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 U.S. 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 their own files to prevent the double 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 gets a form W-2 containing his/her salary and the withheld taxes.

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

The IRS has focused in recent years on reclassifying these independent contractors to employee status.

This allows the IRS to collect from one employer rather than dozens of workers. When the IRS does this reclassification the employer can get stuck paying all of those worker payroll taxes for the last 3 years.

And then the IRS adds penalties and interest.

There are few defenses in these cases and they are difficult to use and expensive to undertake. One of the defenses is for the employer to try to locate the workers and try to persuade them to sign a sworn statement to the IRS that they reported this Form 1099 income on their income tax return and paid the appropriate taxes on it. This is a really difficult task for an employer — many are itinerant workers that have moved on. Others are reluctant for fear of an IRS audit. It’s 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 folks, the IRS is 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 those 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 United States Tax Court agreed. In fact, all 16 judges agreed which is very unusual. In their joint opinion, the entire United States Tax Court unanimously ruled that the IRS must search its own files and determine whether those reclassified independent contractors had filed their own tax returns and reported that income. If so, the employer cannot be made responsible for paying payroll taxes on those reclassified workers.

Let me repeat again for emphasis — the Internal Revenue Service had been collecting taxes twice on the same income, once from the independent contractor and then again from the employer. But no more. It’s no overstatement to say that this case will fundamentally change 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 those workers are reclassified, is not responsible for all those back taxes which have already been paid by the worker.

The impact of this case will be far reaching. The IRS conducts thousands of payroll tax audits each year that can involve this very issue. This new court decision may 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 in business and their workers lost their jobs.

This case ends an IRS practice which really needed to change. Some of the tax top tax lawyers within the IRS fought vigorously against this change in the law. The IRS lost this case and the U.S. taxpayers are the winners.