Employee or independent contractor? It’s a legal distinction that has significant implication for both workers and employers. Take ride-sharing service Uber, for example. It’s now defending a class action lawsuit filed by its drivers who claim they are misclassified as independent contractors. Should plaintiffs be successful, they may be entitled to damages including reimbursement for expenses they incur, such as gas and vehicle maintenance.

Whether a worker is an employee or independent contractor is also an issue of importance to state and federal governments. If a company classifies a worker as a contractor, it does not need to withhold employment taxes or pay unemployment insurance and workers’ compensation premiums. Governments and their various agencies (especially taxing authorities), therefore, prefer that workers be classified as employees, while companies are incentivized to call workers contractors. It’s not a decision that companies and other employers should take lightly, as misclassification can lead to substantial penalties and interest due to lack of tax withholding and other issues.

In 2011, the Internal Revenue Service introduced the Voluntary Classification Settlement Program (VCSP) to encourage taxpayers to comply with past tax obligations. It is intended to give businesses a chance to remedy past classification mistakes, and offers a more lenient penalty framework in which businesses pay reduced back taxes and avoid interest and penalties.

According to a report by the Treasury Inspector General for Tax Administration, more than 25,000 workers from 1,303 entities have been reclassified under the program from its inception through April 2014.

According to the IRS, the VCSP offers the following benefits to taxpayers:

  • Taxpayer pays 10 percent of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year;
  • Taxpayer is not liable for any interest or penalties on the liability; and
  • Taxpayer is not subject to an employment tax audit of the worker classification of the class or classes of workers for prior years.

To participate in the VCSP, an employer must meet certain eligibility requirements and file form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS. When originally announced, for an employer to participate in the VCSP, the employer must have consistently treated its workers in the past as nonemployees, and must have filed all required Forms 1099 for the workers for the previous three years. Also, the employer could not be under audit by the IRS, the U.S. Department of Labor (DOL) or a state agency concerning the classification of the workers at issue.

In 2012, the IRS issued Announcement 2012-45 to revise eligibility requirements under the VCSP. These revisions:

  • Permit a taxpayer under IRS audit - other than an employment tax audit - to participate
  • Make clear that a taxpayer is not eligible to participate if the taxpayer is contesting in court the classification of a class or classes of workers from a previous audit by the IRS or DOL
  • Eliminate the requirement that a taxpayer agree to extend the statute of limitations on assessment of employment taxes as part of a closing agreement with the IRS

Additional information about the VCSP is available on the IRS’s website here.

While the VCSP offers benefits to employers, one of the challenges - and also one of the possible impediments to more employer participation - is that participation in the VCSP only addresses an employer’s potential liabilities with respect to the IRS. An employer could face additional issues due to misclassification with the DOL as well as state agencies.

As governments, as well as plaintiffs’ lawyers, continue to look closely at employers’ classification of workers, employers will need to be vigilant making these determinations - and remedying past mistakes as necessary. We expect that additional guidance will be provided by agencies regarding proper classification, as well legal insights from courts that consider lawsuits brought against employers. The Uber case, barring a settlement in the interim, appears headed for trial as the judge overseeing the case denied Uber’s motion for summary judgment.