IRS Updates Guidance on Employment Tax Worker Classification Disputes

(Parker Tax Publishing January 2025)

The IRS issued a procedure providing updated guidance regarding the implementation of Section 530 of the Revenue Act of 1978 (Pub. L. 95-600), which addresses controversies involving whether individuals are employees for federal employment tax purposes. The IRS also issued a ruling that addresses whether Section 530 or the reduced rates under Code Sec. 3509 apply, and whether the IRS will issue a Notice of Employment Tax Determination under Code Sec. 7436, in five situations set forth in the ruling. Rev. Proc. 2025-10; Rev. Rul. 2025-3.

Background

Section 530 of the Revenue Act of 1978 (Pub. L. 95-600) provides that a taxpayer will not be liable for federal employment taxes, with respect to an individual or class of workers if certain statutory requirements are met. Under Section 530, the taxpayer, not the individual worker, is eligible for relief from the employment tax liability that would otherwise apply, and any related interest or penalties attributable to that employment tax liability. Federal employment taxes include the Federal Insurance Contributions Act (FICA) taxes, the Railroad Retirement Tax Act (RRTA) taxes, the Federal Unemployment Tax Act (FUTA) taxes, and the collection of income tax at source on wages (income tax withholding).

Section 530(a) generally provides that if, for employment tax purposes, a taxpayer did not treat an individual as an employee for any period, then the individual will be deemed not to be an employee for that period, unless the taxpayer had no reasonable basis for not treating the individual as an employee. The relief applies only if, pursuant to Section 530(a)(1)(B), all federal tax returns (including information returns) required to be filed by the taxpayer with respect to the individual for the period are filed on a basis consistent with the taxpayer's treatment of the individual as not being an employee, and, pursuant to Section 530(a)(3), the taxpayer has not treated any individual holding a substantially similar position as an employee for employment tax purposes.

Section 530(a)(1)(A) provides that a taxpayer is entitled to relief if the taxpayer "did not treat an individual as an employee" for purposes of employment taxes. According to the IRS, the legislative history demonstrates that Section 530 applies exclusively to taxpayers involved in employment status controversies with the IRS. Specifically, the legislative history explains that the relief measure was for taxpayers that were "involved in employment tax status controversies" and explains that the legislation prevents the IRS from reclassifying certain individuals as employees whom the taxpayer has treated as independent contractors.

Section 530 relief applies only if the taxpayer did not treat the individual as an employee for federal employment tax purposes for the period at issue and meets each of the following requirements for such period:

(1) the taxpayer filed all required federal tax returns, including information returns, on a basis that is consistent with the taxpayer's treatment of the individual as not being an employee (reporting consistency requirement);

(2) the taxpayer did not treat the individual or any individual holding a substantially similar position as an employee (substantive consistency requirement); and

(3) the taxpayer had a reasonable basis for not treating the individual as an employee (reasonable basis requirement). A taxpayer is treated as having a reasonable basis if the taxpayer's treatment was in reasonable reliance on any of the following: (i) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer (judicial precedent); (ii) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding substantially similar positions (prior audit); (iii) long-standing recognized practice of a significant segment of the industry in which that individual was engaged (industry practice); or (iv) if the taxpayer had some other reasonable basis for not treating the individual as an employee.

If an employer failed to properly treat an individual as an employee, and the employer does not meet the statutory requirements for Section 530 relief, the employer may be eligible for relief under Code Sec. 3509. Code Sec. 3509(a) allows an employer to remit unpaid taxes at reduced rates if an employer fails to deduct and withhold income tax or the employee share of FICA tax with respect to any of its employees because the employer treated that employee as a non-employee. Under Code Sec. 3509(c), the reduced rates do not apply to the determination of the employer's liability for income tax withholding or the employee portion of FICA tax if such liability is due to the employer's intentional disregard of the requirement to deduct and withhold such taxes.

Under Code Sec. 7436, the Tax Court may review two types of employment tax determinations made by the IRS and the proper amount of employment tax, penalties, and additions to tax resulting from the determinations. In order to obtain Tax Court review, the following elements must be present: (1) an examination in connection with the audit of any person; (2) a determination that (i) one or more individuals performing services for such person are employees of such person for employment tax purposes, or (ii) such person is not entitled to relief under Section 530(a) with respect to such an individual; (3) an "actual controversy" involving the determination as part of an examination; and (4) the filing of an appropriate pleading in the Tax Court.

When the first three elements of Code Sec. 7436 are met, the IRS will issue a Notice of Employment Tax Determination under Code Sec. 7436 (Section 7436 Notice). A taxpayer will satisfy the fourth element by filing a timely petition for review of the Section 7436 Notice with the Tax Court. Rev. Proc. 2022-13 provides guidance concerning when and how the IRS will issue a Section 7436 Notice that will document the determination necessary to give the taxpayers the option to petition for Tax Court review. The IRS will not issue a Section 7436 Notice if the taxpayer has agreed to the employment tax liabilities. Agreement is generally accomplished using Form 2504-T, Agreement to Assessment and Collection of Additional Employment Tax and Acceptance of Overassessment (Employment Tax Adjustments Subject to IRC 7436).

Rev. Proc. 2025-10

In Rev. Proc. 2025-10, the IRS provides updated guidance regarding the implementation of Section 530. The procedure modifies and supersedes Rev. Proc. 85-18. The IRS noted that the provisions in Rev. Proc. 85-18 that explained how refunds, credits, abatements, and handling of claims applied to taxpayers who were under audit or otherwise involved in administrative or judicial processes with the IRS at the time of enactment of Section 530 are no longer applicable.

Section 530 applies only when a taxpayer did not treat an individual as an employee for employment tax purposes, and the IRS is proposing to reclassify the individual from a non-employee to an employee. Thus, Section 530 relates solely to worker classification controversies involving the employment status of an individual as an employee or as an independent contractor (or other non-employee).

The IRS applies the following guidelines when determining whether there was "treatment" of an individual as an employee for a period within the meaning of Section 530(a)(1):

(1)The withholding of income tax or FICA taxes from any payments made to an individual, whether or not the tax is paid to the IRS, indicates "treatment" of the individual as an employee.

(2)Generally, the filing of an employment tax return with respect to an individual, whether or not tax was withheld from the payments made to the individual, indicates "treatment of the individual as an employee.

(3)The filing of Schedule H (Form 1040), Household Employment Taxes, with respect to an individual, whether or not tax was withheld from the payments made to the individual, indicates "treatment" of the individual as an employee.

(4)The filing or furnishing of Form W-2, Wage and Tax Statement, with respect to an individual, whether or not tax was withheld from the payments made to the individual, indicates "treatment" of the individual as an employee.

(5)Contracting with a third party to perform acts required of employers with respect to an individual, whether or not tax is withheld or paid to the IRS or the third party otherwise satisfies the terms of the contract, indicates "treatment" of the individual as an employee.

(6) The filing of a delinquent or amended employment tax return for a particular tax period with respect to an individual as a result of IRS collection or examination activities or other compliance procedures, does not indicate "treatment" of the individual as an employee for that period. IRS correspondence that merely advises the taxpayer that no return has been filed and requests information from the taxpayer is not a compliance procedure. However, if the taxpayer takes any of the actions identified in paragraphs (1) through (5) with respect to those individuals in a later period (for example, the taxpayer withholds employment taxes or files employment tax returns with respect to those individuals for the periods following the period audited), those actions indicate "treatment" of the individuals as employees for those later periods.

(7)A return prepared by the IRS under Code Sec. 6020(b) for a period is not "treatment" of an individual as an employee for that period.

Rev. Proc. 2025-10 also provides guidance regarding the reporting consistency requirement in Section 530(a)(1)(B), the substantive consistency requirement in Section 530(a)(3), and the reasonable basis requirement in Sections 530(a)(1)(B) and (e).

Observation: The IRS notes that Section 530 does not change the status, liabilities, and rights of the individual whose classification is at issue. It does not convert individuals from employees to self-employed individuals. If a taxpayer receives Section 530 relief for a class of workers, that taxpayer is relieved from having to withhold income tax and withhold and pay FICA taxes from payments made to members of that class of workers. However, if any individual member or members of that class of workers is otherwise determined to be an employee of the taxpayer, each such employee remains liable for their employee share of FICA tax pursuant to Reg. Sec. 31.3102-1(d).

Rev. Rul. 2025-3

In Rev. Rul. 2025-3, the IRS addresses (1) whether Section 530 or the reduced rates under Code Sec. 3509 apply, and (2) whether the IRS will issue a Section 7436 Notice, in five situations set out in the ruling.

Situation 1

Taxpayer (TP) hires individuals who provide services to TP during the year. For those services, TP pays each individual a weekly fixed amount and a weekly bonus amount. TP does not withhold or pay federal employment taxes with regard to any of the payments and reports the total amount of the fixed weekly amounts and the weekly bonus amounts on Form 1099-NEC, Nonemployee Compensation. During an audit of TP by the IRS for the year, the IRS determines (1) that TP does not meet the statutory requirements for Section 530 relief, and (2) that the individuals are employees of TP. The IRS proposes to assess federal employment taxes on the weekly fixed amounts and the weekly bonus amounts, which should have been reported as wages on Form 941, Employer's QUARTERLY Federal Tax Return, and Forms W-2. TP claims it satisfies the statutory requirements for Section 530 relief and does not agree that the individuals are its employees.

The IRS holds that Section 530 is applicable to this situation because the TP did not treat the individuals as employees, and the IRS is reclassifying the individuals as employees. Whether TP is entitled to Section 530 relief depends on whether the TP satisfies the substantive consistency, reporting consistency, and reasonable basis requirements. If Section 530 does not apply, Code Sec. 3509 may be applicable because the TP treated the individuals as non-employees and did not deduct and withhold federal employment taxes from the weekly fixed amounts and bonus amounts that it paid to the individuals, and the IRS is reclassifying the individuals as employees. Whether TP is entitled to Code Sec. 3509 reduced rates depends on whether it meets the statutory requirements in Code Sec. 3509. The IRS will issue TP a Section 7436 Notice at the conclusion of the audit or after IRS Independent Office of Appeals consideration if no agreement is reached. A Section 7436 Notice will be issued because (1) there was an examination in connection with an audit, (2) there were determinations that (i) the individuals were employees of TP and (ii) TP was not entitled to relief under Section 530 with respect to these individuals, and (3) the IRS and TP disagree on the employment status of the workers and whether the statutory requirements for Section 530 relief have been met (there is an actual controversy involving the determination as part of the audit).

Situation 2

TP employs individuals who perform services during the year. TP treats the individuals as employees for the services that they perform. For those services, TP pays each individual a weekly salary and a weekly bonus amount. TP treats the weekly salary as wages for federal employment tax purposes. TP withholds and pays federal employment taxes with respect to the weekly salary and reports the salary and federal employment taxes on Form 941 and Forms W-2. TP does not treat the weekly bonus amounts as wages for federal employment tax purposes. It does not withhold or pay any federal employment taxes with regard to the bonus amounts and reports the bonus amounts on Forms 1099-NEC. During an audit of TP by the IRS for the year, the IRS concludes that the bonus amounts are wages. The IRS proposes to assess federal employment taxes on the bonus amounts, which should have been reported as wages on Form 941 and Forms W-2. TP claims it satisfies the statutory requirements for Section 530 relief with respect to the bonus amounts and does not agree that the bonus amounts are wages.

The IRS holds that Section 530 is not applicable to this situation because the IRS is not reclassifying the individuals as employees (Holding 2). TP treated the individuals as employees for the services they performed and paid additional wages in the form of bonuses for the same services; there is no controversy over whether the individuals are employees or independent contractors with respect to their services. The reduced rates under Code Sec. 3509 are not applicable for the same reason. The IRS will issue TP a Section 7436 Notice at the conclusion of the audit or after Appeals consideration if no agreement is reached. A Section 7436 Notice will be issued because (1) there was an examination in connection with an audit, (2) a determination was made that TP was not entitled to relief under Section 530 with respect to the bonuses paid to the individuals, and (3) the IRS and TP disagree on whether the statutory requirements for Section 530 relief have been met (there is an actual controversy involving the determination as part of the audit).

Situation 3

The facts are the same as in Situation 2 except TP does not report the weekly bonus amounts on Forms 1099-NEC or any other information return. The IRS holds that Section 530 and Code Sec. 3509 are not applicable to this situation for the same reasons stated in Holding 2. The IRS will issue TP a Section 7436 Notice at the conclusion of the audit or after Appeals consideration if no agreement is reached. A Section 7436 Notice will be issued because (1) there was an examination in connection with an audit, (2) a determination was made that TP was not entitled to relief under Section 530 with respect to the bonuses paid to the individuals, and (3) the IRS and TP disagree on whether the statutory requirements for Section 530 relief have been met (there is an actual controversy involving the determination as part of the audit).

Situation 4

The facts are the same as in Situation 2 except TP does not report the weekly bonus amounts on Forms 1099-NEC or any other information return and does not claim it satisfies the statutory requirements for Section 530 relief with respect to the bonus amounts. The IRS holds that Section 530 and Code Sec. 3509 are not applicable to this situation for the same reasons stated in Holding 2. The IRS will not issue TP a Section 7436 Notice at the conclusion of the audit or after Appeals consideration if no agreement is reached because TP did not claim that TP was entitled to relief under Section 530 concerning the bonuses paid to the individuals, and there is no controversy over whether the individuals are employees or independent contractors.

Situation 5

TP employs individuals who perform services during the year. TP enters into a contract with a third party (3P) to pay each individual a weekly salary, withhold and pay federal employment taxes, and file federal employment tax returns. 3P pays the weekly salaries, withholds, pays federal employment taxes, and reports the weekly salaries and taxes on Form 941 and Forms W-2 using its own employer identification number (EIN). In December of that same year, TP pays a year-end bonus amount directly to each individual for the individual's services during the year but does not treat the year-end bonus amounts as wages. TP does not withhold or pay any federal employment taxes or report the bonus amounts on any information return. During an audit of TP by the IRS for the year, the IRS concludes that the bonus amounts are wages. The IRS proposes to assess federal employment taxes on the bonus amounts, which should have been reported as wages on Form 941 and Forms W-2. TP claims it satisfies the statutory requirements for section 530 relief with respect to the bonus amounts and does not agree the bonus amounts are wages.

The IRS holds that Section 530 is not applicable to this situation because the IRS is not reclassifying the individuals as employees. The year-end bonus amounts are additional wages for the same services performed by the individuals who were treated as employees by TP. The reduced rates under Code Sec. 3509 are not applicable for the same reason. The IRS will issue TP a Section 7436 Notice at the conclusion of the audit or after Appeals consideration if no agreement is reached. A Section 7436 Notice will be issued because (1) there was an examination in connection with an audit, (2) a determination was made that TP was not entitled to relief under Section 530 with respect to the year-end bonus amounts paid to the individuals, and (3) the IRS and TP disagree on whether the statutory requirements for Section 530 relief have been met (there is an actual controversy involving the determination as part of the audit).

For a discussion of the misclassification of workers for employment tax purposes, see Parker Tax ¶210,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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