Employer Absolved from Income Tax Liability After Granted IRS Records

In a unanimous ruling, the Tax Court has made it easier for employers to absolve income tax liability for reclassified employees. A recent court case set a key tax decision that allowed an employer access to IRS tax records of previous employees to determine whether they had paid income taxes on their earnings.

In the case of Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11, the petitioner was being audited by the IRS under suspicion of misclassifying some of its employees as independent contractors. While the tribe opposes this accusation, the underlying dispute emerged from the hefty tax bill received from the IRS as a result of the reclassification.

If an employer mistakenly misclassifies a worker as an independent contractor and does not withhold taxes, it could be responsible for the tax, which can be quite large in the case of many misclassified workers. However, under Code section 3402 of the Internal Revenue Code, an employer is not responsible for the income taxes it should have withheld on misclassified workers if the workers did indeed pay the required tax liabilities on their earnings. This rule prevents the IRS from collecting taxes twice, first from the independent contractors on their individual returns, and then again as a result of the payroll reclassification audits.

In an effort to escape tax liability, the tribe had to show income taxes had already been paid by asking employees to complete Form 4669 Statements of Payments Received. While this method proved somewhat helpful in a number of situations, the tribe could not get in contact with nearly 70 previous workers. This hurdle prompted the Tax Court to mandate the IRS to provide the tribe with tax records of previous workers, showing whether the tax had been paid or not.

The IRS argued the tribe’s bid for discovery through Code section 6103(a), citing the confidentiality of taxpayer information; however, Code section 6103(h)(3) offers an exception to the rule. The exception gives employers access to taxpayer records in the event disclosure is needed during judicial or administrative tax proceedings where the taxpayer and their return has a transactional relationship directly related to the resolution of the proceeding.

After the tribe was able to prove previous workers paid their income tax on earnings, the tribe was no longer responsible for the tax bill received after the IRS alleged misclassification of employees and independent contractors.

This case presents an invaluable precedent for the IRS on all future payroll tax reclassification audits and will no doubt reduce the “profitability” of the IRS audits by limiting the ability to collect the tax twice. Not to mention, this case also serves as a reminder for employers of the importance of accurately determining the classification of its workers. An inaccurate judgment may cause scrutiny by the IRS, tax problems for the employer or potential court proceedings should a discrepancy arise.

If you have any questions regarding your tax liability as an employer, an employee or independent contractor, please contact me for additional guidance at jsheffield@bpw.com or (805) 963-7811.