WALNUT CREEK -- The Internal Revenue Service has ordered the city to pay $72,000 in back taxes after a 2011 audit shows the city incorrectly classified employees as independent contractors, according to an IRS report.

Walnut Creek leaders are protesting that decision, and have filed an appeal claiming contract workers were not, and are not, city employees.

Walnut Creek is also contesting the $72,000 in taxes the IRS says the city owes, according to the June IRS report obtained by this newspaper. The IRS asserts the city did not withhold income taxes or other employment taxes it should have.

"In general, the city disagrees with the initial findings of the IRS," City Attorney Steve Mattas said. "We do not know why the IRS is focusing on Walnut Creek and its practices. We understand the IRS has reviewed practices in other cities. The amounts here are very small and the city's practices are long-standing and consistent with those of other California cities."

Walnut Creek was also charged $6,000 in penalties because the city inadvertently did not file 1099 forms for some independent contractors the city and IRS agree were independent contractors, said Mattas. That payment is not being contested.


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If the city's appeal is denied, the matter could be appealed in tax court. While Mattas believes ultimately Walnut Creek will win, "The city has a number of options it may consider including treating the workers as employees or restructuring its operations" if the appeal fails, he said.

The IRS' full report and letter to Walnut Creek officials alleges that city erroneously classified more than 30 workers -- recreational, arts instructors, actors and production personnel at the Lesher Theatre, and some miscellaneous positions -- as contractors.

The IRS audit examines only one year, 2011, but the city has classified these types of workers as contractors for decades. The IRS would need to audit other years to make assessments for those years, which it has not done, and there is a statute of limitations that limits what the IRS can assess, Mattas said.

Raphael Tulino, an IRS spokesman, said he cannot, by law, confirm or deny the report's findings, or even that such an audit took place. But this newspaper obtained the report, and the appeal, from the city through a records request.

'Recognized practice'

Walnut Creek contends the workers in question -- for example, actors with the city's Center Repertory Theatre Company -- have been treated as contract workers for years and that it's a "long-standing recognized practice of a significant segment of the industry in which such individual was engaged," according the city's appeal to the IRS.

The IRS isn't buying that explanation. "The facts and circumstances also suggest that employer-employee relationship between the city and actors exist," according to the IRS report.

While most employees named in the IRS report are in the Arts and Recreation department, ¿also included is former City Attorney Thomas Haas, who was brought back on as special counsel attorney after City Attorney Paul Valle-Riestra died in 2011. The IRS determined Haas, who was paid nearly $40,000 that year, was an employee and not an independent contractor.

"In applying the common law rules based on the facts and circumstances of this case suggest that the city has the overall behavioral and financial control over the performance of the services of the special counsel attorney, and employer employee relationship exist," according to the IRS report.

The IRS also contends some workers were classified as employees for their primary job, but classified and paid as contractors for other work, according to the report.

Walnut Creek may just be part of an overall crackdown on employee classification by the IRS. The 2013 report, "Employers Do Not Always Follow Internal Revenue Service Worker Determination Rulings," said millions of workers are misclassified as independent contractors when they are actually employees. This means that employers are dramatically underpaying employment taxes, the report claims.

Mattas points to another city, Dana Point, which went through a similar ordeal with the IRS. The government ultimately permitted that city's instructors to be classified as independent contractors. And Mattas points out that even if workers are reclassified as employees, they need to work a certain number of hours per year to be eligible for health care benefits or CalPERS.

Still this audit seems to have made an impact. "The city is reviewing its options on hiring independent contractors versus temporary short-term employees," he said.

Contact Elisabeth Nardi at 925-952-2617 or enardi@bayareanewsgroup.com