Worker misclassification has been a long standing issue because of the difficulty in many situations from distinguishing employees from independent contractors. Additionally, employers prefer to have workers treated as independent contractors to reduce the cost associated with payroll taxes, while the Internal Revenue Service (“IRS”) would prefer all workers to be classified as employees to reduce the number of individuals filing as self-employed. The challenge for employers, who determine that they have inadvertently misclassified workers, is the significant cost in back taxes, interest, and penalties associated with correcting the issue.
On September 21, 2011, in a move to help alleviate this problem, the IRS announced a new program that will enable employers to correctly classify workers as employees rather than independent contractors and obtain relief from federal payroll tax exposure and the associated interest and penalties. This program, the Voluntary Classification Settlement Program (“VCSP”), is designed to increase tax compliance and allows taxpayers to voluntarily change the classification of their workers.
Independent Contractor versus Employee
There currently is not a bright line test that exists to differentiate independent contractors vs. employees. In fact, the IRS generally looks at 20 factors in making the determination if the issue arises on audit. As a result, many employers have inadvertently misclassified workers. Some general distinctions include:
- Independent contractors often times have more control over their schedules, the right to control the training they participate in, the method of payment received, and may work for multiple companies simultaneously
- Employees normally have more narrow guidelines of employment such as set time for working hours, one place of employment, and benefits received (health care, pension plan)
In exchange for participating in this program, the IRS:
- Will not assess any interest or penalties on the amount due
- Will not subject the taxpayer to an employment tax audit with respect to the classification of workers
- Will only require taxpayers to pay 10% of the employment tax liability that would have been due on compensation paid to the reclassified worker(s) for the previous one tax year
To be eligible for the Voluntary Classification Settlement Program, taxpayers must:
- Have consistently treated the worker(s) in the past as nonemployees
- Filed all required Form 1099s for the worker(s) for the previous three years
- Not currently be under audit by the IRS, the Department of Labor, or a state agency concerning the classification of the worker(s)
Extended Statute of Limitations
As part of the program, a taxpayer needs to agree to an extended statute of limitations for the first three years under the program. In other words, the first three years the worker is reclassified appropriately as an employee will be considered open years in which an employment tax audit may occur for 6 years instead
of the usual 3 years.