Thursday, December 15, 2011
Issues & Insights: IRS Offers Employers a Break on Misclassified Workers
Posted by John Panetta
The IRS has announced a new program that allows eligible employers to voluntarily reclassify workers as employees, rather than independent contractors, for future tax periods. In exchange, the employers’ liability for past payroll tax obligations will be reduced to only a minimal payment. The Voluntary Classification Settlement Program (VCSP) is intended to increase tax compliance and reduce the tax and administrative burdens on employers with misclassified workers.
Employee vs. Independent Contractor Issue
An employer enjoys several advantages when it classifies a worker as an independent contractor instead of an employee. For example, it isn’t required to pay payroll taxes, withhold taxes, pay benefits or comply with most wage and hour laws. Independent contractors also are easier to terminate and typically don’t qualify for unemployment compensation.
However, there’s a potential downside: If the IRS determines that workers have been improperly classified as independent contractors rather than employees, the employer can be subject to significant back taxes, interest and penalties.
According to the IRS, a worker isn’t an independent contractor unless the employer has the right to control or direct only the result of the work — as opposed to also controlling the details of how the work is performed. To determine whether a worker is an employee or an independent contractor, the IRS considers three categories of factors related to the degree of control and independence:
Behavioral. Does the employer control, or have the right to control, what the worker does and how the worker does his or her job?
Financial. Does the employer control the business aspects of the worker’s job? For example, is the worker paid a salary? Does the employer reimburse the worker’s expenses? Does the employer provide the tools or supplies to do the job?
Type of relationship. Does the worker receive employee-type benefits? Will the relationship continue after the work is finished? Is the work a key aspect of the employer’s business?
In its announcement, the IRS acknowledged that the determination of the proper classification under these factors may not always be clear.
For that reason, the IRS already offered the Classification Settlement Program (CSP), which allows qualified employers to prospectively reclassify workers as employees. However, the CSP is available only to employers undergoing an audit. The VCSP allows voluntary reclassification outside of the audit process and without the need to go through the normal administrative correction processes.
The VCSP is available to employers that currently treat their workers, or a class or group of workers, as independent contractors or other nonemployees. To be eligible, the employer must have consistently treated the workers as nonemployees and have filed required Form 1099s for the workers for the previous three years.
The employer cannot currently be under audit by the IRS or under audit concerning the classification of workers by the Department of Labor (DOL) or a state governmental agency. Employers that were previously audited by the IRS or DOL on classification issues are eligible for the VCSP only if they complied with the audit’s results.
The employer isn’t required to reclassify all of its nonemployee workers as employees. But after an employer chooses to reclassify some of its workers, all workers in the same class must be treated as employees.
The Application Process
Eligible employers can apply for the VCSP by filing Form 8952, “Application for Voluntary Classification Settlement Program,” along with the name of a contact or authorized representative with valid power of attorney. After the IRS has reviewed the application and verified eligibility, it will contact the employer or representative to complete the process.
If the application is accepted, the employer will enter a closing agreement with the IRS to finalize the terms. The employer must make full and complete payment of any amount due when it returns the signed closing agreement.
In exchange for reclassifying workers as employees, the employer’s liability for past payroll obligations is cut to 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under Section 3509 of the Internal Revenue Code.
Under Sec. 3509, the tax rate for compensation up to the Social Security wage base ($106,800 for 2010 and 2011) is 10.68% in 2010 and 10.28% in 2011. The rate for compensation above the Social Security wage base is 3.24%. Because the amount due is based on compensation paid in the most recent tax year, the 10.68% rate applies under the VCSP in 2011, and the 10.28% rate applies in 2012. The 3.24% rate applies for both years.
The IRS provides the following example: Consider an employer that paid $1.5 million in 2010 to workers who are being reclassified, all of whom were compensated at or below $106,800. The employer submits its application on Oct. 1, 2011, and proposes to reclassify the workers beginning on Jan. 1, 2012. (The application must be filed at least 60 days before the desired reclassification date.) In that case, 2010 is the most recent tax year, so the employment taxes under Sec. 3509 would be $160,200 (10.68% of $1.5 million). Under the VCSP, the employer must pay only $16,020 (10% of $160,200).
In addition to enjoying significant tax savings, the employer won’t be liable for any interest or penalties and won’t be subject to an employment tax audit on the classification of the workers in prior years. The employer will, however, be subject to a special six-year statute of limitations on the assessment of employment taxes for the first three calendar years following the date of reclassification. This doubling of the usual three-year limit provides a strong incentive for employers to continue correctly classifying workers going forward.
Review your Worker Classifications Now
Just days before announcing the VCSP, the IRS signed an agreement with the DOL to improve the coordination of their efforts to prevent employee misclassification by sharing information and law enforcement. Labor commissioners and other agency leaders from seven states signed similar agreements with the DOL, and four other states are also scheduled to sign agreements.
With these agencies swapping information on employee misclassifications, your company must take greater care than ever to properly classify workers, because one agency investigation could easily trigger another. So the time to review your worker classifications is now. If your company needs help determining how to properly classify employees, please give us a call. We can also help you decide whether you could benefit from the VCSP.
If you need additional information regarding this article, contact one of our tax experts at 925.790.2600 or through email at armaninollp.com/contact.
John has more than 30 years of experience providing tax-exempt organizations with a wide variety of tax, business and consulting services including income tax planning, IRS/state tax audit representation, intermediate sanctions planning and compliance, reorganization planning and consulting, unrelated business tax planning, assistance with legislative activity, multi-corporate transaction planning, and private foundation domestic and foreign expenditure planning. John joined the firm from Burr Pilger Mayer. Previously, he led the Western Area Exempt Organizations Tax Practice for both PWC and KPMG. He has also served with the Exempt Organizations Branch of the IRS National Office.