IRS Records of Workers' Income Tax Payments Were Discoverable by Employer

(Parker Tax Publishing April 2017)

The Tax Court held that an employer could seek third-party taxpayer information in an effort to absolve itself of withholding tax liabilities. The fact that the burden of proof was on the employer to show its workers paid income tax did not make their confidential return information nondiscoverable. Mescalero Apache Tribe vs. Comm'r, 148 T.C. No. 11 (2017).

During the 2009-2011 tax years, the Mescalero Apache Tribe either employed or contracted with several hundred workers. The Tribe timely issued Forms W-2 to its employees and Forms 1099 to its independent contractors. The IRS audited the Tribe and reclassified hundreds of independent contractors as employees.

Under Code Sec. 3402(a), an employer must deduct and withhold income and employment taxes on the wages it pays to employees. The employer is liable for the taxes it fails to withhold if it misclassifies workers as independent contractors. However, Code Sec. 3402(d) provides that the employer is not liable for the taxes if the employees paid the tax on their income. To take advantage of Code Sec. 3402(d) and show that the workers paid their income tax, the Tribe asked each worker to complete a Form 4669, Statement of Payments Received. The Tribe was unable to find 70 of the workers who had either moved or lived in remote areas. With respect to those workers, the Tribe sought IRS records of those workers to determine whether the workers had reported their Form 1099 income and paid their tax liabilities. The IRS refused the request, arguing that it was barred under Code Sec. 6103 from disclosing these confidential records. Under the general rule in Code Sec. 6103, returns and information on returns must be kept confidential. However, an exception is provided in Code Sec. 6103(h)(4)(C), which permits disclosure in judicial or administrative proceedings pertaining to tax administration if the return information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer which directly affects the resolution of an issue in the proceeding.

The case went before the Tax Court, which had to decide (1) whether the records of tax payments were return information, (2) to whom the disclosure permitted in Code Sec. 6103(h)(4)(C) could be made, (3) whether the relationship between the Tribe and its workers was a transactional relationship, (4) whether the requested return information directly related to the relationship, and (5) whether the information directly affected the resolution of an issue in the case.

The Tax Court sided with the Tribe and held that the requested records were disclosable under Code Sec. 6103(h)(4)(C). First, the Tax Court noted that, under Code Sec. 6103(b)(2)(A), return information is defined to include tax payments. There was therefore no doubt that the records requested by the Tribe qualified as return information.

Next, the Tax Court considered to whom return information may be disclosed. Noting a split among the circuits, the court followed the Tenth Circuit's decision in First Western Government Securities v. U.S., 796 F.2d 356 (10th Cir. 1986) which held that third party tax return information may be disclosed in judicial and administrative tax proceedings to persons other than government officials as long as the other requirements of Code Sec. 6103(h) are met.

The Tax Court then considered whether the relationship between the Tribe and its workers qualified as a transactional relationship under Code Sec. 6103(h)(4)(C). It found that the ordinary meaning of "transact" was simply to carry on business. Based on the wide variety of business relationships that other courts had held met the definition of a transactional relationship, the Tax Court found that the relationship between an employer and its workers was one that pertains to the carrying on of business and thus was a transactional relationship.

In analyzing whether the requested information directly related to the transactional relationship, the Tax Court found that whether the Tribe's workers paid their tax liabilities was relevant to whether they considered themselves independent contractors or employees, and thus directly related to their relationship with the Tribe.

Finally, the Tax Court considered whether the return information directly affected the resolution of an issue in the instant case. The Tax Court reasoned that workers' views of themselves as either employees or independent contractors is generally a factor in worker classification cases. Further, determining whether the Tribe's workers paid their income tax liabilities as independent contractors would, in the Tax Court's view, tend to prove or disprove the Tribe's case, which would directly relate to the resolution of one of the issues. Finally, the Tax Court noted the overarching issue that if the Tribe's workers did pay their tax liabilities, the Tribe's Code Sec. 3402(d) defense would be proven and that issue would therefore be entirely resolved.

For a discussion of the consequences of treating employees as nonemployees, see Parker Tax ¶210,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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