If the IRS had its way, every worker would be classified as an employee and every employer would pay employment taxes on their wages. Employment taxes are a huge chunk of government revenue and they're easier to collect than other taxes. However, not all workers are employees. Some are independent contractors, others are statutory employees and still others may be partners.

The line between employee and independent contractor is often murky and frequently employers misclassify workers. If you misclassify your workers, you are liable for back employment taxes. To ease the pain, the law provides a safe harbor and the IRS has a special settlement program.

Safe harbor

As soon as the IRS begins a worker classification audit, it is suppose to advise the employer if it qualifies for "Section 530 relief." Section 530 of the Revenue Act of 1978 is a safe harbor for employers that believed their workers were not employees and they were not responsible for employment taxes. If you qualify for the safe harbor you are generally free from paying back taxes. However, you must agree to treat your workers as employees from here on out and pay future payroll taxes.

To qualify for the safe harbor, you have to meet some important tests:

• You had a reasonable basis for not treating the worker as an employee;
• Treatment was consistent; and
• You filed all required Forms 1099 with the IRS.

Over the years, the IRS and the courts have articulated in guidance and decisions what is a reasonable basis to treat a worker as an independent contractor. If an employer's practice is similar to longstanding industry practice or if it relied on IRS guidance or court decisions, it may be able to show it had a reasonable basis to treat workers as independent contractors.

Some reasons are never reasonable. Examples are lower labor costs and treating a worker as an independent contractor solely because the worker requests it.

Consistent treatment is also important. This means that you treated all workers performing similar tasks the same. If you treated some as employees and some as independent contractors, you will fail the consistent treatment test.

--Example. ABC Co. has 30 mechanics on its payroll. They all perform identical duties. Twelve of the mechanics are treated as employees and ABC Co. issues W-2s to them. Eighteen mechanics are treated as independent contractors and ABC Co. issues 1099s. This is inconsistent treatment and ABC Co. is ineligible for Section 530 relief.

Finally, you must have filed all of the required forms with the IRS. This means Forms 1099 for independent contractors. If you didn't file these forms, you cannot seek relief under the Section 530 safe harbor.

Special settlement program

If you treated workers consistently and had a reasonable basis for not treating the workers as employees, the IRS likely will accept 25 percent of the employment tax due instead of 100 percent. You also have to agree to treat the workers as employees in the future.

The outcome isn't so good if you can't show you had a reasonable basis not to treat the workers as employees. In this case, the IRS will demand 100 percent of the employment tax due.

The worker classification settlement program is entirely voluntary and employers are free to reject whatever offer the IRS makes. One good feature about the program is that the offer stays open even after the employer rejects it. The IRS allows employers to reconsider offers and accept them later in the examination process.

Worker misclassification disputes are complicated and the IRS has a strong track record of winning them. If you have questions about the classification of your workers, or the IRS has already contacted you, give our office a call. Together, we can map out a strategy to save you from a potentially huge bill for back employment taxes.