As part of its “Fresh Start” initiative, the IRS is offering help to businesses that may be wrongly classifying employees as independent contractors. The new Voluntary Classification Settlement Program (VCSP) gives certain taxpayers an opportunity to reclassify their workers at reduced tax rates without the threat of future audits and penalties.
Worker classification has long been under scrutiny by the IRS and other taxing agencies. They are finding it increasingly difficult to collect the taxes due on compensation paid to independent contractors. The IRS estimates that half of the five million workers paid as independent contractors each year are misclassified, resulting in approximately $7 billion of lost tax revenue per year.
Why is this such a problem? First, compensation paid to independent contractors is not subject to Social Security and Medicare tax withholding, so businesses paying the compensation are not required to pay the employer portion of these taxes. This provides a substantial savings for businesses, which can also eliminate unemployment taxes, worker compensation, health insurance, and other employee benefits by paying their workers as independent contractors instead of employees.
The IRS has stepped-up employment audits
In 2010, the IRS began conducting 6000 random employment audits and made worker classification one of the main areas of interest. They also heightened enforcement of the rules regarding worker classification.
Currently, the penalty for unintentional misclassification of an employee as an independent contractor is 1.5% of the wages paid to the worker if you correctly filed Form 1099-MISC for that worker. If you did not file 1099-MISC, the penalty doubles to 3.0%. This is in addition to collecting the employee’s past due taxes and paying the employer portion of taxes for the timeframe in question. If the IRS determines that you intentionally misclassified the worker, you will be responsible for 100% of the taxes due on the wages, and you are not allowed to recoup the employee portion of taxes from the worker.
The Voluntary Classification Settlement Program benefits those who qualify
In an effort to rectify the misclassification of workers throughout the United States, the IRS created the Voluntary Classification Settlement Program for employers that think they may be misclassifying employees as independent contractors. This is an opportunity to reclassify workers and receive partial relief from past federal employment taxes. This program is available to businesses, tax-exempt organizations, and government agencies that currently erroneously treat their workers or groups of workers as independent contractors and now would like to correctly treat them as employees.
To qualify for the program, the entity (1) must have consistently treated the workers in the past as independent contractors and correctly and timely filed Forms 1099-MISC for the previous three years, and (2) cannot currently be under audit by the IRS, Department of Labor, or any state agency with regard to worker classification.
If accepted into the program, an employer will owe a penalty of just over 1% of the payments made to misclassified workers during the past year. There will be no interest or further penalty. As an employer, you are not admitting to any wrong doing and you will get a clean slate. You will not be audited for previous years; however, you will be subject to a special six-year statute of limitations on the assessment of employment taxes instead of the usual three years.
To apply for the program, file Form 8952 at least 60 days before you want to begin treating your workers as employees. Continue to treat the workers as independent contractors until you receive notification that you have been accepted into the program.
If you have been misclassifying workers as independent contractors, we urge you to look into this program. In addition to the significant tax relief you receive, you will be able to make a fresh start without admitting any wrongdoing. Please contact us for more information on the Voluntary Classification Settlement Program, or visit irs.gov.
For information on determining the classification of workers, read the article “Employee or Independent Contractor?”.
Elizabeth C. Welhouse, CPP, is a payroll specialist with Schenck. Libby specializes in determining the best payroll processing solutions to fit client needs. She implements new payroll client startups and does payroll software training, along with building and maintaining client exports.