Employer Amnesty - Independent Contractor Misclassification: Come Clean or Else?
On September 21, 2011, the IRS announced a new amnesty program that permits employers to voluntarily reclassify workers for federal employment tax purposes without full penalties. The new program is called the Voluntary Classification Settlement Program (VCSP) and allows employers who have misclassified workers as independent contractors to participate in the program by reclassifying them as employees for future tax periods. The big advantage for employers is that they will (1) pay only 10 percent of the employment tax liability that might have otherwise been due to the IRS for the most recent tax year; (2) not be liable for any interest and penalties on the liability; and (3) not be subject to employment tax audits by the IRS challenging worker classification for prior years.
Why are workers misclassified?
Many employers, particularly small employers, simply do not know or understand the rules relating to who is an employee and who is an independent contractor for federal employment tax purposes.1 While there are a number of factors that should be considered in determining who is an employee and who is an independent contractor, the rules generally boil down to control.2 If the employer controls when, how and where a worker performs his job, then he is generally an employee, whereas, if the worker controls the details of his job, and the employer is only concerned with the ultimate outcome, then the worker may be an independent contractor. In addition, because treating a worker as an independent contractor is less expensive than treating him as an employee, the employer often chooses an independent contractor classification because of the economics. The worker will usually go along because of the perceived savings the worker can achieve by being treated as an independent contractor.3
What else is required of an employer to participate?
First, the employer must agree to extend the period of limitations on assessment of future employment for the three calendar years beginning after the taxpayer and IRS sign a VCSP closing agreement to begin treating the workers as employees. Second, the employer must have consistently treated the workers as nonemployees and filed Forms 1099 for the workers for the past three years. Third, the employer must not currently be under audit by the IRS, the U.S. Department of Labor (DOL) or any comparable state agency. Fourth, if the employer has previously been audited by the IRS or DOL on the worker classification issue, the employer will only be eligible if it has complied with the results of that audit.
Is there a catch?
There definitely is a catch. First, any employer who admits to misclassification could open itself up to audits by other governmental agencies. For example, on September 19, 2011, the DOL, IRS and several state agencies announced a “memorandum of understanding” whereby the IRS, DOL and the state agencies will share certain information regarding worker misclassification.4 Unless and until there is definitive guidance that any information the IRS receives as part of VCSP will not be shared with other agencies, employers should carefully consider whether they should participate in the program. Second, any employer should consider other possible alternatives to VCSP. For example, Section 530 of the Revenue Act of 1978 gives some employers a free pass on certain misclassifications. Participating in VCSP will forever bar the employer’s reliance on Section 530 for all similarly situated employees. Section 530 excuses an employer’s misclassification of a worker for federal employment taxes if it satisfies all of the following: (1) it has never treated the worker as an employee; (2) it has never treated any other worker in a substantially similar position as an employee; (3) it has filed all federal tax returns, including Forms 1099, showing the worker as an independent contractor; and (4) it has a reasonable basis for treating the worker as an independent contractor. There are also other provisions in the Internal Revenue Code that provide for reduced penalties in certain misclassification cases, so that the employer may not bear the full effect of reclassification even if the IRS successfully challenges it. Third, there are other considerations that must be taken into account, such as the impact on the employer’s benefit plans, the possibility of tort or agency liability, how the workers will react to the change, and the costs of unemployment and workers’ compensation coverage for the new employees.
What should an employer do?
First, an employer should review the current classification of its workers and carefully evaluate their status. This review is critical. The IRS and DOL have “declared war” on worker misclassification in recent years, so proper classification is critical. Second, to the extent the employer determines that the workers are properly classified as independent contractors, it should make sure it has properly drafted independent contractor agreements setting forth the arrangements with all such workers. It should also carefully review its employee benefit plans to insure that any reclassification would not cause retroactive inclusion of the misclassified worker in the plans. Third, it should evaluate whether its business operations can be modified to strengthen its position that the worker is an independent contractor, such as reducing the degree of control it exercises over the worker. Fourth, it should consider whether there are other ways the impact of any attempted reclassification by the IRS could be reduced, such as the availability of Section 530 relief. If the employer determines that it qualifies for Section 530 relief, it should think twice before utilizing VCSP.
Misclassification can be a costly mistake. If the IRS can successfully utilize its full arsenal of weapons in a reclassification audit, the penalties of a mistake can be high enough to put many employers out of business. For that reason, VCSP presents both an opportunity and a challenge. No employer should blindly accept the IRS’s offer, and there is no single answer for all employers. Mistaken worker classification can cause permanent hardship to a business and may even threaten the survival of the employer. Any employer who believes that it may have misclassified some or all of its workers should consult with its employment or tax attorney and consider the consequences of participation before deciding whether to accept the IRS’s new offer.
For questions about the information contained in this article, please contact Jay Harrelson at jay.harrelson@h3gm.com or 615.251.1090
WE ARE REQUIRED BY IRS CIRCULAR 230 TO INFORM YOU THAT ANY STATEMENTS CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY YOU OR ANY OTHER TAXPAYER, FOR THE PURPOSE OF AVOIDING ANY PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW.
1However, the problem is not confined to small companies. Over the years, claims relating to worker classification involving national insurance companies and other large companies, such as Microsoft and FedEx Ground Package System, have been litigated.
2The IRS has published a list of 20 factors that can be used in making the determination in Revenue Ruling 87-41. More recently, the IRS has developed criteria that involve three categories of factors for its own audit purposes based on behavioral control, financial control and the relationship of the parties.
3Although the employee will incur additional FICA/Medicare (known as self-employment tax) because he will pay both the employee and employer share and may lose the opportunity for other benefits, he may perceive that treatment as an independent contractor is beneficial because of some additional business expenses that can deducted.
4However, recently some states have announced parallel or similar plans that the employer may utilize.
