Misclassifying workers as independent contractors when they should be treated as employees has long been an issue for employers and can result in significant exposure to tax liabilities. The IRS recently announced the Voluntary Classification Settlement Program (VCSP) for employers that have misclassified their employees as independent contractors or other nonemployees. As a result, this may be the time to do the analysis and potentially cut a check in order to put to bed prior classification issues.

Classification has important federal tax consequences. Employers generally withhold and pay federal income tax and employment taxes (FICA and FUTA) on wages paid to employees, while an independent contractor is solely responsible for the payment of taxes on his or her earnings. Failure by an employer to withhold income and employment taxes from the wages of employees can result in liability for unpaid taxes as well as penalties.

The classification as an employee versus an independent contractor largely centers around the company’s relationship with the individual being paid. The IRS uses a 20-point test to determine classification. Behavioral control, financial control and the relationship of the two parties are generally the biggest factors to consider, although no single factor may determine the classification. The following behavior control elements may indicate the individual is an employee:

• Providing instructions on where, when and how to do the work

• Requiring or providing specific tools, equipment or assistants to be used

• Providing training as to how the work is to be performed

Conversely, if the worker has the following attributes, it may indicate an independent contractor relationship exists:

• Significant financial investment in his or her work

• Opportunity for profit or loss on the work performed

• Significant unreimbursed expenses

The existence of written agreements, the industry norms and various other factors may also impact the classification.

If you feel you may have a classification issue, the VCSP offers employers the ability to settle tax liabilities with significantly fewer penalties as well as audit protection for previous years. In exchange, the employer must agree to treat the misclassified workers as employees on a prospective basis. The IRS also requires the employer to have consistently treated the workers as independent contractors or nonemployees, and filed all required information returns such as Forms 1099 for the workers for the three preceding calendar years. Employers currently under audit by the IRS, the U.S. Department of Labor (DOL) for worker classification issues, or a state government agency are ineligible to participate in the VCSP. Other restrictions may also apply.

In exchange for agreeing to prospectively treat the workers as employees, employers will pay only 10 percent of the employment tax liability that may have been due on compensation paid to the workers in the most recent year, as determined under the already reduced rates under Code Sec. 3509 of 1.5 percent of wages and 20 percent of employee Social Security taxes. Interest and penalties will not be due on the liability. Also, the employer will not be subject to an employment tax audit with respect to classification of workers for prior years.

The IRS has developed Form 8952, Application for Voluntary Classification Settlement Program, to request participation in the VCSP.  The IRS will review Form 8952 and determine eligibility for the VCSP. An employer that receives a rejection notification may reapply. Currently, the IRS has not specified an end date for the VCSP.

As with all tax issues, it is suggested you contact your professional tax adviser for assistance in analyzing your specific situation.

		Dennis Theis is a principal at Maner Costerisan, specializing in audit services for various industries including manufacturing and distribution, nonprofit organizations, and governmental and retail entities. With over 20 years of experience in accounting, Theis is highly regarded by both clients and peers and is an active member of the AICPA, MACPA and IMA.