A version of this article was published in The Daily Record on July 9, 2012.
The correct classification of a worker as an employee or independent contractor has been a continuing area of dispute between many employers and the Internal Revenue Service (IRS). The determination carries with it significant potential costs to an employer.
For example, if the worker is an employee, the employer must withhold federal and state income tax, as well as the employee's share of Social Security and Medicare tax. The employer must also pay its own share of those taxes, plus state unemployment tax. The employer may also be subject to penalties and backup withholding. Additionally, an employee, unlike an independent contractor, may be eligible for other company fringe benefits, such as health insurance and retirement plan benefits.
The determination of whether a worker is a W-2 employee or a 1099 independent contractor is based on a common law test that requires significant discretion. Generally, if an employer has the right to direct and to control how a worker performs services for the employer, that worker is classified as an employee. However, the IRS uses a twenty factor test to make that determination. Due to the absence of a bright line standard, employers are often uncertain that they have made the right decision.
In an effort to "push" employers into accepting employee classification for their workers, the IRS recently announced what many tax professionals describe as a very generous amnesty program. In Announcement 2011-64, released this past September, the IRS rolled out its new Voluntary Classification Settlement Program (VCSP), an amnesty program dealing with the past misclassification of employees.
The VCSP is available to many businesses, tax-exempt organizations and government entities that currently, erroneously treat their workers, or a class or group of workers, as independent contractors, and now want to correctly treat those workers as employees.
Under the new federal program, businesses have an opportunity to reclassify these contractors as employees, and make a very small payment to cover past payroll taxes and to settle any potential employment tax liability. According to the IRS, this initiative is part of a wider effort to help give taxpayers and businesses a "fresh start" with their tax obligations.
Employers that choose to participate in the amnesty program and voluntarily reclassify workers as employees for future tax periods will only have to pay 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year. Tax professionals have estimated this cost to be just over 1% of the employee's salary.
The employer will not be liable for any interest and penalties on the one-time liability. The IRS will also agree not to audit the participating employer with respect to the classification of those workers in any prior years which might still be open or subject to audit. In exchange, employers must agree prospectively to adopt employee classification for these workers for future tax periods, and pay and withhold the required taxes.
To be eligible for the VCSP, the employer must have consistently issued 1099s to the workers, and cannot currently be under audit by the IRS. If there has been a previous audit by either the IRS or the Department of Labor, the employer must have subsequently complied with the findings of that audit.
Applications for the VCSP must be filed on Form 8952 at least 60 days before the employer begins treating the workers as employees. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three.
B. Other Risks and Routes
While for many employers the amnesty program sounds too good to ignore, the VCSP covers only the employment taxes overseen by the IRS. Amounts owing to workers compensation insurance carriers, state taxing authorities and the Department of Labor are not being forgiven through the amnesty. Even the newly classified employees themselves may assert claims for state wage and hour law violations, including unpaid overtime, and other statutory benefits, such as unpaid leave under the Family and Medical Leave Act.
Many businesses that have been treating their workers as independent contractors, rather than employees, and properly issuing and filing forms 1099, believe their workers are independent contractors. These businesses are unlikely to participate in the VCSP because they do not think they have done anything wrong.
Other businesses may choose to claim special relief under a route that predates the VCSP, namely Section 530 of the Revenue Act of 1978. That Section allows an employer to escape employment tax liability for workers, if the employer (1) always treated the workers as independent contractors; (2) filed all returns required for the workers consistent with independent contractor status; and (3) had a reasonable basis for treating the workers as independent contractors.
Interestingly, the "reasonable basis" requirement can be satisfied by a long-standing recognized practice of a significant segment of an industry in which the individual worked. Most importantly, under Section 530, the employer can continue its independent contractor classification even if it is wrong.
In summary, while the VCSP will be advantageous for many employers, it is not for everyone.