Employment tax examinations as the IRS runs them: selection, section 530, the CSP offer, Letter 950 and Letter 3523

How a case is selected

Employment tax returns say little on their face. The manual's starting point: “Employment tax returns generally do not contain information that would provide a basis for identifying issues for examination potential.” So the IRS does not pick Forms 941 the way it scores income tax returns. In its words, “The ET Examination Program is a lead-driven program.” (IRM 4.23.3.1.1, Aug. 26, 2025.)

Selection belongs to Employment Tax Workload Selection and Delivery (ET-WSD), which, per IRM 4.23.3.3, “uses a data-driven approach to case selection involving the filtering and analyzing of electronically stored information from taxpayer forms and returns, searching for anomalies that may raise employment tax compliance issues.” IRM 4.23.23.3 (Apr. 3, 2023) lists the work sources:

• Referrals from inside the IRS: Collection, Criminal Investigation, Bank Secrecy Act examiners, return preparer cases, whistleblower claims and Form 3949-A informants, and the SS-8 Unit. The SS-8 Unit refers a business when it has found workers “improperly treated as non-employee(s)” and told the business to change the treatment of similar workers (IRM 4.23.23.3.1.1.8).
• Referrals from outside: the Department of Labor under a memorandum of understanding, OSHA, and Questionable Employment Tax Practices referrals from state workforce agencies. The manual notes that DOL referrals often involve worker classification.
• Leads: worker classification leads built from Forms SS-8 and Form 8919 (filed by workers who received a 1099 and report the employee share of social security and Medicare tax themselves), officer compensation leads, CAWR non-filer leads, fringe benefit leads, tip leads and COVID-era credit leads.
• Compliance initiative projects, claims and audit reconsiderations.

Many cases start in another audit. Policy Statement 4-4, quoted in IRM 4.23.3.4.1, says an income tax examination will include consideration of the taxpayer's employment tax liability, and income tax, excise and exempt organization examiners run required filing checks on employment tax returns. Revenue officers do the same on field visits, and refer a case if it appears the employer treats employees as non-employees or has questionable fringe benefits. How 1099 filing is checked in every audit is covered in 1099 checks in every IRS audit.

Sometimes the first contact is a compliance check rather than an exam. The manual draws a hard line: “A compliance check is not an examination, it does not directly relate to determining a tax liability for any particular period.” During one, the examiner may review the returns you must file or keep (Forms 940, 941, 8027, W-2, 1099 or W-4) but may not inspect books and records or question whether a worker is an employee. It also does not count as an examination for section 530 purposes (IRM 4.23.3.7 and 4.23.3.7.1), so it cannot give you the prior audit safe haven described below.

What the examiner looks at

The case arrives with a classification sheet listing the issues found at selection. From there, “ET examiners must use their professional judgment to set the scope of the examination and only work issues with merit.” They can limit the scope or expand it, including to prior and later years if the issue is material and recurring, and must document why and tell you orally or in writing when another period is added (IRM 4.23.3.8.2.2). Even a limited scope exam includes an interview, a tour of the business for field exams, required filing checks and penalty consideration.

The required filing checks in IRM 4.23.3.8.2.1 cover the whole payer picture:

• Unfiled employment tax returns, which generally expand the exam.
• Information returns for every reportable payment, such as Forms W-2, 1099-MISC, 1099-NEC and 1099-R. Missing or incorrect forms can open a separate information return penalty case.
• Backup withholding: missing payee TINs, unfiled Form 945, and a history of name and TIN mismatches. The backup withholding side is in the trust fund recovery penalty and backup withholding.

Technical issues follow from what the filing checks and records show. IRM 4.23.5 (Nov. 9, 2023) covers worker classification, corporate officers, statutory employees and non-employees, third-party payers and professional employer organizations, fringe benefits and executive compensation. At the initial interview, if worker classification may be examined, the examiner must hand you Publication 1976, Do You Qualify for Relief under Section 530? (IRM 4.23.3.8.4).

Section 530 comes first

Section 530 of the Revenue Act of 1978 can end a classification case before the employee question is reached. IRM 4.23.5.3.1: “Section 530 is a relief provision that must be considered as the first step in any case involving worker classification.” The examiner must raise it even if you don't: “It is not necessary for the taxpayer to claim section 530 relief for it to be applicable.” You also don't have to concede the workers are employees to get it.

Relief requires three things, each tested and documented even if one already fails (IRM 4.23.5.3.3):

The manual tells examiners to read the third test generously: “It is the intent of Congress that the reasonable basis requirement should be construed liberally in favor of the taxpayer.” The industry practice safe haven treats 25 percent of the industry as a significant segment and a practice over 10 years as long-standing. Advice from an attorney or accountant can be another reasonable basis if it came at the time the decisions were made. Two limits matter. For the prior audit safe haven, an audit that began after 1996 must have examined the status of the same kind of workers, and “Inquiry or correspondence from a Campus or an SS-8 unit is not treated as a past examination.” And section 530(d) denies relief to a firm that places engineers, designers, drafters, computer programmers, systems analysts and similar technical workers with clients (IRM 4.23.5.3.4.2).

If section 530 applies to a class of workers, the examiner stops: the no-change report says relief was granted and why, and worker status for that class is never decided (IRM 4.23.10.10.3.1). How late 1099s can cost this relief is the subject of section 530 and late 1099s.

The Classification Settlement Program offer

If section 530 does not apply and the examiner concludes the workers are employees, the Classification Settlement Program (CSP) usually comes next. IRM 4.23.6 (Feb. 13, 2024) makes the offer mandatory, not discretionary, when the taxpayer timely filed the required Forms 1099 and no exclusion applies. The CSP closing agreement settles the past at a discount in exchange for treating the workers as employees from the first day of the next quarter.

The settlement covers only one year's tax even though the agreement covers every open period. The manual also guards against pressure in both directions. On contractors: “Examiners should remember that engaging the services of an independent contractor is a legitimate business practice.” On refusing: “A taxpayer's rejection of a CSP offer will in no way affect the outcome of the examination.” You keep full appeal rights if you decline, and you can accept at any point in the exam. CSP is not available for non-classification wage issues, for a taxpayer already bound by a classification closing agreement, or for a new business at least 80 percent owned by one that signed such an agreement (IRM 4.23.6.8). A firm not under employment tax examination can get a similar result through the Voluntary Classification Settlement Program. Both programs are compared in CSP and VCSP.

How the tax is computed: IRC 3509

When an employer failed to withhold because it treated an employee as a non-employee, IRC 3509 replaces the employee-side taxes with reduced rates. “Application of IRC 3509 is mandatory if the criteria are satisfied.” Neither the examiner nor the taxpayer can opt out (IRM 4.23.8.5, Apr. 17, 2024).

IRM 4.23.8.5.1 adds that if the failure to file Forms 1099-NEC was due to reasonable cause, the lower 3509(a) rates apply. Full rates replace both columns where the employer intentionally disregarded the withholding requirement, where it withheld income tax but not FICA, and for certain statutory employees. Under IRC 3509(d)(1) the employer cannot recover the tax from the worker, and the worker's own liability is unaffected. The manual notes that Notice 989 tells a reclassified worker how to claim a refund of self-employment tax, and that Form 8919 is used to figure the FICA the worker owes. When all assessments use 3509 rates, the IRS codes the account so Collection knows the trust fund recovery penalty does not apply (IRM 4.23.8.5.2).

Agreed cases, 30-day letters and Appeals

An agreed case closes on one of three forms. Form 2504-T is used when the adjustments are subject to IRC 7436, which covers classification and section 530 issues; Forms 2504 and 2504-S are for adjustments that are not (IRM 4.23.10.6). The distinction matters because IRM 4.23.5.2 says taxpayers must be told of their right to Tax Court review of IRC 7436 issues before any agreement is obtained.

If you don't agree, you get a 30-day letter. IRM 4.23.22.6 (Feb. 27, 2025) names two:

• Letter 950-C for IRC 7436 issues: reclassification of at least one worker, a denial of section 530 relief, or a wage issue that is an IRC 7436 issue. Paying a worker on a Form 1099 and then having the payment treated as wages makes it one, per IRM 4.23.5.2.2.
• Letter 950-D for all other employment tax issues, such as fringe benefits or unreported wages to W-2 employees.

Separate letters go out when both kinds are present. Either letter starts the 30 days to file a protest or small case request that meets Publication 5. Appeals will not take a case with fewer than 365 days left on the assessment statute, which is why the manual recommends 425 days remain when the letter issues and why examiners ask for Form SS-10 to extend the employment tax statute. Classification disputes in Appeals are discussed in worker classification and backup withholding in Appeals.

Letter 3523 and the Tax Court

For IRC 7436 issues, tax cannot be assessed until you have had the chance to go to the Tax Court. The notice that gives that chance is Letter 3523, Notice of Employment Tax Determination Under IRC Section 7436. The manual compares it to the income tax notice of deficiency: “Letter 3523 is similar to a statutory notice of deficiency.” If you do not answer the 30-day letter, Technical Services issues Letter 3523, in field cases generally within 60 days after the response period ends; if you protest and Appeals does not settle the IRC 7436 issues, Appeals issues it (IRM 4.23.22.11.1 and 4.23.22.11.2).

• The deadline. Under IRC 7436(b)(2), a petition must be filed “before the 91st day after the date of such mailing”. The manual says a letter addressed outside the United States allows 150 days.
• Who can petition. Only the business for whom the services were performed, not the workers.
• What the Tax Court decides. Whether the workers are employees, whether section 530 applies, and the correct employment tax and penalties under those determinations. It does not review other employment tax issues.
• Small cases. If $50,000 or less of employment tax is in dispute for each calendar quarter, the business can elect the small case procedure under IRC 7436(c), with no appeal and no precedent.
• No adverse inference. IRC 7436(b)(3) says switching the workers to employee treatment while the case is pending is not taken into account by the court.
• Default. If no petition and no agreement arrive in the 90 days, the tax is assessed (IRM 4.23.22.11.14).

What a payer can do before and during the exam

• Look at your 1099 history first. Timely Forms 1099-NEC for every worker at issue are the price of entry to section 530 and to any CSP offer, and they move the 3509 rate from (b) to (a). A worker for whom no 1099 was filed has none of those protections.
• Gather the reasonable basis evidence from the time. Advice letters, minutes, industry surveys and records of a prior audit that covered the same workers. Evidence created after the exam starts does not show reliance.
• Be consistent across the class. One person in the same role on a W-2 can defeat substantive consistency for everyone in that class.
• Know which letter you have. A Letter 950-C issue goes to the Tax Court through Letter 3523; a Letter 950-D issue does not.
• If you already know you have a problem, the Voluntary Classification Settlement Program is available only before an employment tax exam begins. A Form SS-8 filed by a worker is often the warning sign; see a Form SS-8 filed against your company.

Questions people ask