Publication

Employment Law

IRS Offers Amnesty on Misclassification of Workers

October 2011

The IRS is offering employers a golden opportunity to "voluntarily" correct their classifications as independent contractors of workers that more appropriately should be treated as employees.  The new program, entitled Voluntary Classification Settlement Program (VCSP), is part of the broader "Fresh Start" initiative by the IRS.   It gives employers a tax break from the consequences of incorrect filings in their past and a fresh—and fully compliant—start for their future filings. 

Participating employers will receive two key breaks under the VCSP.  First, the IRS will require them to pay only a ten (10) percent employment tax liability due for the most recent tax year on compensation paid to workers incorrectly classified as independent contractors.  This could be substantially less than what an employer would be required to pay if the IRS discovers misclassifications and the related failures to secure the payment of taxes during an audit.  Second, the IRS will agree not to audit the participant employers with respect to classification of those workers in any prior years which might still be open or subject to audit.  (Generally the IRS looks at approximately three years of returns in a typical audit.)  In exchange, employers must agree to prospectively adopt "accurate" classification of their workers for future tax periods.

To qualify for participation in the initiative, employers must have consistently treated their workers as independent contractors (or nonemployees) for the past three years; must have filed all of the required 1099 Forms for these workers during the previous three years; and must not currently be undergoing an audit concerning classification of workers by the IRS, Department of Labor, or any state agency. 

Classification of workers as employees or independent contractors is a potential minefield for employers because of the changing standards and the often subjective distinction between the two categories of workers.  The current law, based on standards developed through numerous court decisions, recognizes a multitude of factors to be weighed in making the classification.  These include:  whether the "employer" controls the details of the work; how the worker is paid; whether the worker receives benefits; whether the relationship is governed by written agreements; whether the worker is truly a separate business considering the economic realities of the relationship and the allocation of business risk; and many other factors.

Contractor versus employee status is important for many purposes.  Employers are required to withhold income taxes, Social Security and Medicare taxes, and unemployment taxes.  Employers must also secure the payment of workers' compensation benefits (through insurance or permissible self-insurance).  Additionally, employers must comply with numerous employment benefits, labor laws, and regulations.  In contrast, the same obligations generally do not apply to those who hire an independent contractor.  Independent contractor classification has been touted as a way for businesses to reduce expenses associated with ongoing labor costs, workers' compensation, bookkeeping, and business administration, as well as to reduce the risk of unionization.  However, substantial liabilities may arise if a business is found to have misclassified employees as independent contractors.  Private litigation concerning worker classification is on the rise.  Further, federal and state agencies regularly audit for misclassification.  In fact, the VCSP amnesty program comes on the heels of new initiatives by the IRS and state agencies to crack down on worker misclassification as a means to increase tax revenues and assure workers are covered by "safety net" programs.  A Government Accountability Office report in 2009 found that misclassification in the 2006 tax year cost $2.73 billion in unpaid federal taxes, plus unpaid assessments for state taxes, unemployment and disability insurance programs.  Non-employees' use of public and private safety net programs they have not "paid into" for disability, unemployment, and work-related injuries is also considered a cost.

Employers are urged to consult with counsel if they wish to take advantage of the VCSP and correct any misclassifications of workers now, before it is too late.

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