The IRS Offers Relief for Employers Who Have Misclassified Workers

Under the IRS’s Voluntary Compliance Settlement Program (VCSP), employers face minimal penalties if they agree to reclassify ICs as employees. But is it a wise move?

Classifying a worker as an independent contractor instead of an employee can save a hiring firm a bundle on payroll taxes and benefits. However, in recent years the IRS has waged a small war against businesses that, in its view, misclassify workers to achieve these savings. Thus, it came as a bit of a shock when in late 2012 the IRS launched a new program that takes a carrot (rather than stick) approach to the misclassification problem.

Under the IRS’s Voluntary Compliance Settlement Program (VCSP), in return for agreeing to reclassify independent contractors as employees in the future, a hiring firm is granted full employment tax audit relief for all prior years and need only make a minimal payment covering past employer payroll tax obligations.

Who Qualifies for the VCSP?

To be eligible for relief under the program, an applicant must:

  • presently be treating the workers involved as independent contractors
  • consistently have treated all workers in the same group or class as independent contractors in prior years (a class of workers includes all workers who perform the same or similar services)
  • not currently be under a worker classification audit by the IRS, the Department of Labor, or a state agency, and
  • have complied with any prior IRS or Department of Labor worker classification audit.

Ordinarily, to qualify for the VCSP, the hiring firm must have filed all required Forms 1099-MISC for the workers for the previous three calendar years reporting the payments made to the workers. Many hiring firms that misclassify workers fail to file 1099s for them. Thus, this requirement has made it impossible for many firms to take advantage of the VCSP. In an effort to make it easier to qualify for the program, the IRS has eliminated this requirement for hiring firms that apply through June 30, 2013.

How to Apply

The VCSP is voluntary, meaning a hiring firm must apply for it and enter into a closing agreement with the IRS. To apply, a hiring firm must complete and file IRS Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before it wants to begin treating the workers involved as employees. It’s up to the hiring firm to select which class or group of workers it will reclassify as employees. For example, a construction firm that treats drywall installers, electricians, and plumbers as independent contractors can file Form 8952 to voluntarily reclassify the drywall installers as employees, while continuing to treat the electricians and plumbers as independent contractors.

What Happens if You’re Accepted?

The IRS will review the completed Form 8952 to verify the applicant’s eligibility. A hiring firm that is accepted will be required to sign a closing agreement with the IRS in which it agrees to:

  • treat the workers involved and all future workers in the same class as employees for employment tax purposes
  • pay the IRS an amount equaling just over 1% of the wages paid to the reclassified workers for the previous year, and
  • extend the statute of limitations on assessment of employment taxes to six years rather than the usual three years generally applicable to payroll taxes--the extension applies to the first three years after the hiring firm signs the VCSP closing agreement.

In return for all this, the hiring firm will not be subject to an IRS employment tax worker classification audit of the workers involved for any prior years.

Is the VCSP a Good Deal?

On the face of it the VCSP may look like a good deal. Particularly attractive is the unprecendentedly small amount the hiring firm must pay the IRS--a little over 1% of payroll for the workers involved for the prior year, with no interest or penalties. This is substantially less than a hiring firm would have to pay if the IRS determines it misclassified the workers in an audit. In this event, the hiring firm will be liable for all the back FICA taxes it should have paid, a portion of the FICA tax it should have withheld, plus penalties and interest.

However, hiring firms should consider the non-tax implications of agreeing to prospectively classify as employees workers who have been treated as independent contractor (perhaps for years). For example, the affected workers may claim they are entitled to employee benefits for previous years, such as pension and health benefits. Moreover, the hiring firm will likely have to treat the workers involved as employees for state unemployment insurance and workers compensation purposes as well as employment tax purposes. State unemployment insurance and workers comp agencies may view a hiring firm’s reclassification of the workers as employees for employment tax purposes as a virtual admission that they should be treated as employees for all purposes.

Thus, you should consider carefully before applying the the VCSP.

February, 2013

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