ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – THE US TAX COURT WEIGHS IN ON THE ON THE ISSUES DETERMINING EMPLOYEE VS INDEPENDENT CONTRACTOR – NEW TESTS AND NEW WORLD VIEWS – PART 1
By Robert S. Schriebman
This is Part 1 of a series of articles that will discuss the new US Tax Court Decision of Hampton Software Development, LLC v. Commissioner, 61,197(M), T.C. Memo. 2018-87 (June 19, 2018). Throughout this series of articles we will refer to the taxpayer as “Hampton.”
The Hampton case has nothing to do with software development despite the title. The case involves the management a 60-unit apartment complex in Tulsa, OK. The key player is Robert Herndon (Herndon) the property manager of the complex. This is a long decision centering on Herndon and whether he was an employee or independent contractor. The case sets forth a new 8 factor test at the federal level to determine if a worker is an employee or an independent contractor.
Tax Court Memorandum Decisions differ from regular decisions as they are primarily centered around fact-based situations instead of technical points of tax law.
The owners of the apartment complex, William Hampton and Brent Hampton made a few stupid mistakes that I believe may have influenced Tax Court Judge Chiechi in reaching her decision that Herndon was an employee and an independent contractor.
In Part 1, we will discuss the extensive facts and the errors committed by the Hamptons that caused the Tax Court to rule against them. We will also briefly review the 8 factor test set forth by the Court.
The Facts in Hampton
The Hamptons bought the apartment complex in 2009. Herndon had been working as property manager for the prior owners for several years. The Hamptons engaged him to continue to manage the apartment complex. They gave him an apartment and paid him $2,000 a month as a flat fee regardless of how much time and effort the job took. The Hamptons treated Herndon as an independent contractor without any written agreement and only a verbal understanding.
The Hamptons, as owner and operator of the apartment complex, established the amount of rent for each unit as well as the policies, rules, and regulations that were to apply to the apartment complex. These rules included policies on pets, and the use of the swimming pool. Only the Hamptons had the authority to make any changes to the rules and policies governing the apartment complex.
The Hamptons maintained and occupied an office in the apartment complex for operational purposes. The office had a computer, a printer, a file cabinet for retaining tenant files, a book of blank rent receipts, a drop box for rental payments and a deposit bag to use for taking rental payments to the bank. There were also blank rental application forms and blank lease forms.
Herndon managed the apartment complex from day to day. He also did handyman type work such as general maintenance, painting, minor plumbing work, and whatever work was needed in vacant apartments to make them suitable for the occupancy by new tenants. He also had several other jobs as follows:
- Placing newspaper advertisements showing the availability of apartments for rent.
- Accepting applications to rent from prospective tenants.
- Showing apartments for rent to prospective tenants.
- Reviewing applications to rent from prospective tenants.
- Deciding whether to accept or reject rental applications using guidelines that the Hamptons set up for him.
- Deciding whether to evict a tenant.
- Answering telephone calls when the Hamptons were not available.
- Processing rental payments by imputing data into the computer and making deposits.
Herndon often used his own tools when doing repair and maintenance work. He sometimes worked for third party customers in doing handyman work on their properties. This was done in his spare time, but was done infrequently.
The Hamptons did not supervise Herndon’s work as he had about 15 years of prior experience managing the 60-unit apartment complex. The Hamptons gave him no employee benefits other than a rent-free apartment and paying the $2,000 monthly flat fee even when Herndon took his vacations. The IRS auditor did not attribute additional compensation to Herndon as a result of the rental value of the apartment.
The Mistakes Made by William and Brent Hampton
William and Brent made several unfortunate decisions in their relationship with Herndon, the IRS and the Tax Court. Let’s look at them.
The IRS conducted an audit into the worker status of Herndon. The auditor concluded that Herndon was a common law employee and that the Hamptons were liable for back payroll taxes together with interest as well as penalties. During the audit the Hamptons were represented by counsel, but the Hamptons fired the attorney most likely because they did not want to pay more attorney’s fees.
When the IRS assesses payroll taxes for misclassifying workers, certain interest-free reductions can be made by the IRS upon request. This is true even if the IRS also assesses penalties. These rules are set forth in IRC § 3509. Under IRC § 3509, if an employer owes payroll taxes, the debt can be reduced to 1.5% of income tax withholdings, and 20% for FICA Social Security taxes. This assumes that the employer did file payroll tax returns for other workers. These amounts are doubled if no returns are filed, but it still is a bargain because no interest is charged. The Hamptons apparently failed to ask the IRS for these concessions.
The Hamptons failed to pay the audit assessment.
The assessment went into the collection process and the Hamptons received the usual Collection Due Process (CDP) invitation. A CDP process allows you to work out a payment arrangement or other solutions to your tax bill. The Hamptons, while they filed a CDP petition, refused to discuss any payment resolution with the IRS. They only challenged Herndon’s reclassification from independent contractor to employee. That was a stupid thing to do.
The third stupid act on the part of the Hamptons was to their failure or refusal to appear at the US. Tax Court trial of their matter. Thus, they offered no defense or argument directly to the Court to present their point of view. They did file a brief, as required by Tax Court procedures, but they failed to set forth any cogent arguments.
The Hamptons did not give Herndon either a W2 or a 1099 for any tax years in issue.
What did they expect the results to be?!
The US Tax Court 8 Factor Test
In reaching the Court’s decision Judge Chiechi set forth an 8 factor test as follows:
- The degree of control exercised by the person for whom the work is performed over the details of the work;
- Which party invests in the facilities used by the worker;
- The opportunity of the worker for profit or the risk of the worker for loss;
- Whether the principal has the right to discharge the worker;
- Whether the work is part of the principal’s regular business;
- The permanency of the relationship between the principal and the worker;
- The relationship that the principal and the worker believed they were creating; and
- Whether the principal provided the worker any so-called employee benefits.
According to Judge Chiechi, “In resolving the issue of whether a worker is an employee, all of the facts and circumstances must be considered, and no one factor is dispositive.” See Weber v. Commissioner, 103 TC 378, 386 (1994). Judge Chiechi did not discuss the IRS famous “20 factor” test in reaching her decision.
In Parts 2 and 3 we will review all of the 8 factors mentioned above, and also discuss why the Hamptons lost on the issue of safe harbor under Section 530 of the Revenue Act of 1978.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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