Employee or Contractor? Double-Tax Case Could Help Businesses Challenge IRS

A tiny Native American tribe in New Mexico defeated the Internal Revenue Service in a dispute over a system that sometimes lets the government collect the same taxes twice.

The case, decided in April by the U.S. Tax Court, gives employers a new way to challenge the IRS when the agency audits companies and labels their workers as employees for whom paycheck-withholding is required instead of independent contractors responsible for their own taxes.

The Mescalero Apache Tribe, population 5,000, was facing a $565,178 tax bill, plus interest, for failing to withhold taxes from part-time teachers, hunting guides and wood cutters who worked on the tribe's reservation in the mountains between Alamogordo and Roswell. They weren't part of the tribe's casino and ski resort.

To the tribe, the workers were independent contractors; they received Form 1099 from the tribe showing their earnings and were responsible for their own taxes. To the IRS, they were employees, meaning the tribe should have withheld payroll and income taxes.

The line between contractor and employee is fuzzy, fact-dependent and increasingly important for tax and labor policy. Treasury Department data show that 12.2% of households filed a Schedule SE for self-employment taxes in 2014, up from 10.1% in 2000.

In a misclassification case like the Mescalero Apache's, tax law requires the employer to pay the taxes unless it can show that workers have already done so. The easiest way for employers to rebut IRS claims is to have workers sign statements on Form 4669 verifying they made the payments. But itinerant ex-workers are often reluctant and can be hard to find. The tribe had a seven-person team working for two years to track down several hundred workers identified by the IRS and still couldn't find 70 of them.

If those missing ex-workers had properly reported their income, the IRS would be applying the same taxes to the same income twice over.

"It's very difficult to get other taxpayers to sign these 4669s, so very often the government ends up collecting these taxes twice," said Marianna Dyson, an employment tax lawyer at Miller & Chevalier in Washington, D.C., who wasn't involved in the case.

With the data still missing, the Mescalero Apache Tribe could have done what many employers do: reach a settlement with the government or use a tax-code provision that allows for a reduced tax rate. "That's where I normally take my clients if they're wrong," said Robert McKenzie, a partner at Arnstein & Lehr in Chicago.

But the tribe and its lawyers took another tack, asking the IRS to look in its own records for evidence that those 70 workers had filed and paid taxes.

"The government has their tax returns in their computer, and an agent can sit down in three or four hours and look at their returns," said David Leeper of El Paso, Texas, the tribe's attorney.

The IRS refused, citing federal taxpayer privacy laws. Beyond that, the government warned in legal filings that the tribe wanted the government to "research the income tax compliance of a taxpayer's entire workforce" and said the case could cause a "tremendous administrative burden."

Tax Court Judge Mark Holmes sided with the tribe, saying that federal taxpayer privacy law doesn't prohibit this limited disclosure.

"The [IRS] commissioner is going to hate this case," Ms. Dyson said. "This is a terrible result for the government."

Lawyers said the case's reach will likely be limited because many employers will still want to take reduced penalties rather than fight the IRS in court. The IRS didn't respond to a request for comment.

The dispute between the IRS and the tribe continues. If the courts find that the workers should have been considered employees, the tribe would likely still have to pay penalties for failing to file payroll-tax returns.

Write to Richard Rubin at richard.rubin@wsj.com

(END) Dow Jones Newswires

May 09, 2017 08:14 ET (12:14 GMT)