Tax Court Rejects IRS's Attempts to Withhold Info in a Worker Classification Case

In a recent worker classification case, the Tax Court rejected the IRS’s attempts to withhold information that would reveal whether the taxpayer actually owed the tax at issue. This case should be very helpful to taxpayers litigating employment tax issues, including those arising from employee/independent contractor characterization. The IRS has already sought to limit the scope of the ruling.

THE CASE

The substantive issue in the case—Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11 (2017)—is whether the Mescalero Apache Tribe properly treated certain workers as independent contractors. The IRS reclassified the workers as employees, which triggered a large withholding and payroll tax liability for the Tribe. Generally, if an employer fails to properly withhold income taxes from its employees’ wages, the employer is liable for the amounts it should have withheld. However, there is an exception to the rule—if the workers paid their own income taxes, then the employer is not liable. 

The case is ongoing, and the Tribe maintains both that it properly treated the workers at issue as independent contractors (and therefore did not have a withholding obligation) and that, even if the workers were employees, the Tribe is not liable for withholding taxes because the workers paid their income taxes. One would think it would be fairly easy to determine if this exception applies—the IRS could simply check its records and determine if the workers paid income taxes for the years at issue. Of course, just because something sounds easy does not mean it will be. 

THE DISCOVERY FIGHT

To prove that a worker paid his or her income taxes, the IRS requires that an employer obtain a Form 4669 from the worker. The form certifies that the worker paid income taxes on the payments he or she received from the employer. The IRS does not state what an employer is to do if an employer cannot find a worker or if the worker refuses to complete the form. That was the situation facing the Tribe. 

The Tribe was able to locate and obtain the necessary forms from many of its workers. Unsurprisingly, however, it was unable to locate all of the workers. It then asked the IRS to determine which of the “missing” workers paid their income taxes. After the case went to Tax Court, the Tribe requested this information in discovery. The IRS refused to provide the information, and the Tribe filed a motion to compel the IRS to produce the information. 

The IRS first argued that the federal taxpayer privacy law, Code section 6103, barred it from disclosing whether the workers paid their income taxes for the years at issue. The Tax Court, following Tenth Circuit precedent, concluded that section 6103 allows for the disclosure of this type of information in an administrative or judicial proceeding. 

The IRS next argued that even if the law did not bar the disclosure, it did not have to produce the requested information because it did not have the burden of proof. This was an aggressive argument considering that Tax Court Rule 70(b) expressly states that information is discoverable “regardless of the burden of proof involved.” The Tax Court summarily rejected the IRS’s burden of proof argument and simply stated that the party with the burden of proof is still entitled to discovery of its opponent. As for Tax Court 70(b), the Tax Court read it “to mean what it says.” 

A NEW TOOL FOR TAXPAYERS, BUT IN VERY LIMITED CIRCUMSTANCES

The Tax Court’s decision is a powerful tool for taxpayers litigating worker classification cases. However, it may be available to taxpayers only in litigation (and likely only after filing a motion to compel). Although the applicable Section 6103 exception allows the disclosure in a judicial or administrative proceeding, the IRS recently announced that it will not disclose the information in Examination or Appeals. In Chief Counsel Advice 201723020 (May 5, 2017), the IRS stated that although Section 6103 authorizes the disclosure, it does not require the IRS to disclose whether the workers have already paid the tax. It is unclear why the IRS continues to refuse to disclose this information. However, there is no procedural mechanism available to taxpayers to compel information from the IRS during the Examination and Appeals process. Accordingly, if the IRS refuses to disclose this information voluntarily, taxpayers will have to litigate to obtain it. 

Beyond worker classification cases, this is a welcome ruling for litigating taxpayers because the government has become increasingly resistant to discovery of the IRS. Discovery served on the government in tax cases often triggers an automatic objection on the grounds of section 6103, deliberative process, or relevance. The Tax Court’s decision makes clear that the IRS is subject to discovery in tax litigation, even as a defendant, and that it cannot automatically invoke section 6103 and the taxpayer’s burden of proof to bar discovery of the IRS.