On September 21, 2011, the Internal Revenue Service announced a voluntary reprieve for businesses that fear facing an IRS worker classification audit. The Obama administration suspects that between 10 percent and 30 percent of US companies misclassify their workers. According to a 2009 report from the Government Accountability Office, employers who misclassified workers as nonemployees or independent contractors, rather than employees, cost the federal government roughly $2.72 billion in unpaid federal taxes, in addition to losses to local and state agencies such as local employment taxes and unemployment taxes. While employers may realize a substantial savings by classifying workers as nonemployees, an IRS audit based on worker misclassification could cost employers a lot more in interest and penalties in the long run.
The Voluntary Classification Settlement Program (VCSP) offers employers the opportunity to prospectively reclassify some or all of their workers as employees without being subject to an IRS audit or going through the normal administrative correction procedures.
Reduced employment tax liability for prior year
Once an employer enters the program, it will have to pay only 10 percent of the previous year’s employment tax liability with respect to the reclassified workers. The previous year’s employment tax liability is determined under the Internal Revenue Code and includes federal income tax withholding, employee and employer social security tax, and employee and employer Medicare taxes. For workers classified as employees, employers were required to pay employment taxes of 10.28 percent of compensation up to the Social Security wage base in 2011, and 10.68 percent in 2010. The Social Security wage base for 2010 and 2011 is $106,800. Employers are required to pay employment taxes of 3.24 percent of compensation above the Social Security wage base in 2010, 2011, and 2012. 26 USC § 3905. Under the VCSP, employers will only have to pay 10 percent of this liability, effectively saving them 90 percent off what they would have paid if workers had been classified as employees in initial tax filings. It is important to note that the VCSP has no effect on employment tax liability for workers who were already classified as employees. Therefore, employers will still have to pay the entire employment tax liability due for workers who were already classified as employees; the discount only applies to workers being reclassified as employees.
Shelter from some IRS audits
In addition to the savings, the company will not be subject to interest, penalties, back taxes, or misclassification audits with respect to the reclassified workers for previous years. The IRS’ waiver of misclassification audits only applies to the individual workers that have been reclassified, not the employer's workforce as a whole.
In exchange for these benefits, employers will have to sign a closing agreement. The total amount of back taxes due pursuant to this program are required to be paid when the employer returns the signed agreement to the IRS. Within the agreement, the employer must further consent to extend the statute of limitations for worker classification audits, normally three years, to six years for the first three years it participates in the program. So, if an employer begins reclassifying any of its workers in 2012, it will be subject to auditing for six years from the date of filing for tax years 2012, 2013, and 2014.
In addition, all current workers in a classification must be reclassified when filing the application. A classification is made up of any workers who provide the same or similar services. Once a worker is reclassified, all workers in that classification going forward, including new hires, must be classified as employees. Due to the extended statute of limitations, it is likely that employers in the program will face stricter scrutiny of the classification of their workers in future tax years. To help curb further misclassification, the Department of Labor and the IRS have agreed to meet regularly to educate employers about properly classifying their workers.
Which Taxpayers Are Eligible?
Taxpayers are eligible for the program if they have consistently treated the workers they wish to reclassify as nonemployees or independent contractors for tax purposes. This must be demonstrated by having filed 1099s for each of the workers for the previous three tax years. For companies in existence for less than three years or for workers in that classification employed for less than three years, the employer must demonstrate 1099s for the period of their employment up to the date of the VCSP application.
The VCSP covers private businesses, tax-exempt organizations, and government entities. However, public employers will not be able to reclassify those currently being treated as nonemployees into an employee position covered under a § 218 agreement (a §218 agreement is an agreement between the federal government and a state wherein certain state employees in certain titles receive coverage under Social Security and Medicare). Social Security Act § 218, 42 USC 418.
Taxpayers who have previously been examined by the IRS or the US Department of Labor for worker classification are eligible to participate, so long as the audit is complete and the taxpayer has complied with all results of the audit. The IRS has not addressed the eligibility of taxpayers who have complied with the results of a closed state or local audit.
Which Taxpayers Are Not Eligible?
A taxpayer is not eligible if it is currently being audited by the IRS for any reason, even if unrelated to worker classification. Taxpayers who are currently being audited should check with their examiner to determine if they are eligible for the Classification Settlement Program, which is another IRS program similar to the VCSP. It requires that employers have treated all workers in a classification consistently for the tax year(s) for which it is being audited, filed timely 1099s for those workers, and had a reasonable basis for treating the workers as nonemployees or independent contractors. If an employer meets the 1099 requirement, but not the other requirements, some employment tax liability discounts are still available through the CSP.
A taxpayer is not eligible if it is currently contesting the classification of its workers with the IRS.
In addition, a taxpayer is not eligible if it is under investigation by the DOL or a state agency for worker classification.
How Can Taxpayers Apply?
Taxpayers must apply to the program at least sixty days before they wish to begin reclassifying their workers. Employers should submit applications as soon as possible if they would like to be considered for the program for the last quarter of 2011. To apply, employers must complete form 8952, which is available immediately on the IRS website.
The IRS will review all applications and contact all applicants to inform them if they have been accepted to the program. The IRS retains discretion to reject any applicant. While declined applicants are permitted to reapply later, there is no audit shelter for applicants. However, no applicant will be required to admit any liability with respect to past worker classification, regardless of whether they are accepted into the program.
Additional Factors Employers Should Consider
As of now, the IRS has not established an end date for this voluntary program or a maximum savings.
An employer’s tax liability is based on the most recently completed tax year. An employer who wishes to begin reclassifying workers in the last quarter of the 2011 will be required to pay 10 percent of the 2010 employment tax liability with respect to the reclassified workers. An employer who wishes to begin reclassifying workers at any point in 2012 will be required to pay 10 percent of 2011 employment tax liability with respect to the reclassified workers. The IRS has not yet issued guidance as to whether any employment taxes will be due for reclassified workers for the portions of the year prior to their reclassification. For example, if an employer reclassifies its workers beginning November 1, 2011, it will owe 10 percent of the employment tax liability for those workers for the period of their employment in 2010, but it is unclear whether employers will be liable for employment taxes on those workers for January through October 2011.
Exposure to other agencies
The IRS has not addressed how participation in the VCSP will affect employers who may face future state or local worker classification audits for the same time period based on their application to the IRS. The only solace is that applicants will not be required to admit liability for past worker misclassification. This issue is particularly relevant in light of the September 19th agreement between the IRS, the US Department of Labor, and several states to share information in order to combat worker misclassification.
No IRS audit shelter for workers who are not reclassified
To the degree that certain workers have been reclassified under this program, the employer will not be subject to an IRS audit of those individual workers who have been reclassified. However, the IRS will likely check to ensure that all workers in a classification have been reclassified. In addition, other classifications of workers that were not reclassified can be subjected to an IRS audit. The IRS also reserves the right to audit VCSP participants for issues unrelated to worker classification.
Consequences of being an employee
Employers should also consider the consequences of reclassifying workers as employees. Increasing the number of employees can impact employee benefit plans. For example, a company with a defined benefit pension plan or that contributes to a multi-employer plan may face unexpected liability for contributions or benefits for the reclassified workers.
In addition, employees have rights under various labor laws that are not afforded to nonemployees and independent contractors.