The Department audited us for SIX years and reclassified our 1099 subcontractors as employees just because we couldn't produce invoices and business licenses -- is that enough proof, and can they really go back that far?

Plain-English summary

A Virginia roofing and construction business was audited by the Department for a six-year span (January 2014 through December 2019). The Department concluded that a number of workers the business had treated as independent contractors (issuing them Form 1099s) should actually have been classified as employees, with Virginia income tax withheld from their wages -- resulting in withholding tax assessments across the full period. The business appealed on three separate grounds: (1) the workers really were independent contractors; (2) the audit's methodology didn't account for the seasonal nature of the roofing business; and (3) part of the assessment period was simply too old to be assessed at all.

Ground 1 -- worker classification: documentation gaps aren't proof of employment. The Department's auditor asked the business for documentation supporting independent-contractor treatment; the business provided its worker contracts, which the auditor found insufficient, then asked for additional support (invoices for jobs, business cards, business licenses, proof of liability insurance). When the business couldn't produce those specific items, the audit closed and assessments issued. The Tax Commissioner pushed back on this approach: while items like invoices, business cards, licenses, and insurance CAN support an independent-contractor conclusion, their ABSENCE doesn't mean the relationship couldn't have been an independent-contractor one either. The real legal test requires analyzing the actual factors establishing the degree of control the business exercised over the workers (behavioral control, financial control, and the nature of the relationship) -- not simply checking off a specific document checklist.

Ground 2 -- sampling/seasonality: moot, because there was no sampling. The business argued the audit should have accounted for its seasonal (roofing) business cycle when extrapolating a sample period to the full audit. But the audit staff confirmed the assessment was based directly on the business's ACTUAL Form 1099 filings for each year, with no statistical sampling or extrapolation involved at all -- so there was nothing for seasonality to distort.

Ground 3 -- statute of limitations: a real, partial win. Virginia generally allows the Department three years from the later of a return's due date or actual filing date to assess additional tax. Based on the business's own filing history (quarterly through 2015, then monthly), its FEBRUARY 2017 monthly return -- filed March 27, 2017 -- was the last one still within three years of the March 27, 2020 assessment date. Assessing anything OLDER than that would require the Department to show the business had failed to file returns, or filed false/fraudulent ones with actual intent to evade tax -- and the Tax Commissioner found the record simply didn't support that. As a result, everything assessed for periods BEFORE February 2017 had to be abated outright, regardless of the underlying worker-classification merits.

Bottom line: the case (limited now to periods from February 2017 forward) was sent back to the audit staff to conduct a genuine, properly documented factor-based analysis of the worker relationships, with the business given a full opportunity to present contracts, written or oral testimony, and other evidence -- plus a chance to raise its seasonality argument again if it wishes, even though it didn't apply to the original assessment methodology.

What this means for you

Contractors and businesses that classify workers as 1099 independent contractors

Don't assume a worker-classification dispute turns on whether you have a specific checklist of paperwork (invoices, business cards, a license, insurance) -- while that documentation helps, its absence alone doesn't prove an employment relationship; the real question is how much CONTROL you actually exercised over how, when, and where the work got done.

Businesses facing a multi-year Virginia withholding or sales tax audit

Check your own filing history against Virginia's three-year assessment window before accepting an assessment covering the FULL audit period -- unless the Department can show you failed to file, or filed false/fraudulent returns with actual intent to evade tax, everything older than three years from the assessment date (measured from your filing dates) should be time-barred and abated.

Seasonal businesses concerned about audit sampling methodology

Confirm whether your audit actually used STATISTICAL SAMPLING/extrapolation at all -- if the assessment was instead built directly from your actual, complete filings (as in this case), a seasonality argument about sample-period representativeness won't have anything to attach to.

Common questions

Q: If we can't produce invoices, business cards, or a business license for our subcontractors, does that mean they'll be reclassified as employees?
A: Not necessarily -- this ruling confirms the absence of such documentation doesn't prove an employment relationship; the Department must still evaluate the actual degree of control over the worker under the recognized behavioral/financial-control framework.

Q: Can the Department assess withholding tax going back more than three years just because an audit covers a longer period?
A: Not unless it can show you failed to file returns, or filed false/fraudulent returns with actual intent to evade tax -- absent that, the standard three-year assessment window (from the later of the due date or actual filing date) controls, and older periods should be abated.

Q: Does a seasonal business get special treatment in how an audit sample is calculated?
A: It can be a valid argument WHEN sampling/extrapolation is actually used -- but if the audit is based on complete, actual data (like full Form 1099 filings) rather than a projected sample, there's no extrapolation for seasonality to distort.

Citations and references

• Public Document 96-280 (10/10/1996) -- established that the factors in Treas. Reg. § 31.3121(d)-1 serve as the guideline for the employee-vs-independent-contractor determination
• Public Document 18-107 (6/6/2018) -- cited for the audit staff's obligation to fully evaluate an employer's records under the recognized control-based factors
• Public Document 20-170 -- cited alongside P.D. 18-107 on the same audit-evaluation obligation
• Rev. Rul. 87-41 -- the IRS's original 20-factor guideline for employee/independent-contractor classification
• IRS Publication 15-A (2020), Employer's Supplemental Tax Guide -- describes the modern three-category framework (behavioral control, financial control, relationship of the parties) supplementing the 20-factor test

Subject

Administration : Audit - Worker Misclassification, Adoption of IRS Control Doctrine, Roofing Contractor

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-56

Original ruling text

May 4, 2021

Re: § 58.1-1821 Application: Withholding Tax

Dear *:

This will respond to your letter in which you seek correction of the withholding tax assessments issued to * (the “Taxpayer”), for the taxable periods January 2014 through December 2019.

FACTS

The Taxpayer operated a roofing and construction business in Virginia. For withholding tax purposes, the Taxpayer was a quarterly filer for the taxable periods from January 2014 through December 2015 and a monthly filer thereafter. The Department audited the Taxpayer for the periods January 2014 through December 2019. The Department concluded that a number of workers whom the Taxpayer had considered independent contractors and to whom it had issued Form 1099s should have been classified as employees and had income tax withheld from their wages. As a result, assessments were issued for withholding tax due. The Taxpayer appealed, contending the workers in question were independent contractors. The Taxpayer also contends that the audit sample did not take into account the seasonality of its business and that the statute of limitations on assessments barred the Department from assessing tax for a portion of the period at issue.

DETERMINATION

Employee vs. Independent Contractor

Virginia Code § 58.1-460 defines “employee” as “an individual, whether a resident or a nonresident of the Commonwealth, who performs or performed any service in the Commonwealth for wages....” The Code of Virginia does not define “independent contractor” for income tax withholding purposes. Under Title 23 of the Virginia Administrative Code (VAC) 10-140-10 the relationship between an employer and employee or independent contractor is determined in accordance with the test set forth in Treas. Reg. § 31.3401(c)-1. In Public Document (P.D.) 96-280 (10/10/1996), the Tax Commissioner found that the factors enumerated in Treas. Reg. § 31.3121(d)-1 should be used as a guideline for determining whether a worker is an employee or an independent contractor.

In its appeal, the Taxpayer refers to the twenty factors cited above and asserts that nearly every such factor in its case supports its position that the workers were independent contractors. Previously, the IRS set forth twenty factors to help differentiate between employees and independent contractors. See Rev. Rul. 87-41 . The Internal Revenue Manual (IRM) § 4.23.5.7.1 now states that although the 20 factor test may still be used for reference purposes, the primary method is to consider every piece of information in a case that helps decide the extent to which the taxpayer does or does not retain the right to control the worker. This evidence tends to fall into three categories: behavioral control, financial control, and the type of relationship of the parties. See also IRS Publication 15-A, Employer’s Supplemental Tax Guide (2020). It is important to note that not all factors have to exist on one side or the other. It is also important to note that every factor might not be relevant in each case, and depending on the specific circumstances of the case, some factors may be more relevant than others. Typically, an employee relationship will exist when the worker is subject to the will and control of the employer not only as to what will be done but how it will be done. On the other hand, an independent contractor is normally only subject to the control and direction of another as to the result of the work, but not as to the means and methods of accomplishing it. See Treas. Reg. § 31.3121(d)-1.

The audit staff requested documentation from the Taxpayer to support treating the workers as independent contractors. The Taxpayer provided copies of contracts it had with the workers, but the auditor found this documentation to be insufficient. The Taxpayer was then asked for additional support and given a list of documentation that was acceptable, namely invoices for the jobs, business cards, business licenses and proof of liability insurance. When the Taxpayer was unable to produce these items, the audit was concluded and assessments were issued.

While documentation such as invoices, business cards, business licenses and proof of liability insurance may support a conclusion that workers are independent contractors operating their own businesses, the absence of such documentation or the inability of a taxpayer to produce such documentation does not mean that an independent contractor relationship could not have existed. Determinations in cases such as these must rest on an analysis of the factors establishing the extent of control over the workers in question.

Sampling

The Taxpayer also contends that the Department should have taken into account the seasonality of its business when extrapolating the audit sample to determine the Taxpayer’s total liability for the audit period. According to the audit staff, however, the audit was based on the Taxpayer’s issued Form 1099s for the years in question, and no sampling was done. As such, there does not appear to have been an extrapolation that could have been distorted because of the seasonality of the business.

Statute of Limitations

Virginia Code § 58.1-1812 allows the Department to assess omitted taxes within three years of the latter of the due date of the return or the actual date that the return was filed. Under Virginia Code § 58.1-312 A, the Department may assess underreported tax at any time when a taxpayer fails to file a return or files a false or fraudulent return with the intent to evade tax.

The Taxpayer was a quarterly filer for the taxable periods from January 2014 through December 2015 and a monthly filer thereafter. Under Virginia Code § 58.1-472 2, monthly filers must file their returns before the 25th day of the following month. Based on the Taxpayer’s filing history, the monthly February 2017 period was the last return within the three year limitations period because that return was filed on March 27, 2017, and the assessments were issued on March 27, 2020. In order for the Department to have assessed withholding taxes for periods prior to such date, the Taxpayer either would have to have failed to file returns or filed them falsely or fraudulently with the intent to evade payment of the tax. Based on a review of the record, there is insufficient information in this case on which to base a claim that returns were filed falsely or fraudulently with such intent. Therefore, the three year statute of limitations applied.

CONCLUSION

Because insufficient information exists to support a conclusion that the Taxpayer filed withholding tax returns falsely or fraudulently with the intent to evade tax, the three year statute of limitations applied under Virginia Code § 58.1-302. Accordingly, the audit was limited to the tax periods beginning February 2017. Any tax liability assessed for periods prior to that month will be abated.

Under the provisions of Virginia Code § 58.1-205, an assessment of a tax by the Department is deemed prima facie correct. As such, the burden of proof is on the Taxpayer to show the Department’s assessment is incorrect. The Department’s regulations, however, require an evaluation an employer’s records to determine if its workers are employees or independent contractors pursuant to the factors enumerated in Treas. Reg. § 31.3121(d)-1 and as further described in Rev. Rul. 87-41 and more recently in IRS Publication 15-A. The Department’s audit staff, therefore, must give taxpayers a full opportunity to present information and evidence concerning their relationships with workers. Such evidence may take the form of written documentation, including, but not limited to, any contracts that existed between the taxpayer and the individuals in question. The evidence may also include, but again not be limited to, written or oral testimonials from individuals with knowledge of the relationships, including members of management or the individuals themselves whom the Department is trying to determine were employees or independent contractors. Once a taxpayer has had a full opportunity to present such information, the audit staff should undertake a complete evaluation of such evidence and fully document its analysis in reaching its audit conclusions.

Accordingly, the case will be returned to the audit staff to conduct a complete examination of the relationships at issue in accordance with the procedures outlined above. The Taxpayer, in turn, must provide sufficient information to support its contention that its workers were independent contractors during the tax periods at issue. In particular, the Taxpayer and the audit staff should review IRS Publication 15-A for a discussion of the different categories of factors at issue. In addition, the Taxpayer will be given an opportunity to present information and evidence concerning the seasonality of its business, if it wishes. Once the examination is completed, the audit staff is directed to prepare a revised audit report and communicate the result of the examination to the Taxpayer in writing. The report should fully analyze any information the Taxpayer is able to provide concerning the factors described above. Should the Taxpayer wish to appeal the result of the revised audit, it will have 90 days from the date the audit staff communicates the audit result in writing in which to appeal.

The Code of Virginia sections, regulation and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3451.M

Related Documents

96-280

18-107

20-170