individual tax return and paid the income tax due (thus relieving the employer of withholding tax liability).
In this case, the tribe was unable to locate 70 of the workers, so it asked the Tax Court to order the IRS to search those workers’ records to determine if they had reported their Form 1099 income and paid their tax liabilities.
The IRS argued against disclosure, stating that the IRC prohibits disclosing workers’ tax return information to employers and those workers’ returns – including a taxpayer’s payments – should be kept confidential.
Until this case, the question of whether an employer can use trial discovery to access its workers’ IRS records in order to reduce its own tax liability was unprecedented.
The Ruling and the Reasoning
The court ultimately disagreed with the IRS’ confidentiality argument, pointing out that the general rule comes with an important exception. Tax return information may be disclosed in a judicial proceeding if that tax return information directly:
- relates to a transactional relationship between a third party and litigant in that proceeding, and
- affects the resolution of that proceeding.
The first part of the test was satisfied merely because transactions occur between an employer and its workers. They further determined that whether the tribe’s workers paid their tax liabilities in full tends to show whether they considered themselves independent contractors or employees – and thus directly related to their relationship with the tribe.
Finally, the court found that how the workers viewed themselves, as employees or contractors, IS a factor in worker classification cases. Whether they paid their income tax liabilities as contractors would tend to prove or disprove the tribe’s case (i.e., if the tribe’s workers paid their taxes, the tribe’s defense would be proved and entirely resolved).
Having determined that the tribe satisfied the exception of nondisclosure of tax return information, the U.S. Tax Court ruled that the tribe was entitled to obtain the workers’ tax return information from the IRS.
The Net of Implications
The IRS has been particularly aggressive casting a wide net in its pursuit of misclassified employees in recent years, putting employers with contractors at real risk of fishing for a big tax bill if they misclassify employees as independent contractors and fail to collect and pay withholding taxes on their earnings.
If the IRS determines that your business misclassified workers, this court ruling could benefit you by:
- allowing you to determine if the workers already paid income tax on their earnings– even if you can’t obtain Forms 4669 from all of the reclassified workers.
- getting you off the hook for misclassification altogether, as the payment of taxes by workers who were treated as contractors weighs against the existence of an employment relationship.
- saving you substantial money in unpaid taxes plus minimum wages and overtime, penalties, Social Security and Medicare contributions, unemployment and workers’ compensation premiums, and employee benefits.
Worker classification is complex and heavily regulated. Failing to comply can have serious and costly implications. We invite and encourage you to contact CRI with your specific questions regarding these matters so you don’t find yourself on the hook for a hefty tax bill you possibly could have avoided.