Program Offers Past Payroll Tax Relief to Employers Who Reclassify Their Workers as Employees


The Internal Revenue Service launched a new program on September 21, 2011 that will enable many employers to resolve past worker classification issues and achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers.

Under the Voluntary Classification Settlement Program (VCSP), employers — including businesses, tax-exempt organizations and government entities — can obtain substantial relief from federal payroll taxes they may have owed for the past if they treat workers who were previously classified as independent contractors as employees going forward.

Benefits of Participation

Employers who participate in the VCSP will agree to classify certain workers who were classified as independent contractors in the past as employees in the future. The only payment due is approximately 10 percent of the employment taxes due (including Federal Insurance Contributions Act, or FICA) for the most recent tax year for the workers being reclassified under the VCSP. No interest and penalties are due on the 10 percent payment.

Conversely, if an employer is audited by the IRS and the audit results in reclassification of workers who were previously classified as independent contractors to employees, the employer faces an additional tax assessment of three years of full back taxes, plus stiff interest and penalties. Penalties can include an amount equal to 1.5 percent of the employee’s taxable wages on account of the income taxes not being withheld and 20 percent of the employee FICA taxes not withheld, plus interest on all past due tax and penalties compounded daily at a current rate of 4 percent. In addition, any person required to collect, account for and pay income and FICA tax who willfully fails to do so faces criminal prosecution of a felony and faces penalties of an additional $10,000 per violation and up to five years in prison.


Long-Standing Safe Harbor Provision May Be Eliminated

Misclassification of employees as independent contractors costs the U.S. Treasury billions in lost revenue. The last comprehensive estimate of worker misclassification, performed in 1984, estimated that 15 percent of employers misclassified more than three million employees, resulting in an estimated tax revenue loss of $1.6 billion in 1984 dollars.1 The total 1,181 worker misclassification audits in 2008 resulted in 71 percent of cases closed with assessments, and an additional $63.5 million in additional tax assessed.2 Yet since 1978, employers who have misclassified employees and independent contractors have been able to take “safe harbor” in Section 530 of the Revenue Act of 1978. Section 530 protects employers who qualify for relief not only from assessments of past due
tax for misclassification of workers, but it also prevents the IRS from reclassifying independent contractors as employees on a going-forward basis. Employers who have misclassified employees as independent contractors may qualify for Section 530’s safe harbor provision if each of the following applies:

  1. the employer consistently treated the workers, and any individual holding a substantially similar position, as independent contactors for tax purposes for those tax periods and all periods after 1978
  2. the employer filed all forms (including form 1099) and returns required for the workers for those periods and all periods after 1978 and the returns were all consistent with nonemployee status
  3. the employer had a reasonable basis for treating the workers as nonemployees

Given the significant dollar amounts at stake, many members of Congress believe that Section 530 provides too much leeway for worker classification abuse and has resulted in many inappropriate worker classifications being grandfathered in. Several bills have been introduced that would repeal or drastically reduce Section 530’s impact, and President Obama’s fiscal 2012 budget and deficit reduction plan both call for complete elimination of Section 530.

Planning Ahead

Given the uncertainty surrounding the safe harbor provision and the favorable terms of the Voluntary Classification Settlement Program, a thorough and detailed review of the status of workers is in order for all employers. While the program provides certainty and a minimal cost for back taxes, participation may not be necessary for all employers who classify workers as independent contractors.