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Misclassification of Workers and its Aftermath

Posted on Jan. 5, 2018

Last spring we reported on the Tax Court decision in Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11 (2017), in which the Tax Court determined that the taxpayer could obtain information about tax reporting by its former employees. The tribe did not classify these individuals as employees during the period of employment; however, the IRS determined that the individuals who worked for the tribe were employees and not independent contractors. Where an employer has misclassified its employees, the employer is liable for certain taxes that would have been paid through proper withholding of employees unless the employer can show that the employees paid the taxes.

The tribe tried to track down the employees to determine if they properly reported the taxes. It could not reach most of them and sought through discovery in Tax Court to find out from the IRS whether the employees paid. The IRS resisted citing the disclosure provisions; however, the Tax Court ordered the IRS to turn over information which would allow the tribe to calculate its liability after taking into account the employee payments. This post is about the rest of the story because, not too long after the opinion came out, the IRS issued CCA 201723020 limiting the scope of the opinion in the view of Chief Counsel’s office. For those interested in this issue, you should also look at the blog post by the National Taxpayer Advocate on this subject.

The CCA takes the position that a taxpayer that has misclassified employees cannot obtain information about the employees from Exam or Appeals but can only obtain the information through the discovery process in court. In a resource starved agency, it seems counterproductive to drive taxpayers into court just to obtain information that will allow the taxpayer to determine the correct liability. No one has this information other than the IRS and the individual employees who are typically scattered to the wind. If the misclassification only involves one or two employees, maybe the employer can readily find the misclassified employees; however, if the number of employees is substantial the employer will almost certainly encounter problems tracking down the all of the employees at the time of the misclassification. The CCA will cause employers in these larger cases to petition the Tax Court just to use discovery.

The opinion provides that:

“It is important to note that the court’s determination that the workers’ return information was discoverable was based largely on the representation by the Tribe that it has already made a significant effort to locate the workers and that it had failed only with respect to a relatively small number.  It is also important to note that IRC 6103(h)(4) authorizes disclosure, but does not require it; thus the court’s determination that the workers’ return information “is disclosable under section 6103(h)(4)(C)” does not create a requirement that the Service disclose the information.

Thus, Mescalero does not stand for the proposition that taxpayers and/or their representatives are entitled to workers’ return information during the conduct of an employment tax audit or at the Appeals consideration level. Instead, the Mescalero decision is limited to discovery requests made by a taxpayer during the pendency of a Tax Court proceeding, where the Tax Court has the ability to determine hether the requested information is disclosable pursuant to IRC 6103(h)(4), AND has balanced the relevancy of the requested information against the burden placed on the Service pursuant to Tax Court Rules 70(b) and 70(c).”

Since section 6103(h)(4) permits disclosure, it seems a better way may be to give the information to taxpayers at the examination level but charge them for the cost of obtaining the information so that the IRS is not the loser in this situation. Charging a reasonable search fee allows the taxpayers to obtain the information early in the process, saves resources of both parties inherent in the use of Appeals and the Tax Court. The decision expressed in the CCA makes a loser out of everyone when a much easier solution seems available. The National Taxpayer Advocate is rightfully critical of the decision in her blog post. Once the attorneys in Chief Counsel’s office opine that the decision to disclose is up to the IRS and not barred by section 6103, the door is open for the IRS to make a reasonable decision. The path suggested in the CCA should be ignored by those entrusted to administer the law.

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