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IRS Makes Voluntary Reclassification of Workers Less Taxing

By Marcia Richards Suelzer, MA, JD | June 29, 2012

The IRS takes a very dim view of the misclassification of employees as independent contractors. In fact, tracking down employers who misclassify workers is a high priority for the IRS, as the recent collaboration with the Department of Labor indicates: Employee or Independent Contractor? Feds and States Join Forces to Fight Worker Misclassification.

Despite its aggressive enforcement actions, the IRS also seems to be aware of the old bromide: "You can catch more flies with honey, than with vinegar." So the agency has announced a new Voluntary Classification Settlement Program (VCSP).

Why Misclassify?

At first glance, classifying workers as independent contractors seems to be an excellent way of reducing both paperwork hassles and out-of-pocket costs for tax payments. After all, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on the wages that you pay to your employees. You are spared all of these obligations if the person doing the work is an independent contractor.

In tax law, as in much of life, the easiest option in not necessarily the wisest one. Leaving aside the disruption and unpleasantness associated with an extensive IRS audit, you risk owing more in taxes than you would have had you correctly classified your workers. If you classify an employee as an independent contractor without a reasonable basis for doing so, you may find yourself paying a portion of the employee's Social Security taxes and a portion of the income tax withholding on their wages, as well as your own portion of Social Security taxes.

Tip. If you can control what the worker does and how it will be done, and not simply the result to be accomplished, then it is likely the worker is an employee. Over the years, 20 factors have been developed that help analyze whether the worker is an employee or independent contractor. See our discussion, The IRS's 20-Factor Analysis, for more information.

Why Voluntarily Re-classify?

One of the biggest benefits of reclassification is peace of mind. Employers who participate in the voluntary reclassification program will not be audited on payroll taxes related to these workers for prior years. In the words of IRS Commissioner Doug Shulman: “This settlement program provides certainty and relief to employers in an important area.”

A second important benefit is that you will save a considerable amount of money if you voluntarily reclassify, rather than waiting for the IRS to find you and reclassify your workers following an audit. Under the voluntary program, you will only owe 10 percent of the employment tax liability due on compensation paid to the workers for the most recent tax year, determined under the rules that apply to reclassifications.

Example. You own a construction company. You have been classifying your drywall installers as independent contractors. During an audit, the IRS disagrees and reclassifies them as employees. The workers' total compensation for 2010 was $500,000 and none of the compensation exceeded the Social Security wage base. Even if you qualify for reduced liability, you will owe $53,400 (10.68 percent of $500,000) for 2010 wages. You will owe a similar amount for previous years for which the workers were misclassifed.

Assume the same facts as above, but you apply to participate in the Voluntary Classification Settlement Program. Under this program, the maximum amount you will owe is $5,340: 10 percent of the most recent year's applicable employment taxes.

If a 90 percent savings isn't enough to pique your interest, you also will be spared any interest and penalties on the liability.

Warning. Your tax issues could be even worse if you are considered a person who is responsible for withholding and paying over taxes (and nearly every small business owner is going to be a responsible party). You could be held personally liable for the amount of tax that should have been paid over to the IRS, in addition to owing the worker's portion of employment taxes and income tax withholding.

There is one downside to participation--but the benefits are likely to outweigh it. In order to participate in the VCSP, you must agree to extend the employment tax limitations period from three to six years for the first three years after you enter into the agreement. This means that the IRS has longer to determine if you are honoring the terms of the agreement or surface other issues with your employment taxes.

Who Can Participate?

You can participate in the program if you meet these three requirements:

  • You must have consistently treated your workers as nonemployees;
  • You must have filed all required Forms 1099 for these workers for the past three years; and
  • You currently are not under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.

You apply by filing Form 8952, Application for Voluntary Classification Settlement Program. You can file the form at any time, but you must file at least 60 days before you want to begin treating the workers as employees. This means that you must file by November 2, 2011, if you want to start treating a group of workers as employees beginning with the New Year.

Related items:
Employee or Independent Contractor? Feds and States Join Forces to Fight Worker Misclassification.

Posted September 27, 2011.

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