Employees Versus Independent Contractors – Update on IRS Compliance Program


“Worker classification” has been a major source of disputes between taxpayers and the IRS for decades, but it seems to be an especially hot issue right now. In reaction, the IRS established the Voluntary Classification Settlement Program (VCSP) in late 2011 and recently liberalized the initiative.

Worker classification deals with whether individuals should be classified as employees or independent contractors for federal employment tax purposes. In this article, we will refer to businesses and entities that hire workers as employers (regardless of whether the workers should be classified as employees or independent contractors) and we will refer to the individuals who do the work as workers (regardless of whether they should be classified as employees or independent contractors).

Why Worker Classification Matters

When a worker is properly classified as an employee, the employer generally must withhold from the worker’s wages:

  • Federal income tax (FIT), and
  • The employee’s portion of the Social Security and Medicare taxes (FICA tax).

The employer must also:

  • Pay its portion of the Social Security and Medicare taxes.
  • Pay federal unemployment tax (FUTA).
  • File federal payroll tax returns.
  • Follow many burdensome IRS and Department of Labor (DOL) rules.

The employer may also have to deal with state and local income tax withholding, state unemployment and workers compensation taxes, and compliance with even more rules and regulations. Taking care of all the compliance work is costly and that is on top of the extra taxes.

Workers can be classified as employees based on various statutes, regulations, and court decisions. The IRS and DOL rules can differ from state and local rules. That said, if the IRS guidelines permit a worker to be treated as an independent contractor, the employer will usually be covered across the board.

Properly classifying a worker as an independent contractor is advantageous because the employer does not have to worry about employment tax issues or providing expensive fringe benefits such as medical insurance, retirement plans, paid sick leave, maternity leave, paid vacations, and so forth. In addition, the employer does not have to worry about providing the worker with “adequate” health coverage or paying a penalty in 2014 and beyond (pursuant to the 2010 healthcare legislation).

When an employer pays $600 or more in a year to a worker who is properly classified as independent contractor, a Form 1099-MISC must be issued to report the amount paid. That is usually the extent of the employer’s bureaucratic responsibilities.

However, if an employer treats a person who is actually an employee as an independent contractor, the employer could face significant assessments for unpaid employment taxes plus interest and penalties. The employer could also be on the hook for employee benefits that should have been provided but were not.

Voluntary Program for Improperly Classified Workers

In late 2011, the IRS opened up the Voluntary Classification Settlement Program (VCSP). The program obligates employers to reclassify the affected class, or classes, of workers as employees for future periods in exchange for paying a heavily discounted amount to cover unpaid federal employment taxes for past periods for the workers.

The discounted amount is based on 10 percent of a formula amount for the employer’s most recent prior year. For example, if 2012 is the most recent prior year, the discounted amount equals 10 percent times 10.28 percent of each affected worker’s 2012 wages up to $110,100 (the Social Security tax ceiling for 2012) plus 10 percent times 3.24 percent of any 2012 wages above $110,100. That is not a bad deal for workers that an employer knows have been misclassified.

No penalties or interest are charged for past periods, and the employer will not be subject to a federal employment tax audit for the affected class or classes of workers for prior years.

To be eligible for the VCSP, the employer must satisfy all the following requirements.

  1. The workers in question must have been consistently treated as independent contractors in the past.
  2. Forms 1099 must have been filed for the workers for the previous three years.
  3. The employer must not currently be under an IRS audit (as explained below, this requirement has been liberalized).
  4. The employer must not be under audit by the Department of Labor or a state agency with regard to worker classification issues.
  5. If the employer was previously audited by the IRS or the Department of Labor with regard to worker classification issues, the employer must have complied with the audit results.

Participation Can Have Serious Side Effects

Any decision to participate in the VCSP should not be made lightly for several reasons including:

State liabilities – Participation might open an employer up to audits, taxes and penalties from state agencies.

Benefits – Workers reclassified as employees might make a claim for fringe benefits they feel they should have been receiving all along, such as inclusion in the employer’s retirement and health plans.

Future costs – Treating the affected workers as employees from now on might be an expensive proposition. In addition to owing employment taxes (federal, state, and local) from now on, your business may also face other substantial costs. These include the cost of providing employee benefits and exposure to the requirement to provide adequate health coverage or be fined, starting next year.

Important: There may be other alternatives to the VCSP that are more advantageous. Before proceeding, it is imperative for employers to consult with tax and legal professionals familiar with worker classification issues.

Liberalizations to the Original Program

Q. Are not-for-profit organizations and government entities eligible for the VCSP?

A. Yes, if all eligibility requirements are met.

In guidance issued in late 2012, the IRS liberalized some of the original VCSP requirements (IRS Announcement 2012-45).

  • Employers that are under IRS audit — other than an employment tax audit — are now allowed to participate. This represents a liberalization of the third requirement listed above.
  • Employers are no longer required to agree to extend the statute of limitations period for assessing federal employments taxes as part of the VCSP closing agreement. Employers were previously required to extend the period for three years for each of the first three years after the date of the closing agreement.

June 30 Deadline

In another recent move, the tax agency announced a temporary liberalization of the original VCSP deal — the so-called VCSP-TEE initiative (IRS Announcement 2012-46). Through June 30, 2013, employers that failed to file Forms 1099 in prior years for the affected class, or classes, of workers but meet the other requirements listed above can apply to participate in the VCSP-TEE. Under this initiative:

  • Employers that are approved for participation must pay a larger but still-discounted amount for unpaid prior-year federal employment taxes for the affected class or class of workers than under the standard VCSP provisions and a discounted penalty for failing to file Forms 1099 for the affected class or classes of workers. Once again, that is not a bad deal for workers you know have been misclassified.
  • The discounted amount for unpaid prior-year federal employment taxes is based on 25 percent of a formula amount for the employer’s most recent prior year. For example, if 2012 is the most recent prior year, the discounted amount equals 25 percent times 12.91 percent of each affected worker’s 2012 wages up to $110,100 (the Social Security tax ceiling for 2012) plus 25 percent times 5.03 percent of any 2012 wages above $110,100.
  • Employers that are approved for VCSP-TEE participation will not be assessed interest or penalties on the discounted amount for unpaid prior-year federal employment taxes nor will they be exposed to a federal employment tax audit for the affected class or classes of workers.

Employers can apply to participate in VCSP or VCSP-TEE by submitting a form to the IRS. Consult with your tax adviser if you think your business might be a candidate for either of these voluntary programs.

About Scale Finance

Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout the southeast including Charlotte, Raleigh/Durham, Greensboro, Wilmington, Washington D.C. and South Florida with a team of more than 30 professionals serving more than 100 companies throughout the region.