When the IRS determines that independent contractors are taxed as employees, it is up to the employer to show that the IRS determination is incorrect. One way to do this is to show that the workers paid tax even though the employer did not withhold the tax. In Mescalero Apache Tribe v. Commissioner, 148 T.C. 11, the court addressed whether an employer has access to an employee’s IRS records to show that the employer is not liable for taxes it failed to withhold.
Employment Tax Audits
The IRS’s Small Business/Self-Employed Division has a small team of employment tax auditors whose job is to determine whether employment taxes are correctly determined, withheld and remitted to the IRS. These auditors conduct stand-alone employment tax audits and they are often brought into ongoing income tax audits when the income tax auditors uncover employment tax issues.
Employment tax auditors focus on worker classification cases. These are cases whereby the employer has paid workers as independent contractors rather than employees. There are a number of rules that apply in determining which classification is correct. There are also very generous settlement programs available to resolve these types of audits. These settlement programs require the employer to treat their workers as employees going forward. This affords little help if the workers really are independent contractors or if the other non-tax implications are too much to accept treating the workers as employees–such as entitlement to employee benefits, healthcare, etc.
There are also a number of options for employers who want to challenge the IRS’s worker classification determination. One option is to simply show that the worker paid the tax, as the law does not allow the IRS to collect the tax twice. So how does an employer show that the worker paid the tax? They usually do this by contacting the worker and asking them to fill out a form to indicate that the tax was paid. But what if the employer cannot locate the worker or if the worker refuses? The IRS has records showing whether the worker paid the tax. The IRS has always taken the position that it cannot disclose the worker’s IRS records to the employer given the confidentiality rules in the Code.
The Confidentiality Rules
This brings us to the Mescalero Apache Tribe case. The court analyzed the confidentiality rules and concluded that they do not prevent the employer from getting access to the worker’s records on audit or in court. This is limited to disclosure in judicial and administrative tax proceedings to persons other than government officials if the information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer (i.e., worker) which directly affects the resolution of an issue in the proceeding.
It is not clear whether the IRS will acquiesce to this decision or whether the U.S. Tax Court would reach the same conclusion when applying the law of a different circuit or if other courts will follow the decision. Nevertheless, the case provides employers with something to cite when requesting access to IRS records for their workers during and following employment tax audits.