Administration: Audit - Lack of Records
May 22, 2024
Re: § 58.1-1821 Application: Withholding Tax
Dear *****:
This will respond to your letter in which you seek correction of the withholding tax assessments issued to ***** (the “Taxpayer”), for the taxable periods January 2021 through November 2022.
FACTS
The Taxpayer, a painting business in Virginia, was owned by a single individual (the “Owner”). The Department audited the Taxpayer for the taxable periods January 2021 through November 2022. The Department concluded that the Taxpayer’s workers who had been classified as independent contractors should have been classified as employees and assessments were issued for withholding tax due as well as applicable civil penalties. The Taxpayer paid the tax portion of the assessment for the periods January 2021 through December 2021 and filed an application for correction, contending that the workers in question were independent contractors.
DETERMINATION
Employee Defined
Effective January 1, 2021, under legislation enacted by the 2020 General Assembly (House Bill 1407, Chapter 681 of the 2020 Acts of Assembly, and Senate Bill 744, Chapter 682 of the 2020 Acts of Assembly), Virginia added Chapter 19 to Title 58.1, relating to misclassification of employees as independent contractors. Virginia Code § 58.1-1900 A provides that:
For the purposes of this title and Title 40.1, Title 60.2, and Title 65.2, if an individual performs services for an employer for remuneration, that individual shall be considered an employee of the party that pays that remuneration unless such individual or his employer demonstrates that such individual is an independent contractor. The Department shall determine whether an individual is an independent contractor by applying Internal Revenue Service [IRS] guidelines.
Pursuant to IRS guidelines, the Department adopted the common-law analysis to determine whether an individual is an employee or an independent contractor. See Public Document (P.D.) 99-143 (6/11/1999) and P.D. 21-56 (5/4/2021). Generally, “an employee is subject to the will and control of the employer not only as to what shall be done but how it will be done.” Treas. Reg. § 31-3401(c)-1. Consistent with the IRS, the Department will consider all information regarding the relationship between the worker and the business that provides evidence of the degree of control and the degree of independence that existed. See Internal Revenue Code (IRC) § 3121(d)(2) and Treas. Reg. § 31.3121(d)-1. In IRS Publication 15-A, the IRS explains that facts providing this evidence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.
In making such a determination, the Department will examine all evidence regarding a worker’s classification, including, but not limited to, any contracts that existed between the taxpayer and the individuals in question, and written or oral testimonials from individuals with knowledge of the relationships, including members of management or the individuals themselves. Such evidence may also include the types of documents used to evidence worker classification under the 20-factor test enumerated in Rev. Rul. 87-41, 1987-1 C.B. 296.
Behavioral Control
Under this test, a determination must be made as to whether the business has the right to direct and control how the worker does the task for which they were hired. This requires an examination of the instructions given to the worker and the training provided by the business. An employee generally must follow instructions given by the business regarding, among other things, when and where to work, what tools or equipment to use, what workers to hire or assist him with the work, where to purchase supplies and services, and what order to follow in performing the work. Because the amount of instruction needed may vary according to the complexity of the work and the skill of the worker, it is not required that the business actually give instructions, but rather that the business retains the right to issue such instructions. Further, providing training to the worker regarding how to perform a task in a particular manner would be indicative of an employee relationship. An independent contractor would typically use his own methods for performing tasks.
The Department’s auditor concluded that the Taxpayer controlled the work of the individuals and instructed them as to their duties and assignments. The audit report, however, failed to provide any factual explanations or documents to support this conclusion. The report also states that some of the workers were temporary and, in some instances, worked only one job.
According to the Taxpayer, the workers were contracted when the Owner could not physically perform all scheduled work within the time required. For these jobs, the Owner provided the paint, location and, if necessary, deadlines. The workers provided their own tools, decided how to complete the work, and were not supervised on-site by the Owner. The workers were also free to retain their own assistants. In addition, the Taxpayer did not provide any training to the workers.
Financial Control
To evaluate this test, the extent to which a business controls the business aspects of the worker’s job must be analyzed. This involves looking at the extent to which the worker has unreimbursed business expenses, the extent of the worker’s investment, and the extent to which the worker makes his services available to others. In addition, how the business pays the worker and whether the worker can realize a profit or loss are other factors to consider.
The auditor indicated that none of the workers carried business licenses and that the Taxpayer carried the risk of their work. The workers’ failure to carry business licenses, however, did not mean that they could not have at least a share of the risk of loss.
According to the Taxpayer, it did not reimburse the workers for any expenses they incurred on projects. The workers also were required to provide their own tools, including paint brushes and ladders, which can be a significant investment in the painting industry. Further, the workers did not have an exclusive relationship with the Taxpayer and were free to seek and accept painting projects either on their own or from other contractors.
Type of Relationship
The analysis of a business’s relationship with a worker includes examining any written contracts describing the parties’ intent and whether the worker is provided typical employee benefits such as health care, vacation, and pension plans. In addition, the permanency of the relationship and the extent to which the worker’s services are a key aspect of the regular activities of the business can be indicative of the type of relationship between the parties.
The audit report simply states that the workers did what regular employees do for employers. While painting contractors may hire employees to do the type of work that the Taxpayer’s workers were engaged to do, the report’s description provides no analysis as to the type of relationship that may have existed between the Taxpayer and the workers.
On the other hand, evidence indicates that the Taxpayer did not provide the workers any benefits and that Taxpayer issued Forms 1099 each year. The Taxpayer indicates that many of the workers were only used once or twice and that it did not issue Forms 1099 to workers who worked less than a week.
CONCLUSION
Under the provisions of Virginia Code § 58.1-205, an assessment of a tax by the Department is deemed prima facie correct. As such, the burden of proof is on the Taxpayer to show the Department’s assessment is incorrect. In addition, Virginia Code § 58.1-1900 provides a presumption that an individual who performs services for remuneration is an employee. The Department’s regulations, however, require an evaluation of a business’s records to determine if its workers are employees or independent contractors pursuant to the factors enumerated in Treas. Reg. § 31.3121(d)-1 and as further described in Rev. Rul. 87-41 and, more recently, in IRS Publication 15-A. It does not appear that this evaluation was conducted in full by the audit staff.
In this case, the auditor determined that the workers were employees rather than independent contractors because the workers did not have business licenses, business liability insurance, or other documentation to show that they were independent contractors, and that only one worker filed a federal Form Schedule C. While documentation such as invoices, business cards, business licenses, and proof of liability insurance may support a conclusion that workers are independent contractors operating their own businesses, the absence of such documentation or the inability of a taxpayer to produce such documentation is not conclusive evidence of an employee/employer relationship. Determinations in cases such as these must rest on an analysis of the factors establishing the extent of control over the workers in question. See P.D. 21-56.
Because the audit report and documentation fail to show that the Taxpayer improperly characterized the workers as independent contractors, the assessments will be abated, and a refund issued for any withholding tax that has been paid.
While the Department concedes that the Taxpayer’s workers should not be considered employees for the taxable periods at issue, the Taxpayer should be aware that the Department has the authority to conduct similar worker classification audits in subsequent years. Virginia Code § 58.1-102 requires taxpayers to maintain suitable records that substantiate information required by the Department.
As discussed above, documentation showing a worker’s status can vary and the Department’s auditors must examine the entire relationship as evidenced by documentation and oral testimony. To assist the Department’s auditors in making an accurate determination, proprietors should strive to maintain sufficient records, including contemporaneous notes, worker agreements, training and guidance materials, federal identification numbers, residency documentation, and address or other documentation, as applicable, evidencing the relationship with a worker. In addition, proprietors should refrain from engaging individuals who refuse or are unable to provide sufficient documentation in order to issue a Form 1099 or W-2, if appropriate.
Worker misclassification cannot be determined by a confined list of evidence or documentation. An examination of the entire relationship as evidenced by all relevant documentation that a proprietor or worker may possess, any written or verbal explanations of the proprietor’s relationship with its workers, or any other relevant information that shows how the parties treated the relationship must be conducted in order to appropriately classify a worker as an independent contractor or an employee.
On an application for correction, the Department will continue to be flexible with regard to documentation presented to determine a worker’s classification. However, as audit processes are refined over time, the Department may find that a proprietor’s failure to keep accurate and contemporaneous records as to the activities of its workers and the relationship it has with those workers may become a significant factor in favor of upholding assessments. See Virginia Code § 58.1-102. Keeping such records will assist audit staff in making timely and accurate determinations.
The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
James J. Alex
Tax Commissioner
Commonwealth of Virginia
AR/4524