Misclassification of workers remains a hot button issue. The IRS continues to scrutinize employers’ worker classification practices, and it is likely that health reform will cause the Department of Labor to review classification issues even more closely than it has in the past.
In an effort to encourage employers to reclassify independent contractors as employees, the IRS created the Voluntary Classification Settlement Program in 2011. The program limits the tax liabilities of employers who voluntarily reclassify independent contractors. Recently, the IRS expanded the program to cover a wider range of situations and provided additional clarifications.
In general, workers are classified as either employees or independent contractors, depending on a variety of factors including the degree of supervision and control exercised by the employer. For employees, an employer is required to withhold income and employment taxes (Social Security and Medicare) and to pay the employer portion of employment taxes, and the employee generally will be eligible to participate in the employer’s employee benefit plans. In contrast, an employer does not have a withholding obligation or employment tax liability with respect to amounts paid to independent contractors, and most employee benefit plans exclude independent contractors (or at least individuals classified as independent contractors) from participation.
If an employer misclassifies a worker as an independent contractor and that worker is later found to be an employee, the employer could–
- be required to pay to the IRS the amounts that the employer should have withheld from the employee;
- be exposed to tax penalties for failure to withhold taxes and failure to pay the employer portion of payroll taxes; and
- be forced to enroll the employee in its employee benefit plans on a retroactive basis.
The Voluntary Classification Settlement Program
In recent years, the IRS has increased scrutiny of employers’ worker classification practices. As part of this enforcement effort, the IRS has created the Voluntary Classification Settlement Program (“VCSP”) to provide employers with a voluntary means to reclassify independent contractors as employees with limited tax consequences. (VCSP does not address employee benefit plan eligibility issues.)
This program was recently revised in a number of ways. Some of these changes are intended to make VCSP more employer-friendly:
- Employers under audit for issues other than worker classification can now participate;
- Employers are no longer required to extend the assessment period of limitations for employment taxes to participate in VCSP; and
- The recent guidance provides a 6-month window for employers that have not properly reported independent contractor income on Form 1099 to participate in VCSP.
Other changes make VCSP less employer-friendly:
- The IRS clarified that, when an entity is under audit, all members of its affiliated group are ineligible for VCSP; and
- VCSP is unavailable to employers contesting the results of previous worker classification audits.
Under the revised VCSP, an employer may prospectively reclassify a worker or group of workers as employees. The employer will not be liable for any additional employment tax, interest or penalties and will not be subject to employment tax audit for the reclassified employees, provided that:
- the employer pays 10 percent of the employment tax liability for the most recent tax year as if the workers had been classified as employees for such year (determined under the reduced rates of section 3509(a) of the Code);
- the employer files Form 8952; and
- the employer enters into a closing agreement with the IRS to finalize the terms of the VCSP.
To be eligible for VCSP:
- the employer must have consistently treated the workers as independent contractors;
- the employer must have filed all required Forms 1099 for the workers for the previous three years (the 1099 requirement is waived for applications filed on or before June 30, 2013, but in such cases the employer (1) must file and furnish to workers any unfiled Forms 1099 for the previous 3 years and (2) must pay 25 percent of the employment tax liability for the previous year (determined under the reduced rates of section 3509(b) of the Code) and (3) will be subject to a reduced penalty for failure to file the Forms 1099);
- the employer is not under employment tax audit by the IRS or under audit concerning the classification of workers by the Department of Labor or a state agency (this restriction applies to all members of the employer’s affiliated group);
- the employer has complied with the terms of all agreements with the IRS or the Department of Labor regarding any earlier audit of worker classification;
- the employer is not contesting in court the classification of workers from previous audits by the IRS or the Department of Labor; and
- the application for VCSP is approved by IRS.
VCSP is available to private-sector employers, tax-exempt organizations, and governmental entities.