Whether to classify a worker as an employee or an independent contractor is an eternal question for businesses of all sizes. Generally, the IRS favors classification of workers as employees. In contrast to the treatment of an independent contractor, for employees employers are liable for withholding state, federal and social security taxes from wages, and for paying the employer’s portion of social security taxes, as well as federal and state unemployment taxes. Accordingly, the reclassification of workers from independent contractors to employees during an IRS worker’s classification audit can result in steep tax consequences for businesses in the form of additional liability, penalties and interest. Recently, the IRS issued Revenue Ruling 2025-3, which examines five scenarios illustrating when relief may be provided and when the taxpayer can seek judicial review of an IRS determination in U.S. Tax Court. The Revenue Ruling provides guidance for taxpayers evaluating the risks of classifying workers as non-employees and navigating relief provisions in the face of a potential reclassification determination.
Taxpayer Relief Provisions
To mitigate the potentially devastating tax effects of a reclassification determination, Congress has provided relief provisions for IRS reclassifications of workers, available to taxpayers that meet certain criteria, including section 530 of the Revenue Act of 1978 (“Section 530 Relief”), and section 3509 (“Section 3509 Reduced Rates”) of the Internal Revenue Code of 1986, as amended (the “Code”).
Section 530 Relief allows a taxpayer to avoid federal employment tax liabilities and have interest and penalties forgiven in the event of an IRS reclassification determination. To take advantage of Section 530 Relief, the business must (1) have timely filed all federal tax returns consistent with the worker being treated as a nonemployee; (2) treated the worker, or any similarly-situated worker, as an independent contractor for all tax periods; and (3) had a reasonable basis for such treatment (collectively referred to as the “Section 530 Tests”). Where a business failed to treat a worker as an employee, but is not eligible for Section 530 Relief, the business may be able to take advantage of reduced unemployment tax rates under section 3509(a), provided that the business did not intentionally disregard the requirement to deduct and withhold income tax and consistently treated the worker as a nonemployee for both federal income tax and FICA purposes.[1] After an IRS examination in which there is a determination that workers should be reclassified or that the business is not entitled to Section 530 Relief, the business may seek U.S. Tax Court review, provided that there is an actual controversy concerning the determination.[2]
Generally, to take advantage of Section 530 Relief or Section 3509 Reduced Rates, the business must request such relief, have treated the workers as nonemployees, and then the IRS reclassified the workers as employees after an audit.
Revenue Ruling 2025-3
Scenario 1
Nonemployee Compensation: Employer hires workers to provide services, pays the workers a fixed amount and fixed bonus each week, does not withhold or pay federal employment taxes, and reports the payments on Form 1099-NEC “Nonemployee Compensation.” The IRS audits the business and determines that the business fails to meet the requirements of Section 530 Relief and reclassifies the workers as employees. Employer believes it qualifies for Section 530 Relief and disagrees with the IRS’s reclassification of its workers.
Provided that employer satisfies the Section 530 Tests, employer may take advantage of Section 530 Relief because the business did not treat the workers as employees and there is a reclassification of the status of the workers. Alternatively, employer may use Section 3509 Reduced Rates as the business treated the workers as nonemployees, did not pay or withhold federal employment taxes, and there is a reclassification of the workers’ status. Since the IRS determined that workers should be reclassified and Section 530 Relief was inapplicable, Taxpayer will be able to seek review in U.S. Tax Court due to the disagreement with the IRS determinations.
Scenario 2
Employee Compensation as to Wages, But Not Bonuses: Employer treats workers as employees, but withholds and pays federal employment taxes only with respect to the weekly fixed amount; the weekly fixed bonus is treated as in the first scenario. The IRS audits the business and determines that the weekly fixed bonus amounts are wages which should have been reported on Forms 941 and W-2. Employer claims it qualifies for Section 530 Relief and disagrees with the IRS’s reclassification of its payments. Section 530 Relief and Section 3509 Reduced Rates are not available because there is no reclassification of the workers’ status, instead employer treated the workers as employees and paid the additional bonus amounts for the same services. Because there was a determination made and controversy over whether the business is eligible for Section 530 Relief, employer can seek review in U.S. Tax Court.
Scenario 3
Unreported Bonuses: The same facts as the second scenario, except that employer does not report the weekly bonus amounts on any information return. As with the second scenario, Section 530 Relief and Section 3509 Reduced Rates are not available, but employer may petition U.S. Tax Court for review.
Scenario 4
Unreported Bonuses and No Section 530 Relief: The same facts as the third scenario, except that employer does not claim it meets Section 530 Relief with respect to the bonus payments. Here, not only are Section 530 Relief and Section 3509 Reduced Rates not applicable because there was no reclassification of the workers’ status. Taxpayer cannot petition U.S. Tax Court for review because the business did not claim it qualifies for Section 530 Relief and there is no disagreement over whether the workers are employees.
Scenario 5
Third-Party Payroll Contract: Employer treats workers as employees in all respects and contracts with a third-party to pay salaries, withhold federal employment taxes and file federal employment tax returns. But, employer pays employees direct bonuses and does not withhold or pay federal employment taxes or report the bonuses on any information return. The IRS audits the business and determines that the bonuses are wages. Employer claims it qualifies for Section 530 Relief and disagrees with the IRS’s reclassification of its payments. Neither Section 530 Relief nor Section 3509 Reduced Rates are available here because the year-end bonuses are additional wages paid for the same services performed by the workers, who the business treated as employees. Yet, employer may still seek judicial review because there was a determination made and disagreement over whether the business qualifies for Section 530 Relief.
Taxpayer Takeaways
Revenue Ruling 2025-3 clarifies that there must be a reclassification of the workers’ status from nonemployees to employees in order for an employer to take advantage of Section 530 Relief or Section 3509 Reduced Rates. Taxpayers who wish to plan for relief in close calls should ensure that similarly situated workers are treated consistently as either employees or non-employees with respect to wages and bonuses, as well as on federal employment or information returns, and that there is a reasonable basis for such treatment. It is always helpful to review worker determinations in advance and document the basis for the determination so that the information is handy in the event of an IRS examination.
In addition to the relief analyzed in Revenue Ruling 2025-3, Taxpayers may be eligible for one of two settlement programs offered by the IRS: the Classification Settlement Program (“CSP”) and Voluntary Classification Settlement Program (“VCSP”). Each program is subject to certain criteria and provides varying relief. Notably, the CSP is available to Taxpayers in the midst of an employment tax audit and the VCSP is not.
Employers seeking additional information about the tax implications of worker classification should reach out to a qualified tax professional.
[1] While still reduced, the rates increase where the employer did not also meet information return requirements (e.g. filed Forms 1099).
[2] Revenue Ruling 2025-3 also elucidates when Taxpayers may seek judicial review in U.S. Tax Court. The Section 7436 Notice allows the taxpayer to file a petition in U.S. Tax Court.
