The Internal Revenue Service has released new guidance, Rev. Rul. 2025-3, clarifying the application of Section 530 of the Revenue Act of 1978, Section 3509 of the Internal Revenue Code (IRC), and Section 7436 of the IRC in five common situations where the IRS has determined that a worker is misclassified as a non-employee.

Background

Section 530 provides relief to certain taxpaying businesses that failed to pay employment taxes for an individual worker whom the IRS is proposing to reclassify from non-employee (e.g., independent contractor) to employee. This relief measure applies to classification disputes with the IRS only, and does not apply to the classification of payments to an individual, nor to misclassification disputes under any other law such as the Fair Labor Standards Act. Section 530 terminates a taxpayer’s employment tax liability with respect to an individual not treated as an employee if certain statutory requirements are met:

1. Reporting Consistency: The taxpayer must have timely filed all required federal tax returns consistent with its treatment of the individual as a non-employee. For example, if it is the taxpayer’s position that the individual is an independent contractor, not an employee, then the taxpayer should have filed all required Forms 1099-NEC (nonemployee compensation for payments of $600 or more in a calendar year).
2. Substantive Consistency: The taxpayer or predecessor did not treat the individual, or any worker holding a substantially similar position, as an employee at any time after December 31, 1977. A substantially similar position is one in which the job function, duties, and responsibilities are substantially similar, and where the control and supervision of those duties and responsibilities are also substantially similar.
3. Reasonable Basis: The taxpayer had a reasonable basis for not treating the individual as an employee and relied on one of the following safe harbors:
   
   1. A prior audit where there was no assessment of employment taxes attributable to the treatment of the individuals in substantially similar positions;
   2. Reliance on a long-standing recognized practice of a significant segment of the industry in which that individual was engaged. The taxpayer must have reasonably relied on such practice at the time it began treating the individual as a non-employee; or
   3. Judicial precedent, published ruling, or a letter ruling to the taxpayer at the time it began treating the individual as a non-employee.

If none of the safe harbors apply, Section 530 can still be established on some other reasonable basis, such as advice of counsel, favorable state decisions on such workers’ status or even a reasonable application of the common law.  

If a taxpayer does not meet the statutory requirements for relief under Section 530, then it can find a ray of hope under IRC section 3509. This section allows an employer to remit unpaid taxes at reduced rates if the employer fails to deduct and withhold income tax or the employee share of the FICA¹ tax with respect to any of its employees because the employer treated that employee as a non-employee. Section 3509 will not apply if the taxpayer treated such individual as an employee and there is a dispute only as to the characterization of payments.

Finally, IRC section 7436 provides that the United States Tax Court may have jurisdictional review over employment tax determinations made by the IRS and the amount of tax, penalties, and additions to tax resulting from the determinations. To obtain United States Tax Court review, the following elements must be met:

1. The IRS conducts an examination in connection with an audit;
2. As part of the audit, the IRS determines that:
   
   1. One or more individuals performing services for such person are employees of such person for purposes of “subtitle C,”² or
   2. Such person is not entitled to relief under Section 530(a) with respect to such an individual;
3. An “actual controversy” exists involving the determination as a part of an examination; and
4. An appropriate pleading is filed in the United States Tax Court. 

When the first three elements are met, the IRS will issue a Section 7436 Notice. A taxpayer will satisfy the fourth element by filing a timely petition for review of the Section 7436 Notice with the United States Tax Court.

New Guidance on the Application of Sections 530, 3509, and 7436

The following are common misclassification scenarios and guidance on how the IRS will apply the above tax relief / safe harbor sections.

SITUATION 1: An employer taxpayer (TP) hires individuals and pays them a weekly fixed amount and a weekly bonus amount. TP does not withhold or pay federal employment taxes, and reports the total payments on Form 1099-NEC as nonemployee compensation. During an audit, the IRS determines that TP doesn’t qualify for Section 530 relief and the individuals are employees. The IRS proposes to assess federal employment taxes on the weekly fixed amounts and bonus amounts, which should have been reported as wages on Form 941 and Forms W-2. TP claims it satisfies the requirements for Section 530 relief.

1. HOLDING: Section 530 is applicable because the TP did not treat the individuals as employees, and the IRS is reclassifying them as employees. TP will be entitled to Section 530 relief if the statutory requirements are met. If Section 530 does not apply, then TP may be entitled to section 3509 reduced rates if the statutory requirements are met. The IRS will issue a Section 7436 Notice if no agreement is reached between TP and the IRS. A Section 7436 Notice will be issued because (1) there was an examination in connection with an audit, (2) there were determinations that (a) the individuals were employees of TP, (b) TP was not entitled to relief under Section 530 with respect to these individuals, and (3) the IRS and TP disagree on the employment status of the workers and whether the statutory requirements for Section 530 relief have been met.

SITUATION 2: TP hires individuals and pays them a weekly fixed amount and a weekly bonus amount. TP treats the salary as wages for federal employment tax purposes, and withholds and pays employment taxes. However, TP does not treat the bonus amount as wages and reports the bonus amount on Forms 1099-NEC without withholding or paying any federal employment taxes. The IRS determines that the bonus amount is wages and proposes to assess federal employment taxes on the bonus payments. TP claims it satisfies the statutory requirements for Section 530 relief with respect to the bonus amount and does not agree that the bonus amount are wages.

2. HOLDING: Section 530 is not applicable because the IRS is not reclassifying the individuals as employees. This type of relief does not apply to matters involving the characterization of payments to individuals. It only applies to classification disputes regarding the status of an individual as an employee. For the same reason, IRC section 3509 also does not apply. TP treated the individuals as employees for the services rendered and paid additional wages in the form of bonuses, therefore, there is no existing controversy as to the classification of the individuals as employees. The IRS will issue the TP a Section 7436 Notice at the conclusion of the audit or after appeals consideration if no agreement is reached.

SITUATION 3: Same facts as Situation 2, except the TP does not report the weekly bonus amount on Forms 1099-NEC or any other information return.

3. HOLDING: Section 530 and IRC section 3509 are not applicable to this situation for the same reasons stated in Holding 2. The IRS will issue the TP a Section 7436 Notice at the conclusion of the audit or after appeals consideration if no agreement is reached.

SITUATION 4: Same facts as Situation 2, except TP does not report weekly bonus amounts on Form 1099-NEC or any other information return, and TP does not claim that it satisfies Section 530.

4. HOLDING: Section 530 and IRC section 3509 are not applicable to this situation for the same reasons stated in Holding 2. The IRS will not issue the TP a Section 7436 Notice at the conclusion of the audit or after appeals consideration if no agreement is reached because the TP did not claim that TP was entitled to relief under Section 530 concerning the bonuses paid to the individuals, and there is no controversy over whether the individuals are employees or independent contractors.

SITUATION 5: TP hires individuals and enters into a contract with a third party (3P) to pay each individual a weekly salary, withhold and pay federal employment taxes, and file tax returns. The 3P pays each individual, withholds and pays federal employments taxes, and files tax returns. That same year, TP pays a year-end bonus to each individual but does not treat the bonus amounts as wages. TP does not withhold or pay federal employment taxes on the bonus amounts and does not report the bonus amounts. During an audit, the IRS determines that the bonus amounts are wages and proposes to assess taxes on the bonus payments. TP claims it satisfies the requirements for Section 530 relief.

5. HOLDING: Section 530 and IRC 3509 are not applicable because the IRS is not reclassifying the individuals as employees. The IRS will issue the TP a Section 7436 Notice at the conclusion of the audit or after appeals consideration if no agreement is reached.

Rev. Proc. 2025-10, modifying and superseding Rev. Proc. 85-18, clarifies and expands on the definition of an employee for purposes of Section 530, requirements for filing necessary returns, and the reasonable basis safe harbor rules. Additionally, it expands on its interpretation of the term “treat” in determining if a taxpayer did not treat an individual as an employee for Section 530(a) purposes.

In determining whether there was treatment of an individual as an employee, the IRS states that factors to consider include the withholding of income tax or FICA taxes, filing employment tax returns, filing Schedule H (Form 1040), filing or issuing Form W-2s (Wage and Tax Statement), or contracting with a third party to perform employer acts indicates treatment of the individual as an employee.³

Additionally, the IRS will provide written notice of Section 530 availability before or at the start of an employment tax audit and will first consider if the taxpayer meets the statutory requirements of Section 530 before determining if the individuals are employees. Again, there are limits to Section 530 relief—in determining if Section 530 applies, the IRS will determine if the matter involves the proper classification of an individual as an employee or the characterization of payments which are not covered by Section 530.

Rev. Proc. 2025-10 further discusses the reasonable basis requirement to obtain relief under Section 530. The IRS acknowledges that Congress intended the reasonable basis requirement to be construed liberally in favor of the taxpayer. But note, the taxpayer must be able to show that it actually and reasonably relied on the asserted reasonable basis during the periods at issue and at the time of its decision.

Conclusion and Recommendations:  While seeking to clarify Section 530, it appears that the IRS is continuing to try to limit the scope of Section 530 and make it more difficult to apply. For example, if there is reasonable reliance upon case law, the taxpayer needs to show it relied upon such case law at or before the classification decision was made. This can present significant problems if, for example, the decision was made decades ago, and there is unlikely to be any documentation from such time period. Taxpayers needs to be vigilant about ensuring a reasonable basis for its classification decisions and clearly document the basis and decision-making process. Taxpayers concerned about status should work with counsel to ensure such decisions are properly made.