The IRS, U.S. Department of Labor (DOL), and various states have joined together in an effort to crack down on misclassification of employees as independent contractors, as reported in the October 10, 2011 edition of Legal News: Employment Law Update. In combination with the increased investigation and enforcement of laws pertaining to employee classification, the IRS has also introduced the Voluntary Classification Settlement Program (VCSP), which allows companies to prospectively reclassify certain individuals as employees without significant penalties. However, there are certain restrictions and pitfalls to be aware of before your company enters the VCSP.

Under the VCSP, employers may reclassify independent contractors as employees if the workers have been consistently treated as non-employees, and the employer has filed the appropriate 1099 forms for the previous three years. Additionally, the employer may not be currently undergoing a classification audit by the IRS, DOL, or any state agency; if the employer had previously been the target of such an audit, it must have complied with the results to be eligible for the VCSP.

Eligible employers will reclassify these workers as employees for future tax periods and pay 10 percent of the employment tax liability due for the most recent tax year as a result of the reclassification, with no penalties or interest on that liability. The IRS also will agree not to audit the employer as to classification of these workers for prior years. However, the employer must agree to extend the limitations period for assessment of employment taxes for an additional three years for each of the first, second, and third years after it reclassifies its employees. The IRS also has no obligation to accept an employer’s participation in the VCSP.

Not only is the employer required to agree to extend the assessment period for an additional three years, but there are other factors to consider before deciding to enter the VCSP. Though the IRS will limit an employer’s federal tax liability under the program as described above, the DOL and various state agencies are not involved with the program at this time, and it is possible that any reclassification with the IRS may lead to back penalties and assessments by these agencies. Therefore, any consideration of whether to participate in the VCSP should include a determination of potential liability to agencies other than the IRS.

The VCSP may be an effective tool for employers who realize they have misclassified workers and wish to proactively address the issue before they become the target of an IRS investigation. However, there are significant considerations beyond federal tax liability that must be considered when assessing whether the program is right for your company.