IRS launches worker classification settlement program

Issue January 2012 By Christopher G. Beck

Whether a business should treat a particular worker as an employee or an independent contractor has been a longstanding source of contention between the business community and the Internal Revenue Service. Generally, business owners recognize that the tax and regulatory requirements are less onerous when they treat their workers as independent contractors rather than employees.

Therefore, the incentive for many is to find a way to treat their workers as independent contractors. Because worker classification is based on the facts and circumstances of each case, attempts by the IRS -- as well as state tax and unemployment authorities -- to reclassify workers have often led to litigation. By 1978, Congress offered a safe harbor for businesses that misclassified employees as independent contractors. The safe harbor has since led to its own body of case law. In light of these developments, the issue of worker misclassification remains.

On Sept. 21, the IRS launched a Voluntary Classification Settlement Program (VCSP), a program designed to provide employers an opportunity to reclassify workers as employees for employment tax purposes. The VCSP allows eligible employers to obtain relief similar to that offered under the Classification Settlement Program (CSP) for employers under examination. Under the VCSP, employers not under examination may voluntarily reclassify their workers as employees for future tax periods, with limited tax liability for past nonemployee treatment of workers.

To qualify for the VCSP, employers must meet eligibility requirements, they must apply through the VCSP, and they must enter into a closing agreement with the IRS.

According to the IRS, the program is designed to increase tax compliance by employers and reduce their burden by providing greater certainty for them, for their workers and for the government. Commissioner Doug Shulman described the program as part of a wider effort to help give employers a fresh start with their tax obligations. The program is open to many businesses, tax-exempt organizations and government entities that currently treat their workers, or a class or group of their workers, erroneously as independent contractors or nonemployees and want to prospectively treat the workers as employees.

To qualify for the program, employers must meet the following eligibility requirements:

  • They must want to reclassify voluntarily certain workers as employees for federal income tax withholding, FICA and federal unemployment taxes for future periods;
  • They must presently be treating workers as nonemployees;
  • They must have complied with any Form 1099 filing requirements for the past three calendar years with respect to the workers they seek to reclassify as employees. Employers will satisfy this requirement if they provided Forms 1099 to workers for the entire time they worked for the employer if they worked for the employer less than three years;
  • They must have treated the workers consistently as nonemployees;
  • They must not currently have a dispute with the IRS over whether the workers are employees or nonemployees for federal employment tax purposes;
  • They currently must not be under examination by the IRS;
  • They must not be under examination by the Department of Labor or any state agency for the proper classification of the workers; and
  • They either must not have been subject to a prior IRS or Department of Labor examination for the classification of workers, or if they have been examined previously, they must have complied with the results of the prior examination.

Employers interested in reclassifying their workers as employees under the program can apply by filing Form 8952: Application for Voluntary Classification Settlement Program.

Those employers who are accepted into the program will be required to pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Internal Revenue Code Section 3509. They will not face interest or penalties, and they will not be subject to an audit for payroll taxes related to the reclassified workers for prior years.

Additionally, an employer must agree to extend the period of limitations on assessment of employment taxes for the first three years after the date the employer elects to begin treating the workers as employees under the VCSP closing ?agreement.

When asked about his expectations regarding the popularity of the program, Commissioner Shulman stated that it is unclear how many employers may enter the program, or how much revenue it will generate. He did state, however, that the IRS will maintain a "robust audit program" to pursue employers who intentionally sidestep the law.

Should an employer forego the program and later face an employment tax audit, the IRS will review the business-worker relationship by focusing on whether the business has the legal right to control what work is done and how it is to be done by its worker. In addition, the IRS will consider the 20-factor test from Revenue Ruling 87-41.

If an audit results in a change in the status of workers from nonemployees to employees, the result may be additional tax, penalties and interest for prior years of worker misclassification. The potential exposure could be substantial, even for small businesses.

Even when not the subject of an audit, a business or a worker may complete a Form SS-8: Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to seek a determination by the IRS of the business' or the worker's individual circumstances.

When asked whether the Massachusetts Department of Revenue has plans to issue its own classification amnesty program to accompany the VCSP, a DOR spokesman stated that the DOR conducted a similar amnesty in the past, but few employers came forward. The spokesman said that the DOR is not currently working to issue a directive. n
Christopher G. Beck is an associate attorney at Vacovec, Mayotte & Singer LLP in Newton, a firm concentrating in tax law. Beck focuses his practice on domestic and international tax planning, compliance and controversy.