IRS Employment Tax Audits: Spotlight on Independent Contractors and Deferred Compensation Arrangements

The IRS’s employment tax National Research Project is currently under way with 2,000 audit letters already in the hands of various corporate, tax-exempt, and governmental entities and a second wave of audit letters likely to arrive in mailboxes later in 2010.

The goals of the National Research Project are to:

• secure current statistical data for computing the employment tax gap (i.e., the lost tax revenue due to improper worker classification and related tax payments and withholding); and
• determine the key compliance issues in this area for increased IRS scrutiny on future audits.

While the audits will be comprehensive in scope, IRS has identified the following issues for particular focus: worker classification, fringe benefits, payroll tax reporting, and executive or deferred compensation. This article highlights an area that combines the worker classification and executive compensation issues—deferred compensation arrangements between employers and independent contractors.

To ensure compliance with the law and to be prepared for an IRS audit, companies should review the deferred compensation rules under §409A of the Internal Revenue Code of 1986, as amended (the Code) ¹All references herein are to the Internal Revenue Code and the Treasury Regulations thereunder. as they apply to workers classified as independent contractors.

Code Section 409A

Section 409A was enacted in 2004 as a broad-based statutory reform of the taxation of nonqualified deferred compensation. Deferred compensation is any compensation earned in one taxable year by the “service provider,” ²A “service provider” who is an independent contractor subject to §409A can be an individual as well as a corporation, S corporation, partnership, or personal services corporation. which is or may be payable in a later taxable year. ³One key exception to this general rule is the short-term deferral exception. If the compensation amount is earned in one taxable year and the service provider actually or constructively receives the payment no later than two and one-half months following the close of that taxable year, such compensation will not be subject to the §409A rules due to the short-term deferral exception, provided that the plan or agreement does not provide for a possible later date of payment. Some typical deferred compensation arrangements include:

• elective bonus or salary deferral arrangements (for employees, directors, or independent contractors);
• payments made to an executive upon a change in control of the employer; and
• supplemental retirement or top-hat plans.

As a general rule, stock option awards granted at fair market value and restricted stock awards are not subject to the §409A rules.

Deferred compensation subject to §409A rules must be in compliance with the statute and regulations, including specific timing and form of payment rules.

While deferred compensation arrangements are more likely in the context of employer/employee relationships with executives and upper-level management, independent contractors may have deferred compensation arrangements in connection with payments that are contingent on successful completion of a particular project or task, or the company hitting certain targets and benchmarks.

All deferred compensation subject to §409A had to meet the documentary and operational rules set forth in final regulations by Dec. 31, 2008. Failure to adhere to these comprehensive rules can result in severe penalties to the service provider (i.e., the independent contractor or employee)—the amount in violation is subject to immediate taxation, a 20% additional tax, and interest at 1% above the underpayment rate. For the employing entity, such violation may result in failed reporting and withholding obligations on the deferred amounts.

In connection with the employment tax audits, IRS is likely to scrutinize any deferred compensation arrangement that may be subject to §409A to determine if it complies with the final regulations or has been properly corrected in accordance with Notice 2010-6. ⁴

2010-3 I.R.B. 275.

Proper Worker Classification

As a threshold matter, companies should review all independent contractor arrangements and determine whether the contractor is correctly classified as such or should really be classified as an employee. Improper classification will not only have an impact on any deferred compensation arrangements (as discussed below) but will also impact tax withholding and reporting obligations, participation in employee benefit plans, and other employment-related statutory rights (such as unemployment benefits and antidiscrimination rules).

The worker classification determination is based on a facts and circumstances review in light of available IRS guidance about what factors may assist in the determination process. In general, the IRS guidance keys to which party has control of the arrangement and the services provided, by focusing on three categories: behavioral control, financial control, and the relationship of the parties. ⁵While not the focus of this article, additional IRS guidance on the factors for worker classification analysis can be found in Rev. Rul. 87-41 (outlining the “20 factor” test) and a 1996 IRS training manual for auditors (providing additional guidance on the three categories to consider for classification determinations). Additionally, numerous articles have been written on making proper worker classification determinations.

Companies should review all current independent contractor classifications to affirm proper classifications or correct improper classifications.

Independent Contractors and 409A

Once companies have determined that independent contractors have been properly classified, any deferred compensation arrangements with these individuals should be reviewed in light of §409A. Due to the exemption discussed below, §409A may not apply to many deferred compensation arrangements with current independent contractors; however, such arrangements should be reviewed to ensure that this general exemption from §409A applies or, if it does not apply, that proper steps are taken to become compliant with the §409A rules.

Unrelated Services Exemption

A deferred compensation arrangement between an independent contractor and an “unrelated” ⁶For purposes of the §409A regulations, a person is “related” if the relationship tests under §267(b) or §707(b)(1) are met, except that a 20% test is used in lieu of the 50% test. service recipient is exempt from §409A if during the taxable year in which the independent contractor obtains a legally binding right to the compensation (i.e., the year of deferral), the independent contractor:

• is actively engaged in the trade or business of providing such services (excluding services as an employee, director, or any management services ⁷If the independent contractor is performing “management services,” any deferred compensation connected to such management services will not qualify for the exemption under §409A. Management services includes any “actual or de facto direction or control of the financial or operational aspects of the trade or business of the service recipient, or investment management or advisory services provided to a service recipient whose primary trade or business includes the investment of financial assets, such as a hedge fund or real estate investment trust.”); and

• provides “significant services” to two or more service recipients that are not related to each other or to the independent contractor.

Significant Services

The determination of whether the independent contractor has provided “significant services” to two or more service recipients is based on a facts and circumstances test. However, the §409A regulations contain a safe harbor if the revenue generated from services by the independent contractor to any service recipient (or group of related service recipients) does not exceed 70% of the total revenues generated by the independent contractor for providing such services during the taxable year.

Additionally, the regulations provide for a “lookback” safe harbor if the independent contractor meets this 70% revenue test for at least three consecutive years. An independent contractor who satisfies the lookback safe harbor will be deemed to meet the 70% safe harbor for the current year as long as the independent contractor did not know or have reason to anticipate that the 70% safe harbor would not be met for the current taxable year. This means that if the independent contractor had satisfied the 70% safe harbor test in the three prior years, the independent contractor will be deemed to meet the 70% safe harbor test in the current year (causing any deferred amounts in the current year to be exempt from §409A).

All arrangements with unrelated independent contractors should be reviewed to determine whether the “significant services” requirement is met and whether the independent contractor is providing such services to two or more unrelated service recipients. If these requirements are not met, the deferred compensation arrangement is subject to all the documentary and operational requirements of §409A.

Companies will also have to consider how to obtain the necessary information to make this assessment since the “significant services” analysis requires information about the independent contractor’s other service arrangements.

Related Services

If the independent contractor has entered into a deferred compensation arrangement with a “related” service recipient, the arrangement will be exempt from §409A only if it is a “bona fide agreement, method, program or other arrangement” arising in the ordinary course of the independent contractor’s trade or business to the extent that:

• the service provider is properly performing services as an independent contractor (i.e., the service provider cannot be improperly classified);
• the independent contractor otherwise qualifies for the 70% safe harbor described above (i.e., the independent contractor provides services for at least two unrelated service recipients (in addition to the related service recipient) and meets the 70% revenue threshold requirement); and

• the arrangement (and its corresponding practices, such as billing and collection practices) is substantially similar to arrangements with unrelated service recipients to whom the independent contractor provides “substantial services” and that produce a majority of the total revenue the independent contractor earns that year in the corresponding trade or business. ⁸Regs. §1.409A-1(f)(2)(v).

Therefore, among other requirements, any independent contractor arrangement with a related party must be properly classified as such and cannot constitute a majority of the independent contractor’s revenue for the taxable year. Additionally, the actual arrangement must be substantially similar to other arrangements the independent contractor has entered into with unrelated service recipients. This means that for a related service recipient to make this determination, it will need to understand other arrangements the independent contractor has in place to the extent the contractor can provide such information.

Employers should review such arrangements to ensure that the classification of any independent contractor is appropriate and the other requirements described above are met; otherwise, the arrangement is subject to all the requirements of §409A.

Worker Classification Changes and 409A

At times, an independent contractor arrangement may end because the individual becomes an employee of the service recipient, or an employee may terminate from employment and begin providing independent contractor services to the former employer. For example, the independent contractor may seek full-time employment with the company he or she works for when a position becomes available. Or a current employee looking to retire may wish to continue working for the employer on a contract basis.

These changes in worker classification may affect any prior or new deferred compensation arrangements and implicate whether §409A applies to such arrangements. This makes proper worker classification and compliance with the independent contractor exemption from §409A critically important in determining the taxation of deferred compensation arrangements.

If a deferred compensation arrangement properly qualifies for the exemption from §409A, then the deferred amounts under that arrangement will not become subject to §409A in a later year if the independent contractor becomes an employee or contractor who is subject to §409A. ⁹Preamble to §409A regulations, T.D. 9321, 72 Fed. Reg. 19234 (4/17/07). In addition, if an independent contractor defers amounts under an arrangement exempt from §409A, that arrangement will not be aggregated with a later deferred compensation arrangement if at that time the independent contractor has become an employee. Regs. §1.409A-1(c)(2)(ii). For example, if a bona fide independent contractor who meets the 70% safe harbor enters into a deferred compensation arrangement in 2010, the amount deferred in 2010 will not later become subject to the §409A rules because the independent contractor becomes an employee of the service recipient in 2012.

Provided that the arrangement was properly exempt from §409A in the year of deferral, the deferred amount (and any related earnings) will not become subject to §409A in a later year merely because the independent contractor becomes an employee or no longer meets the §409A exemption rules; however, any amounts deferred in that later year may not qualify for the independent contractor exemption from §409A. ¹⁰As noted previously, the determination for whether a deferred compensation arrangement with an independent contractor is exempt from §409A occurs at the time the amounts are deferred (i.e., at the time there is a legally binding right to receive such payments).

However, an employee often will retire or be laid off, but immediately be rehired as an independent contractor of the service recipient. In this event, the individual will not be deemed to have a “separation from service” (for the purposes of determining whether any payment under a deferred compensation arrangement subject to §409A is made due to a separation from service that meets the §409A requirements ¹¹Regs. §1.409A-1(h)(2). Under §409A, an independent contractor is considered to separate from service at the time the contract expires, if the expiration “constitutes a good-faith and complete termination of the contractual relationship.” For example, if the parties anticipate that the contract will be renewed (i.e., neither party has eliminated the contractor as the possible service provider under a new contract) or that the independent contractor will become an employee, the independent contractor will not yet have a “separation from service” for purposes of an eligible payment event under §409A.) until the individual has separated from both the employee and independent contractor relationships.

In addition, if an independent contractor becomes an employee, he or she will not have a “separation from service” for purposes of a payment event under the individual’s prior deferred compensation arrangements that are subject to §409A. ¹²A deferred compensation plan can satisfy the §409A requirements with respect to amounts payable to an independent contractor upon separation from service if the plan provides that (1) the service provider cannot receive payment before at least 12 months after the day the contract expires, and (2) such amounts will not be payable on that date if after the contract expires, but before the payment date, the service provider performs services for the company again as an independent contractor or employee. Regs. §1.409A-1(h)(2)(ii). One caveat to this rule is that when an employee is also serving as a director to the company, continued employment will not be taken into account for determining when the employee has separated from service as a director under a deferred compensation plan that is not aggregated with any other deferred compensation plan the employee participates in as an employee or vice versa. This means that proper worker classifications and understanding what a “separation from service” means under the §409A regulations for both worker classifications is key before any deferred compensation payment is made to such individual.

Next Steps

In light of IRS’s current focus on employment tax issues, including deferred compensation and worker classifications, companies should review:

• all independent contractor arrangements to ensure that such classification is proper, and
• all deferred compensation arrangements to determine whether the arrangement is truly exempt from §409A or must meet the documentary and operational requirements of §409A.

If the independent contractor exemption does not apply, any deferred compensation arrangement must be corrected under the available corrections programs and brought into compliance with §409A.

A proactive review of these arrangements, as well as other areas of IRS focus under the National Research Project, may enable companies to determine areas of noncompliance and make necessary corrections prior to an actual IRS audit.