A Closer Look at the IRS’s New Voluntary Program for Employers to Reclassify Workers as Employees
The Internal Revenue Service (IRS) recently announced a Voluntary Classification Settlement Program (VCSP) that will allow eligible employers to reclassify, as employees, workers whom they have previously treated as independent contractors. Given the significant risks associated with employee misclassification and the complexity of the legal guidelines involved, employers should take a careful look at the VCSP to determine whether it would be beneficial for them in particular situations.
If accepted into this program by the IRS, the employer will be required to pay only a fraction of the federal employment taxes (payroll taxes) that it would have owed for the workers if they had been classified as employees in the most recently closed tax year, with no interest or penalties, and will not be subject to audit by the IRS for prior years with respect to employment taxes for those workers. The employer must agree to treat the workers as employees going forward, and must agree that for the first three years under the program, the statute of limitations for assessments on federal employment taxes will be six years rather than the usual three years.
This program is generally available to a wide range of employers, including corporations, sole proprietors, partnerships, tax-exempt organizations, and state and local governments. To be eligible, the employer is required to identify one or more classes of workers that it wishes to reclassify, and it must have been consistently treating all workers in those classes as non-employees, including by filing any required Forms 1099 with respect to all such workers for the past three years. In addition, the employer must not be currently under audit by the IRS; there must not be a current dispute between the employer and the IRS as to the proper classification of the workers for federal tax purposes; the employer must not be under examination by the U.S. Department of Labor (DOL) or any state agency concerning the classification of the workers; and the employer must not have been previously examined by the IRS or the U.S. DOL concerning the classification of workers, or, if there was such a prior examination, the employer has complied with the results of the examination.
All employers should be aware that there are significant risks to treating workers as independent contractors when they are actually employees under applicable law. Employers are required to withhold state and federal employment taxes from employees’ wages (including income tax, Social Security, and Medicare) and are also required to pay the employer’s portion of Social Security and Medicare taxes, as well as unemployment taxes. While the employer does not have these obligations for a true independent contractor, it could be found liable for non-compliance if the worker is deemed to have actually been an employee. Further, employees have rights to unemployment insurance, Workers’ Compensation, and Family and Medical Leave Act (FMLA) leave; the right not to be discriminated against because of race, sex, etc.; the right to be paid minimum wage for all hours worked and overtime, if applicable; and rights to the employee benefits offered by the employer, etc. — and workers who have been incorrectly treated as independent contractors can also claim such rights. The legal guidelines for when a worker is an independent contractor versus an employee are unclear and difficult for employers to follow with any degree of certainty. As a result, many employers who use workers on an independent contractor basis have some concern as to whether this practice could survive a legal challenge.
An employer that has already been considering changing some or all of its independent contractors to the legally safer category of employees, meets the eligibility criteria of the VCSP, and would like to receive amnesty for its federal tax treatment of the independent contractors in past years may want to give serious consideration to this new voluntary program. The past tax that would have to be paid under the VCSP is minimal: 10 percent of the last year’s employment taxes for the reclassified workers, computed under the reduced rates of Internal Revenue Code § 3509. Under that section, the total employment tax rate for 2011 on employee compensation up to the Social Security wage base is 10.28 percent, and on compensation above the Social Security wage base is 3.24 percent. (See the IRS FAQs on the VCSP below). Under the VCSP, the employer would pay only 10 percent of that amount. Thus, if an employer applies in 2012 to start the VCSP that year, and in 2011 (the last completed tax year) it paid $1 million in total compensation to the class of workers that will be subject to the VCSP, all of whom were compensated below the Social Security wage base, the 2011 tax liability would be $102,800 (10.28 percent of $1 million), and the VCSP payment would be 10 percent of that, or $10,280.
Participation in the VCSP begins with the preparation and submission of Form 8952 (see below). The form must be submitted to the IRS at least 60 days before the employer wishes to begin treating the reclassified workers as employees. No payment is submitted with the form, because the IRS retains discretion as to whether or not to accept the employer into the program. (This discretion at least applies to determining whether the employer meets the eligibility requirements of the program and has identified a viable class of workers to be re-classified.) If accepted for the VCSP, the employer will enter into a “closing agreement” with the IRS, make its VCSP payment, and begin treating the reclassified workers as employees.
It bears repeating that an employer wishing to participate in the VCSP must be able to identify one or more classes of workers that this program will apply to; show that it has consistently treated all the workers in those classes as non-employees in the past, including by filing 1099s; and agree to treat all such workers as employees going forward. To illustrate what it considers to be a “class” of workers, the IRS uses the example of a construction company that currently contracts with drywall installers, electricians, and plumbers, and decides that it will reclassify all the drywall installers as employees. (See the IRS FAQs). Clearly, this program is not suitable for employers that have been treating some workers within a given class as employees and others in the same class as independent contractors.
Employers that participate in the VCSP will only be protected from additional liability for past federal employment taxes pertaining to the reclassified workers. The program does not provide protection from tax or other claims under state law, or from federal wage/hour claims (such as overtime claims), employee discrimination claims, or employee benefits claims pertaining to past years. Employers should therefore carefully consider whether participation in the VCSP might cause newly classified employees to assert such claims based on an argument that they were employees in the past years as well, and whether the employer would have a viable defense to such claims. Also, while it is not clear whether state tax authorities will learn about VCSP employers from the IRS, this possibility cannot be discounted since IRS and the U.S. DOL have been working closely with the states on independent contractor issues. For that matter, it is at least theoretically possible that since the IRS retains discretion as to whether or not to approve an employer’s VCSP application, it could deny the application and then audit the employer for past federal employment taxes. That may be unlikely because it would tend to undercut public acceptance of this voluntary program, but cautious employers may want to wait awhile before deciding whether to participate in the VCSP and monitor whether the program is working as desired.
For an employer that has some concerns about the correctness of its treatment of workers as independent contractors, but nevertheless feels it has a colorable argument that the “safe harbor” under Section 530 of the Revenue Act of 1978 applies, it might make even more sense to be cautious about signing up for the VCSP. The IRS previously instituted a related program called the Classification Settlement Program (CSP), which applies to employers that are currently under tax audit for worker classification issues. Under the CSP, if the IRS believes that an employer under audit violated the law by treating employees as independent contractors, and the employer is relying on the Section 530 safe harbor and otherwise meets the same criteria that are now being required by the VCSP, the IRS will offer a settlement if the employer can show it had a reasonable basis for treating the employees as independent contractors as the safe harbor requires. This settlement could be only 25 percent of the employment tax that would otherwise have been payable for the challenged workers for the last tax year.
Thus, an employer that is currently relying on the Section 530 safe harbor might decide that it makes sense to simply wait and see if it gets audited, because if that happens the employer might be successful due to the safe harbor; and if the IRS finds a potential violation, the employer may qualify for a settlement that is not significantly larger than the payment called for the VCSP.
Any employer that is interested in the VCSP should closely review its particular situation and weigh all relevant factors and options with its tax professional and legal counsel before deciding whether or not (or when) to participate.
If you have questions about the VCSP or how it may impact your business, please contact: Sean P. Beiter (716.566.5409; firstname.lastname@example.org), Richard A. Braden (716.566.5436; email@example.com); Matthew C. Van Vessem (716.566.5476; firstname.lastname@example.org), or another member of the Goldberg Segalla Labor and Employment Practice Group.