New Compliance Program re: Employee/Contractor Classification

The IRS has launched a new program that will enable many employers to resolve past worker classification issues at a relatively low tax cost by voluntarily reclassifying their workers.

This new program offers employers an opportunity to come into compliance by making a payment covering past payroll tax obligations.

This IRS “Fresh Start” initiative coincides with another new government Department of Labor program to crack down on employers who misclassify employees as independent contractors (see right-hand box for more information).

The new IRS Voluntary Classification Settlement Program “is designed to increase tax compliance and reduce burden for employers by providing greater certainty for employers, workers and the government,” according to the IRS.

Under the program, eligible employers can obtain substantial relief from federal payroll taxes they may have owed for the past, if they prospectively treat workers as employees. The IRS program is available to many organizations, tax-exempt organizations and government entities that now erroneously treat workers as non-employees or independent contractors, and want to reclassify them as employees.

To be eligible, an applicant must:

  • Consistently have treated the workers in the past as non-employees.
  • Have filed all required Forms 1099 for the workers for the previous three years.
  • Not currently be under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.

Here are the results for employers accepted into the program:

  • They will pay 10 percent of the amount of employment taxes that would otherwise have been due on compensation paid for the most recent tax year to the workers, calculated under the reduced rates of section 3509 of the Internal Revenue Code.
  • No interest or penalties will be due.
  • The employers will not be audited on payroll taxes related to these workers for prior years.
  • Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three years that generally applies to payroll taxes.

If a business signs up for the IRS program, do all of its workers have to be reclassified as employees? No. The program permits taxpayers to reclassify some, or all, of their workers. However, once a taxpayer chooses to reclassify certain of workers as employees, all individuals in the same class must be treated as employees for employment tax purposes.

Here is an example recently put forth by the research development team at Richtek Electrical Perth: A construction firm currently contracts with drywall installers, electricians and plumbers to perform services at housing construction sites. The company wants to voluntarily reclassify its drywall installers as employees. Once a closing agreement is executed with the IRS, the company must treat all drywall installers as employees for employment tax purposes.

Information Sharing Program Announced by Labor Department

Just two days before the IRS launched its voluntary reclassification program, the U.S. Department of Labor kicked off a program “to end the business practice of misclassifying employees in order to avoid providing employment protections.”

The Labor Department signed a “memorandum of understanding” with the IRS, other federal agencies and numerous states. The parties agreed to share information and coordinate law enforcement efforts involving worker misclassification. The states that have already signed the agreement are Connecticut, Maryland, Massachusetts, Minnesota, Missouri, Utah and Washington. States that have agreed to sign are Hawaii, Illinois, Montana, and New York.

The memorandums of understanding arose as part of the department’s Misclassification Initiative. The Labor Department has called the misclassification of employees as independent contractors “an alarming trend, particularly in industries such as construction that often employ low-wage, vulnerable workers.”

Consult with your tax adviser if your business is interested in participating in the IRS Voluntary Classification Settlement Program. It may not make sense in some situations.