Reclassification of an enterprise’s workers from contractor to employee by one or more government agencies is a recurring concern, for both enterprise and agency alike. The Internal Revenue Service (“IRS”) scores three types of problems from misuse of independent contractor status: (1) underpayment of income tax by the worker; (2) underpayment of employment taxes due on the services rendered; and (3) past due tax payments and increased agency administrative costs. The US Department of Labor (“DOL”) is equally concerned about labor misclassification; upon full implementation of the Affordable Care Act in 2014, labor classification’s impact on the amount of mandatory insurance coverage will increase the risks associated with mis-classification.
In 2011, the IRS rolled out a relief program to tempt businesses to rejoin the employer ranks. The Voluntary Classification Settlement Program (“VCSP”) offers participating employers more certainty in worker treatment and in future payroll tax examination results, participation in the program costs less than what would be assessed by IRS audit. The IRS has increased the benefits from VCSP and reduced many of its burdens, which arguably kept some enterprises from participating. However, to enjoy the enhancements of the revised VCSP, businesses must take certain steps before July 2013.
Misclassification of an employee as an independent contractor generally exposes a business to multiple years of delinquent employment taxes, interest and penalties. Often, the business is aware of improper classifications of laborers, but it is unsure how or whether to correct those mistakes. In other cases, a current review of worker classification – for mandatory health coverage under federal health insurance statutes, for example – often reveals labor classification error. Regardless of how errors in labor groupings occur, the VCSP is available to any eligible business.
Businesses meeting the following requirements are generally eligible to participate in the revised VCSP:
- The business has consistently treated, and is currently treating, a worker as a non-employee.
- The business agrees to treat such worker as an employee prospectively.
- The business is not currently under (i) a federal employment tax audit, (ii) a DOL worker classification audit, or (iii) a similar audit by a state agency – under the initial program an enterprise under IRS income tax audit could not participate.
- The business must furnish its workers who will be reclassified as employees with accurate Forms 1099 for the prior three years if such documents should have been but had not been filed – those forms are to be sent to the IRS as well.
- For those business that failed to furnish the reclassified workers with Forms 1099 for the most recent three tax years, a completed VCSP application must be filed with the IRS on or before June 30, 2013. Note, after this deadline passes, the initial voluntary worker reclassification program will only be available to those businesses that had previously furnished Forms 1099 to workers for the prior three tax years. Thus, an employer has the opportunity if it acts before July 2013 to retroactively catch up with its filing requirements and, thus, qualify for the VCSP’s benefits (described below).
If able to participate in the program, a business would:
- Pay only 25% of the employment tax liability for the reclassified worker(s) for the most recent tax year at reduced employment tax rates, versus three years of all federal employment taxes due at full rates.
- Pay a reduced penalty for failing to file Forms 1099 for the worker(s) for each of the three previous tax years if such documents should have been filed, but were not, as opposed to the full penalty for failure to timely file these information returns.
- Avoid deficiency interest and other non-compliance penalties.
- Avoid an IRS worker classification audit for the subject worker(s).
To illustrate application of the VCSP terms, assume in each of years 2010 through 2012, XCo pays $50,000 to a worker classified as independent contractor and fails to issue Forms 1099. During a mid-year 2013 review of worker classification, XCo determines that the worker should have been classified as an employee for federal tax purposes. In exchange for voluntarily reclassifying this worker through the VCSP, XCo must pay only (i) $3,855 in federal employment taxes (i.e., 25% of the product of $50,000 of compensation paid to the worker in the most recent tax year and the reduced tax rate of 10.28%), and (ii) a $150 penalty for failing to timely furnish and file Forms 1099 to the worker (i.e., $50 for each unfiled Form 1099 multiplied by three unfiled Forms 1099).
As with any IRS voluntary disclosure program, there are detriments to participation in the VCSP. Perhaps most obvious, participation in the VCSP places a spotlight on the participating business, potentially increasing audit for income tax and other tax issues not resolved in the VCSP. In addition, if worker classification is unclear, a business might prevail on the original classification and thus benefit from reduced payroll taxes and avoided VCSP penalties.
Taft’s Tax practice group
has significant experience evaluating proper worker classification status, etermining the consequences of misclassification under the general IRS audit rules and under its VCSP, and negotiating productive outcomes with the employment tax specialists at the IRS and their state counterparts. We are happy to join with the Labor & Employment practice group
on DOL or other agency worker mis-groupings, and to assist other firm clients in determining whether they should participate in the VCSP.