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Misclassification of workers and the tax consequences

Why it is important to ensure that each worker is properly classified? The distinction between independent contractor and employee determines the amount of taxes that must be withheld from a worker’s pay.

A recent U.S. tax court case provided some potential help for employers who get this determination wrong. At issue in the tax court litigation was whether past employees improperly classified as independent contractors had paid their tax bills.

Mescalero Apache Tribe v. Commissioner

The IRS audited the Tribe based on concerns that certain workers had been misclassified as contractors. In an attempt to limit any penalty, the Tribe sought to locate former workers to determine whether they paid income taxes on their 1099 income. But they were unable to locate 70 of these workers.

Check your records

The Mescalero Apache Tribe asked the IRS for these workers' return information, so they could determine whether these workers had independently paid their taxes. The IRS argued it couldn’t disclose the information since it was confidential.

But the tax code in all its complexity offered an exception to the confidentiality rule. Ultimately, the Federal Circuit Courts were split on the issue of who could access information through the exception. Because the case originated out of the Tenth Circuit, the Tax Court followed that circuit’s interpretation.

A taxpayer victory of sorts

Because how the worker’s viewed themselves was at issue in the case – whether they paid tax liabilities as independent contractors could affect the Tribe’s case and the resolution of one important issue. Ultimately, the court held that an employer fighting the IRS over reclassified worker’s could access IRS records to find out if the employees paid proper income tax on their 1099 earnings.

This case may yet be appealed, but at the moment it lends a hand to employers who are facing audits over the classification of workers. It also provides a lesson that doing some investigation on the front end to ensure proper worker classification can avoid disputes down the road.

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