Earlier this year we described the IRS’s Voluntary Classification Settlement Program (VCSP), which substantially reduces an employer’s liability for back taxes when the employer voluntarily reclassifies employees who have been treated as independent contractors. Through June 30, the relief program is available even if the employer did not file Forms 1099 reporting the compensation paid to the workers. Starting in July, however, an employer will be eligible for the program only if the employer filed all required Forms 1099 for the previous three years with respect to the workers it wishes to reclassify.
What does worker classification have to do with health reform? Quite a lot, as it turns out. Starting in 2014, employers with more than 50 full-time employees will owe a “shared responsibility” excise tax if they fail to offer group health coverage on every day of the month to at least 95% of their full-time employees and the employees’ dependent children. A “full-time employee” is a common-law employee who works an average of at least 30 hours per week. (You will find a more detailed description of the shared responsibility rules here and here.)
An employer can exclude up to 5% of its full-time employees and their dependents from group health coverage before it triggers this excise tax. The 5% threshold gives an employer some leeway if it fails to offer health coverage to a small number of full-time employees or dependents. If the employer has misclassified a number of common-law employees as independent contractors, leased employees, or other non-employees, however, the employer might exceed the 5% threshold without knowing it.
If an employer fails the 95% test, the penalty is substantial. The employer must pay an annual nondeductible excise tax of $2,000 for each full-time employee in excess of 30, regardless of whether the employer offers health coverage to the employee. For example, if an employer has 10,030 full-time employees, and the employer fails to offer health coverage to 503 of those employees (including employees misclassified as independent contractors), the employer will owe an annual excise tax of $20 million.
Even if the employer meets the 95% test, the employer might owe a separate nondeductible excise tax if it fails to offer affordable health coverage to a lower-income employee, and the employee purchases individual health coverage through an insurance exchange. This excise tax is $3,000 per full-time employee, but the tax applies only with respect to the lower-income employees who actually purchase coverage through an exchange. In this case, too, an employer might owe the excise tax for a common-law employee who is misclassified as an independent contractor, leased employee, or other non-employee.
These shared responsibility penalties raise the stakes for employers with workers who might be misclassified. Employers that misclassify employees as independent contractors already face potential employment tax liability and penalties for failing to withhold income tax and failing to withhold and pay employment tax on the workers’ wages. Misclassified workers might also create a risk of liability under other federal and state laws that protect employees, such as liability for minimum wages and overtime pay, paid leave under state leave laws, worker’s compensation, and state unemployment compensation.
Until now, however, employers generally have been able to avoid retroactive liability under employee benefit plans by excluding from coverage under the plans any workers who are classified as non-employees in the employer’s payroll records. If the workers are later reclassified (for example, as a result of an IRS or Labor Department audit), the workers must be covered by the plans going forward if they are otherwise eligible, but they do not have to receive retroactive benefits. Although the shared responsibility rules do not require an employer to provide retroactive health benefits, these rules expose the employer to the risk of substantial retroactive penalties for failing to offer group health coverage to misclassified employees.
Worker classification has always been a difficult issue for employers. The standards that distinguish a common-law employee from an independent contractor are subjective and fact-dependent, and they resist bright-line tests. Even if a company adopts a rigorous worker classification policy, it often finds that its business units are applying a more flexible set of rules in practice as they respond to competitive pressures, headcount restrictions, or the need to bring back retirees with special skill sets.
Congress recognized these difficulties many years ago and created a limited safe harbor in section 530 of the Revenue Act of 1978. Under the safe harbor, a business may treat workers as independent contractors (not only retroactively, but also prospectively) if it has a reasonable basis for doing so and meets certain other conditions. IRS Publication 1976 describes the conditions for section 530 relief.
A business that properly relies on the section 530 safe harbor is not liable for failing to withhold and pay employment tax for common-law employees who are misclassified as independent contractors. Section 530 does not provide relief from other potential consequences of worker misclassification, however. The regulation interpreting the employer health mandate does not extend section 530 relief to the shared responsibility excise taxes. Accordingly, an employer that currently relies on the section 530 safe harbor to avoid liability for employment tax is still potentially at risk for very substantial shared responsibility excise taxes for misclassified workers starting in 2014.
Worker classification has been a focus for audit and enforcement initiatives at the federal and state level. For example, the Labor Department is working with the IRS and state agencies to identify misclassified workers. (A description of the Labor Department’s worker classification initiative is available here.) The IRS launched an audit project targeting worker classification issues in 2010, in response to a 2009 GAO report that attributed substantial lost tax revenues to worker misclassification.
Worker advocates have expressed a concern that employers will attempt to reclassify common-law employees as independent contractors in order to avoid providing health coverage or paying a shared responsibility tax starting in 2014. Worker classification audit and enforcement activity is likely to increase at the federal and state level in response to these concerns and in reaction to the ongoing search for tax revenue at all levels of government.
Employers might wish to take a careful look at their worker classification practices and consider whether the Voluntary Classification Settlement Program provides useful relief before the expanded eligibility condition expires on June 30.