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Court Denies IRS Attempt to Reclassify Workers; Denies Taxpayers' Request to Recoup Costs

(Parker Tax Publishing May 2017)

A district court held that, even though two companies that provided home care workers to elderly clients won their battle with the IRS and were entitled to classify their workers as independent contractors, the company was not entitled to recoup attorney's fees and administrative costs relating to the case. After looking at various factors, and noting the lack of any legal precedent, the district court found that the IRS's position that the companies' workers were employees and not independent contractors was substantially justified. Nelly Home Care, Inc. v. U.S., 2017 PTC 191 (E.D. Pa. 2017).


In Nelly Home Care, Inc. v. U.S., 2016 PTC 164 (E.D. Pa. 2016), a district court granted summary judgment to two related companies, Nelly LLC and its successor, Nelly Home Care, Inc. (collectively "Nelly"), and held that the companies had a reasonable basis for treating home care workers as independent contractors and not as employees. In that case, the facts indicated that Helen Carney formed and managed both companies, which provided home health care services after matching companions with elderly clients. Carney herself was a companion before starting her own business. While working as a companion, she learned that some home care service providers treated their workers as independent contractors.

After forming Nelly LLC in 2004, Carney conducted a survey of 20 home care companies to determine how they classified their companions for tax purposes. Seven of these companies classified companions as independent contractors. The remaining companies treated them as employees. Shortly after Carney incorporated Nelly Home Care, Inc. in 2009, she attended a mandatory conference at the Pennsylvania Department of Health. At the conference, Carney was told that home care registries, the classification under which Carney registered Nelly Home Care, Inc., treated workers as independent contractors.

In the meantime in 2007, the IRS audited Carney's personal income tax returns for the 2004 and 2005. Carney provided the IRS with information about Nelly LLC, including documents relating to gross receipts, expenses, and copies of independent contractor agreements. As a result of the audit, the IRS concluded Carney had underreported her income, commingled business and personal accounts, and charged 80 percent of her personal expenses through Nelly LLC. Consequently, the IRS adjusted Carney's personal tax liability. The IRS again audited Carney's personal income tax returns in 2011. This time, the audit was resolved with a "no change" determination.

The IRS later began an employment tax audit of Nelly LLC and Nelly Home Care, Inc. It determined that both companies owed a combined total of $4,000 in back employment taxes for tax years 20082012. Nelly paid the tax and promptly sought a refund. After hearing nothing from the IRS for six months, Nelly filed suit in a district court, claiming it was entitled to relief under the safe harbor provisions of Section 530 of the Revenue Act of 1978.

The district court judge granted Nelly's motion for summary judgment. The judge concluded that, while Nelly was not protected by the statutory industry practice or prior audit safe harbors of Section 530, Nelly had a reasonable basis for treating the companions as independent contractors. In reaching this conclusion, the judge considered the cumulative effect of Carney's experience and research, the personal IRS audits which included a review of her companies' business practices, and Pennsylvania regulations. He found that these factors together provided a reasonable basis for Nelly's decision to classify companions as independent contractors. Accordingly, he entered judgment in favor of the companies and against the IRS in the amount of $4,000. After the decision, Nelly sought an award of $100,000 for attorney's fees and costs pursuant to Code Sec. 7430(a), contending it was entitled to the fees and costs because it won the case on summary judgment.

Recovering Litigation or Administrative Costs

Under Code Sec. 7430(a), in any administrative or court proceeding which is brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty, the prevailing party may be awarded a judgment or a settlement for (1) reasonable administrative costs incurred in connection with such administrative proceeding; and (2) reasonable litigation costs incurred in connection with such court proceeding. Code Sec. 7430(c)(4)(A) defines a prevailing party as any party which has substantially prevailed with respect to an amount in controversy, or substantially prevailed with respect to the most significant issue or set of issues presented. However, there is an exception in Code Sec. 7430(c)(4)(B) where the government is the defendant and establishes that its position in the proceeding was substantially justified. In that case, the taxpayer is not treated as a prevailing party even though the taxpayer won the case.

Section 530 Safe Harbors

Section 530 of the Revenue Act of 1978 provides employers with relief from federal employment tax obligations if certain requirements are met. To invoke the safe harbor of Section 530, the taxpayer must establish that it had a reasonable basis for treating the worker as an independent contractor based on either: (1) legal precedent; (2) a prior audit; or (3) a recognized practice of a significant segment of the relevant industry. In addition to these statutory bases, there is a judicially created "any reasonable basis" safe harbor. If the employer-taxpayer establishes any of these bases, it is relieved from liability for paying the employer's share of employment taxes for a worker it had incorrectly treated as an independent contractor.

IRS's Arguments

With respect to the underlying case which Nelly won and the IRS lost, the IRS argued that Nelly had not met any of the statutory safe harbors under Section 530. First, it argued Nelly failed to meet the industry practice safe harbor because it did not demonstrate that a significant portion of the home health care services industry classified workers as independent contractors. Second, the IRS contended that the prior audit safe harbor did not apply because Nelly was not the taxpayer audited in 2007, which is a requirement for the prior audit safe harbor provision of Section 530. The IRS also argued that Nelly failed to establish any reasonable basis for treating its workers as independent contractors to satisfy the judicially created safe harbor. To support its position, the IRS emphasized that Nelly had obtained worker's compensation insurance for its companions, which is typically provided for employees and not independent contractors, and it had failed to obtain advice from an accountant or lawyer on how to classify its workers.

The IRS argued that, even though Nelly was successful in the earlier case, it was not a prevailing party because the IRS's position was substantially justified. Thus, the IRS said, Nelly was not entitled to an award for attorney's fees and costs.

District Court's Decision

The district court held that the IRS's position was substantially justified and denied Nelly's request for attorney's fees and costs under Code Sec. 7430(a). The court noted that the term "substantially justified" means the IRS had a reasonable basis in both law and fact. The position taken, the court observed, need not have been correct, only reasonable.

In the underlying case, the court said, there were no cases where courts had considered the position taken by the IRS. Nelly did not succeed in demonstrating that it was entitled to relief under the statutory bases under Section 530. Instead, it convinced the judge that it had a "reasonable basis" for classifying its companions as independent contractors despite the absence of a statutory basis. The reasonable basis ground is fact-specific, the court noted, and is subject to varying interpretations of the facts and circumstances of the case. The reasonable basis result could have gone either way, the court said. Indeed, after reviewing the record, the court opined that it might have ruled differently than the judge in the underlying case. That the IRS did not win on the merits, the court concluded, did not establish that its position was or was not substantially justified.

Additionally, the court stated that the fact that the case was decided on summary judgment did not mean the government's position was not substantially justified. After looking at the various factors, together with the lack of any legal precedent, the district court found sufficient evidence to support the reasonableness of the IRS's position that Nelly's workers were employees, not independent contractors.

For a discussion of the effects of a misclassification of employees, see Parker Tax ¶210,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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