Section 530 – Reasonable Basis

April 12, 2013Guest Contributor – Thomas M. ReganCategories: Accounting, Audits, Employment Taxes, Independent ContractorsTags: , ,

This is the fourth article in a series dedicated to using Section 530 of the Revenue Act of 1978 as protection for businesses that have been using independent contractors, in good faith, but are now facing an IRS or State of Minnesota audit of that practice. Section 530 may be 34 years old, but it is still a viable option for many businesses.

Section 530 relief is available to a business that treats workers as independent contractors if the following tests are met.

  1. Reporting Consistency. The taxpayer files all requisite tax returns on a basis consistent with treatment as independent contractors;
  2. Substantive Consistency. The taxpayer has treated all workers holding substantially similar positions as independent contractors; and,
  3. Reasonable Basis. The taxpayer had a reasonable basis for treating the workers as independent contractors.
  4. In this article, we focus on the third of these three elements, Reasonable Basis. Section 530 requires that the taxpayer have a reasonable basis for treating its workers as independent contractors. It provides the following examples of reasonable basis.

Precedent. Judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer, indicating the workers can be treated as independent contractors.

Past Audit. A past IRS or state audit of the taxpayer in which there was no assessment attributable to the treatment of the individuals holding positions substantially similar to the workers being reclassified.

  1. Other Agency Audits. Employers may rely on past agency determinations involving the proper classification of their workers. In Peno Trucking v. Comm ‘r, 296 Fed. Appx. 449, 460-463 (6th Cir. 2008), the employer argued that prior workers compensation decisions provided a reasonable basis under Section 530. The Sixth Circuit Court of Appeals reversed the Tax Court and determined that an “official determination” of a governmental agency constituted sufficient reasonable basis for Section 530 purposes.
  2. Audit of a Predecessor. An audit of a predecessor business can be used as reasonable basis. The IRS may classify this as “other reasonable basis,” but it is still effective.
  3. Audit of a different group of employees. The prior audit may not have to be of the same workers doing the exact same job. In Lambert’s Nursery and Landscaping, Inc. v. U.S., U.S., 894 F.2d 154, 156 (5thCir. 1990) that court used a prior audit of landscape workers to provide a reasonable basis for later hired janitors as it examined the relationship between the workers and the business to be the controlling factor, not the specifics of the job performed.

Long Standing Recognized Practice. A long standing recognized practice of a significant segment of the industry in which such individual was engaged.

  1. How long must a practice exist to be long standing? Section 530(e)(2)(C)(i) provides that a “long standing practice” cannot be construed as mandating a practice that has continued for more than 10 years.
  2. How much of the industry is a significant segment? Section 530(e)(2)(13) clarifies that twenty-five percent (25%) of the taxpayer’s industry is deemed to constitute a “significant segment” of the industry.” The legislative history to Section 530 notes that a lower percentage may constitute a “significant segment” depending on the facts and circumstances. In all cases, the IRS and the state cannot require the employer to show more than twenty-five percent (25%) to prove that a significant segment of the industry is using independent contractors.
  3. How is the “industry” defined?  Geography? In J & J Cab Service, Inc. v. U.S., 1995 WL 214326, 5 (1995) the Court accepted company’s use of surveys limited to its county of operation as a proper representation of its industry. Occupation?  Duties can define the occupation. The IRS, in TAM 9625002 found that bicycle and vehicles couriers were similar in that they were both couriers. The IRS looked to the task being accomplished.
  4. What does it mean to “rely” on a “long standing recognized practice? What if you learn of the practice before the IRS audit? In Beck v. U.S., 67 F. Supp.2d 567, 568 (D. S.C. 1998), the business was entitled to rely on its interviews with competitors as a basis for Section 530 relief. In Options for Senior America Corp. v. U.S. 11 F. Supp. 666, 669 (D. Md. 1998), a business that surveyed 20 of 30 competitors and found that 80% treated them as independent contractors. The business was allowed to rely on that as a reasonable basis for Section 530 relief.  What if you learn of the practice after the audit starts?  Facts learned after the audit started were not facts the taxpayer could have relied on. West Virginia Personnel Services, Inc. v. U.S., 78 A.F.T.R.2d 96-6600, 9 (1996).
  5. How can the business prove the “long standing practice?” Taxpayer’s testimony about his or her personal experience with industry; Workers’ testimony about their experience with other businesses in the industry; Affidavits from workers and competitors; Surveys of others in the industry, including competitors; or, expert testimony about the practices in the industry.

Other Reasonable Basis.  Can the business rely on professional advice as to how it can classify its workers? Usually yes, but it depends on the court.  In Smokey Mountain Secrets, Inc. v. U.S., 910 F. Supp. 1316, 1324-25 (E.D. Tenn. 1995), the court stated that “reliance upon the professional advice rendered by two CPAs… constitutes a reasonable basis for the employer having treated its tele-marketers and delivery persons as independent contractors.”  The court in U.S. v. Arndt, 201 B.R. 853 (M.D. Fla. 1996) took the opposite position. It rejected reliance on professional advise as not meeting the requirements of technical advice . This seems like a bad decision. The court ignored the Supreme Court’s holding in U.S. v. Boyle, 469 U.S. 241, 251 (1985) and misconstrued Section 530’s exception for technical advice. Technical advice is one form of  reasonable basis, but it is not the standard for all advice. In Boles Trucking, Inc., 77 F.3d 236, 242 (8th Cir. 1996), the court noted that a taxpayer may rely on the advice of professionals, but it still has the burden of demonstrating that its reliance was reasonable.