Independent Contractor Compliance Blog

If so, are you treading on thin ice?

What is Safe Harbor?

Some think Section 530 of the IRC is a “Get Out of Jail Free Card.”  They think a business that qualifies for Safe Harbor may treat a worker as an Independent Contractor for federal employment tax purposes, (see Thin Ice Warning below) regardless of the worker’s individual status under common or statutory law.

Is it really that easy?

I believe for a while even IRS auditors thought they were barred from assessing anyone who had misclassified a worker as an IC.  However, in recent years the IRS has retrained their auditors and tightened up the application of Section 530.  Here are the high level rules the IRS uses in applying Safe Harbor during a tax audit.

How does a business qualify for Safe Harbor?

It gets a little complicated…To qualify you must meet all three of the following requirements:

1. 1. You have a Reasonable Basis for not treating a worker as an employee by having at least one of these:
      • A previous audit (after 1996) holding the individual or class of workers as IC’s.
      • There must be a ruling, such as a federal court decision, holding them as IC’s that meets legal standards of application.
      • Show the industry substantially does it this way (this gets problematic in actual application).
      • Show you were following reliable legal advice (again-problematic).
   2. You exercised Substantive Consistency in the treatment of these individuals.  If at any time in the past you treated this (or similar) workers as employees you fail this test.
   3. You exercised Reporting Consistency by properly filing all required federal tax returns (including information returns such as 1099 MISC) consistent with your belief they were IC’s.

As usual, the devil is in the application.  It’s surprising how easy it is for the IRS to find where you fail just one of these tests, which throws you out of the Safe Harbor and into the Tax Storm.  (Remember the recent articles about Fed Ex and the $300 million tax assessment for only one year?  Do you think their attorneys didn’t make a run on Safe Harbor?)

Thin Ice Warning:  Your risk could be much more than federal employment taxes.

Even if you can take refuge in Safe Harbor for federal employment tax purposes, doing so does not protect you from legal challenges by other federal or state enforcement agencies (such as, U.S. Department of Labor, State of California Department of Industrial Relations, etc).

For example, The State of California’s Employment Development Department (EDD) is not legally bound by the IRS Safe Harbor law and will not honor an IRS Safe Harbor ruling.  Therefore, for tax purposes, it is possible to treat an individual as an IC for the IRS and still be required to report and pay taxes to the State of California as an employee.

Maybe more important are co-employment and labor law issues.

Safe Harbor does not apply to labor laws or to civil lawsuits by workers who claim they are common law employees and want the benefits.  Therefore you can not use Safe Harbor to defend yourself in the labor law enforcement and civil cases that follow.