Mescalero Apache Tribe v IRS

2017 TCR 11 (2017)
Reviewed By The Court

Summary of the Case

This is one of the most important cases in recent United States Tax Court history. The IRS has, for many years, been able to collect the same taxes twice — once from an independent worker, and then again from an employer. That has now ended. In the future, the IRS must search its own files to prevent double this taxation.

1. Law

Businesses typically have two kinds of workers. The first is simply an employee. Each payday, the employer withholds payroll taxes from the employee and sends them to the IRS. At the end of the year, the employee receives a Form W-2 containing his or her salary, and listing taxes withheld.

The second kind of worker is an independent contractor. Generally speaking, these are people who get paid per job. They include all kinds of workers, including carpenters, painters, truckers and many more. At the end of the year, the worker receives one or more Forms 1099 reflecting all of the income paid, and indicating no withholding.

The IRS has focused in recent years on reclassifying these independent contractors as employees. This allows the IRS to collect from one employer, rather than dozens of workers.

When the IRS does attempt this reclassification, the employer can become responsible for payroll taxes for independent contractors hired over the last 3 years. On top of that, the IRS will add penalties and interest.

There are few defenses in these cases, and they are both difficult to use and expensive to undertake. In one of the defenses, the employer will try to locate the workers and try to persuade them to sign a sworn statement to the IRS that they reported their Form 1099 income on their tax return and paid the appropriate taxes. This is an extremely difficult task for an employer. Many are itinerant workers who have moved on to other jobs. Others are reluctant, fearing an IRS audit. It’s often almost impossible for an employer to mount this defense.

Thus, the IRS is collecting the same taxes twice — once from the worker, and then again from the employer. That’s right, the IRS was collecting the same money twice.

2. Facts

The Mescalero Apache Tribe has a large number of employees, and also, a large number of independent contractors. The IRS tried to reclassify these independent workers as employees and impose three years of devastating back taxes, penalties and interest on the employer.

The employer argued that the IRS should not be allowed to collect the same taxes twice. Instead, the employer argued that the IRS should be ordered to look into its own computer files and remove workers who had already filed and paid their taxes. Seems fair, right? The IRS argued vigorously that the burden should remain on the employer, and not on the IRS.

In 2017, the U.S. Tax Court agreed. In fact, all 16 judges agreed, which is very unusual. In their joint opinion, the entire U.S. Tax Court unanimously ruled that the IRS must search its own files and determine whether those reclassified as independent contractors had filed their own tax returns and reported that Form 1099 income. If so, they ruled, the employer cannot be made responsible for paying payroll taxes on those reclassified workers.

Let me repeat again, for emphasis: The IRS had been collecting taxes twice on the same income — once from the independent contractor, and then again from the employer. But this practice is no more. It’s no overstatement to say that this case has fundamentally changed the way the IRS collects payroll taxes.

3. Future Impact of Case

This new court decision eliminates the second round of taxation. It means that the employer, even if independent workers are successfully reclassified, is not responsible for back taxes that have already been paid by the worker.

The impact of this case will be far-reaching. Each year, the IRS conducts thousands of payroll tax audits that can involve this very issue. This new court decision could save employers an incredible amount of money, time and worry. Prior to this ruling, employers that were subject to these payroll tax audits were frequently unable to defend the case or pay the taxes. In some cases, the employers were unable to continue to do business, and their workers lost their jobs.

This case ends an IRS practice that desperately needed to change. Some of the tax top tax lawyers within the IRS fought vigorously against this change in the law, but they lost, and U.S. taxpayers are the winners.