The Department assessed us for failing to withhold tax on workers we treat as independent contractors, using VEC data -- can we still make our case that they're properly independent contractors?

Plain-English summary

A business was audited and assessed withholding tax for 2017-2018 after the Department received information from the Virginia Employment Commission (VEC) suggesting some of its workers should have been classified as employees, not independent contractors. Virginia law specifically authorizes the Department to receive this kind of worker-classification data from the VEC, and the Department made related adjustments reflecting individual income tax returns the workers themselves had filed. The taxpayer appealed, insisting the workers were genuinely independent contractors and pointing to the 20-factor test long used by the IRS (and cross-referenced in Virginia's own withholding regulations) to distinguish employees from contractors -- covering things like who controls how the work gets done (behavioral control), who controls the business/financial aspects of the relationship (financial control), and the nature of the relationship itself (written contracts, benefits, permanency, and so on).

The problem: the auditor never actually applied that test. The Tax Commissioner found the Department's own auditor didn't appear to have made an independent analysis of whether the workers were employees or contractors -- instead, the assessment leaned on the VEC's classification. While a Department assessment is legally presumed correct (the taxpayer bears the burden of proving it wrong), Virginia's regulations require the audit staff to actually evaluate an employer's records against the federal control-based factors described in IRS guidance (Rev. Rul. 87-41, updated by more recent IRS Publication 15-A analysis focused on the three broader categories of control). Because that evaluation never happened, the case was sent back down rather than decided outright.

The Tax Commissioner directed the audit staff to: (1) give the taxpayer a full opportunity to submit evidence (written contracts, testimony from management or the workers themselves, or other documentation) about how much control the business actually exercised; (2) conduct a complete, documented evaluation of that evidence under the modern IRS framework; and (3) issue a revised written audit report. The taxpayer then gets a fresh 90-day window to appeal the revised result if it still disagrees.

What this means for you

Businesses facing a withholding assessment based on VEC or third-party worker-classification data

You're entitled to a genuine, individualized evaluation of your specific facts under the recognized behavioral-control / financial-control / relationship-type framework -- an assessment can't simply adopt another agency's classification without the Department's own audit staff doing that analysis and documenting it.

Anyone preparing to argue independent-contractor status in a Virginia audit

Come prepared with concrete evidence: written contracts, records showing how much control you exercised (or didn't) over how the work got done, and testimony from people with direct knowledge of the relationship. The ruling emphasizes that not every factor needs to point the same direction, and not every factor is equally relevant in every case -- so build your strongest evidence around the specific facts of your relationship with each worker.

Taxpayers weighing whether to appeal a revised audit result

If your case gets remanded like this one, you keep your appeal rights -- you'll have 90 days from when the audit staff communicates its revised written result to appeal again if you still disagree.

Common questions

Q: Can the Department base a withholding assessment just on VEC data showing workers should be classified as employees?
A: Not without more -- the Department can lawfully receive and use VEC information under Va. Code § 58.1-3 C, but its own regulations still require an independent, documented evaluation of the actual employee-vs-contractor factors, not a simple adoption of another agency's classification.

Q: What kind of evidence should I gather to support independent-contractor treatment?
A: Written contracts with the workers, records or testimony showing the degree of control (or lack of it) you exercised over how the work was performed, and any other documentation bearing on behavioral control, financial control, and the type of relationship (benefits, permanency, and similar factors).

Q: Does an assessment automatically get thrown out if the auditor didn't apply the full test?
A: Not necessarily thrown out -- here, the case was returned to the audit staff to do the analysis properly, rather than the assessment being outright reversed; the taxpayer still needs to present its evidence and the outcome depends on how that evaluation comes out.

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 alongside P.D. 21-56 for the audit staff's obligation to evaluate employer records under the recognized control-based factors
• Public Document 21-56 (5/4/2021) -- cited for 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) that supplements the 20-factor test
• Angelson v. Commonwealth of Virginia is not cited in this ruling; see the companion P.D. 21-77 (responsible-officer test) for that case

Subject

Administration : Audits - VEC Information

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-81

Original ruling text

July 6, 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 your client * (the “Taxpayer”), for the taxable periods January 2017 through December 2018.

FACTS

Under audit, the Taxpayer was assessed for failure to withhold taxes from employee wages during the taxable periods at issue. The Taxpayer appeals, contending the workers were independent contractors, not employees.

DETERMINATION

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.

In accordance with Virginia Code § 58.1-3 C, the Department received information concerning the Taxpayer’s workers’ classifications as employees from the VEC. The Department allowed adjustments to reflect Virginia individual income tax return information filed by the Taxpayer’s workers as provided under Virginia Code § 58.1-467. The Department’s auditor, however, does not appear to have made an independent analysis as to whether the workers were employees or independent contractors.

CONCLUSION

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 of 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. See also P.D. 18-107 (6/6/2018) and P.D. 21-56 (5/4/2021). 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. 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 documents 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/3449.M

Related Documents

96-280

18-107

21-56