In a news release dated September 21, 2011 (IR-2011-95) and Announcement 2011-64, the Internal Revenue Service (the “IRS”) announced a new voluntary classification settlement program (the “VCSP”) as part of its overall “Fresh Start” initiative to get taxpayers into federal tax compliance. The VCSP allows eligible employers (each, an “employer”) to come into federal tax compliance by reclassifying workers as employees on a voluntary basis in exchange for a minimal payment covering a portion of past employment tax obligations without waiting for an IRS audit. The general eligibility, filing and other considerations for participating in the VCSP are briefly summarized below.
Background: Significance of Worker Classification for Federal Tax Purposes
Federal and state governmental agencies apply a myriad of tests to determine whether a worker is properly classified as an employee or an independent contractor. Different tests are used by the Department of Labor, the National Labor Relations Board, the Equal Employment Opportunity Commission, individual states and their agencies, and of course, the IRS. Consequently, it is possible for a worker to be classified as an employee for one purpose, and at the same time, be classified as an independent contractor for another purpose.
The IRS uses what is referred to as the common law test for worker classification. Generally, if an employer has the right to direct and control how a worker performs services for the employer, that worker is properly classified as an “employee” for tax purposes. The IRS considers, among other things, 20 factors to help determine a worker’s classification for wage withholding purposes (the “20-factor test”), which factors are grouped into the following general categories: (1) behavioral control, which refers to the factors indicating a right to direct or control how the worker performs the work; (2) financial control, which refers to factors indicating whether or not the employer has the right to control the economic aspects of the worker’s task; and (3) the type of relationship between the parties, which refers to factors indicating how the worker and the employer perceive their relationship with each other. Under the 20-factor test, it is not necessary that all factors point to characterization as either an employee or an independent contractor. Depending on the circumstances, some factors may be irrelevant to the classification of a particular worker. Further, the courts are not bound by the 20-factor test. The Tax Court, for example, issued an opinion listing only 11 factors to be applied in making a worker classification determination, thus evidencing that the 20-factor test is not a rigid test.
An employer must withhold federal income tax from an employee’s compensation and pay it over to the Treasury. If an employer misclassifies a worker as an independent contractor and fails to withhold the income taxes, the employer can be penalized by the amount of the income taxes that should have been withheld. Other civil penalties may apply as well. An employer also is required to withhold and pay over the employee’s share of Federal Insurance Contributions Act (“FICA”) tax. There is an employer’s share of FICA taxes that also must be paid to the Treasury by the employer. Taxes under the Federal Unemployment Tax Act (“FUTA”) are not withheld from the employee, but must be paid by the employer. Worker misclassification could result in the imposition of civil penalties on the employer under FICA and FUTA as well as under the income tax provisions.
The IRS in recent years has launched a number of enforcement and compliance programs to address the growing problem of worker misclassification, including various examination initiatives, information sharing agreements with the U.S. Department of Labor, and more recently, the Classification Settlement Program (“CSP”) for employers already under audit. The CSP permits employers to settle worker classification disputes by way of closing agreement in exchange for reduced federal employment taxes and relief from interest and penalties. Employers must meet certain requirements to qualify for the CSP. Those employers not eligible for the CSP, however, remain exposed to potential employment tax and civil penalty liability for worker misclassification, and as such, the VCSP may be an attractive alternative.
VCSP Eligibility Requirements
In order to be eligible to participate in the VCSP, an employer must:
- Have consistently treated its workers as independent contractors or other nonemployees;
- Have filed all required Forms 1099 for its workers for the previous three years;
- Have complied with the results of any previous examination by the IRS or the Department of Labor concerning the classification of workers; and
- Not currently be under examination concerning the classification of workers by the IRS, the Department of Labor or by a state government agency.
VCSP Filing Requirements
To apply for the VCSP, an employer must file Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before the date upon which it will treat its workers as employees. An employer accepted into the VCSP will be required to pay an amount effectively equaling just over 10% of the employment tax liability pertaining to the reclassified workers for the most recently completed tax year. No interest or penalties will be due, and the employer will not be audited for employment tax purposes for any prior tax years. However, an employer will, for the first three years under the VCSP, be subject to a special six-year statute of limitations for employment taxes (as compared to the usual three years), and further, will be required to prospectively treat reclassified workers as employees. For additional guidance regarding Form 8952, including how to compute the payment due under the VCSP, employers should refer to a series of new frequently asked questions released by the IRS on October 5, 2011.
State Tax Considerations
Employers generally are subject to state and local tax withholding requirements and payroll taxes. Most states follow the IRS guidelines for worker classification as employees or independent contractors. As noted above, the VCSP only applies with respect to federal taxes. Whether or not states and localities will launch programs similar to the VCSP remains to be determined.
General Non-Tax Considerations
An employer considering participating in the VCSP should carefully evaluate the myriad of non-tax considerations associated with worker reclassification, including various statutory legal protections afforded to employees that do not apply to independent contractors. Such statutory legal protections include, without limitation, the Fair Labor Standards Act, the Americans with Disabilities Act, the Family Medical Leave Act, Title VII of the Civil Rights Act of 1964, and the Uniformed Services Employment and Reemployment Rights Act. Additionally, employees are eligible to participate in an employer’s ERISA benefit plans (“ERISA plans”). Thus, workers reclassified as employees may be entitled to retroactive benefits, and the employer may be required to retest its ERISA plans under ERISA’s nondiscrimination requirements. Lastly, an employer reclassifying workers as employees is required for immigration purposes to obtain Form I-9, Employment Eligibility Verification, from employees and is subject to potential fines for failure to do so. The foregoing non-tax considerations are just a few of the considerations an employer should evaluate prior to worker reclassification.
The VCSP affords employers an opportunity to get into immediate federal tax compliance regarding a misclassification of workers at a relatively minimal cost. However, employers considering the VCSP should carefully consider both the tax and non-tax considerations of participation. It is recommended that employers considering the VCSP consult with a qualified professional to assess each of the foregoing.