Safe Haven Rule

The tax law provides a "safe haven" rule that, for some employers, can minimize your uncertainty when it comes to the proper treatment of workers as employees or independent contractors for purposes of employment taxes. If you meet the terms of the rule, your characterization of an individual as an independent contractor will not be challenged.

This rule provides that an individual who has consistently not been treated as a common-law employee for any period after 1977 will not be reclassified as an employee if you, the employer, have filed all required federal tax returns, including information returns (Forms 1099-MISC), and if you had a reasonable basis for not treating the individual as an employee.

In other words, if you have always treated a certain worker as an independent contractor and properly filed the corresponding tax returns, you may be in the clear.

What's a "reasonable basis" for not treating someone as an employee? There are three factors you may use:

  • judicial precedent, published rulings, or technical advice or a letter ruling you received from the IRS
  • a past audit by the IRS in which there was no assessment for your treatment, for employment purposes, of workers holding positions substantially similar to the position held by the worker in question
  • long-standing recognized practice of a significant segment of the industry in which the individual works (for example, most workers in your industry are treated as independent contractors by employers)

Recent legislation in this area has clarified and added to the requirements for qualifying for the safe haven:

  • Employers can't rely on a clean bill of health from an audit that began in 1997 or thereafter, unless it specifically examined the issue of whether the worker involved or any worker holding a substantially similar position should be treated as an employee. (Employers can still rely on prior audits that began before 1997, even if they weren't related to employment tax matters.)
  • To prove that a "significant segment" of your industry treats such workers as independent contractors doesn't require you to show that more than 25 percent of your industry treats them as independent. (However, if less than 10 percent of your industry treats such workers as independent contractors, it's unlikely to be considered a significant segment.)
  • An industry practice need not have continued for more than 10 years, or to have began prior to 1979, for it to be considered long standing based on the particular facts and circumstances. This allows new industries to take advantage of the safe haven rule relief.
  • For audits beginning in 1997 and after, IRS employees must, at the beginning of an audit involving worker classification issues, provide you with written notice of the safe haven provisions. (If the worker classification issue arises after the audit begins, you're entitled to notice at the point the issue is first raised.)
  • Once you establish that it was reasonable not to treat a worker as an employee under the safe haven rule, the burden of proof shifts to the IRS as to the treatment of that worker, for purposes of the safe haven rule.

If you don't satisfy any of the provisions above, you're not out of the ball game yet. Employers have been found to have a reasonable basis for treating workers as independent contractors when their treatment is based on something similar to the specific provisions spelled out. For example, when a corporation obtaining services from dentists relied on a statement from the state dental board's council that it would be illegal to enter into an employer-employee relationship with the dentists, the IRS granted the corporation safe haven relief.

On the other hand, an employer who treats certain workers as employees and others as independent contractors when the two groups hold substantially similar positions will more than likely be denied relief under the safe haven rule. Also, if you have treated someone as an employee anytime after 1977 and try to convert him or her to an independent contractor, you are not eligible for the safe haven.

Finally, what happens if your workers don't satisfy the requirements of the safe haven rule? Your workers aren't automatically employees the common law test of the workers' status is applied.