Classifying a worker as an independent contractor can be costly if IRS is successful in reclassifying that worker as an employee. The business potentially may owe back employment taxes, penalties and interest on that worker’s compensation for the most recent three tax years, the usual period during which IRS may assess additional taxes. The employment taxes are composed of the employer’s and employee’s shares of the FICA tax, the FUTA tax and the income tax the business should have withheld from the employee.
To understand the significance of the VCSP, it is helpful to review the options available to businesses with classification issues before the VCSP. Section 3509 of the Internal Revenue Code of 1986 provides some relief to the taxes that otherwise would be imposed when a worker is reclassified. The Classification Settlement Program (CSP) for businesses undergoing an IRS employment tax examination also provides relief, but does not apply to businesses not under an employment tax examination. The VCSP builds on both Section 3509 and the CSP.
Section 3509. To ameliorate the harsh treatment that results from reclassifying an independent contractor as an employee, Section 3509 reduces an employer’s liability for federal income tax withholding and the employee portion of the FICA tax where the employer failed to deduct and withhold those taxes because it treated the employee as a nonemployee (e.g., an independent contractor). The liability is reduced from the amount the employer was required to withhold to 1.5% of the employee’s wages for federal income tax withholding, and from 7.65% of the employee’s wages to 20% of such amount for the employee’s portion of the FICA tax. If the employer failed, without reasonable cause, to comply with applicable information reporting requirements consistent with the treatment of the employee as a nonemployee (e.g., filing a Form 1099-MISC, Miscellaneous Income), the percentages are doubled so that the employer pays 3% of the employee’s wages for federal income tax withholding and 40% of the amount of the employee’s FICA tax (i.e., 40% of 7.65% of the employee’s wages).
An employer must meet several requirements to be eligible to apply Section 3509 rates. The employer must have treated the worker as a nonemployee for purposes of both income tax withholding and FICA tax. Thus, if the employer withheld federal income tax but did not withhold the employee’s share of FICA tax, Section 3509 rates are not available. The employer must also have treated the worker as a nonemployee for purposes of information reporting. Thus, if the employer filed a Form W-2, Wage and Tax Statement, with respect to such employee, Section 3509 rates are not available. Further, if the employer intentionally disregarded the deduction and withholding requirements, the reduced rates do not apply, and the employer is liable for the full taxes that should have been withheld.
Classification Settlement Program. IRS established the Classification Settlement Program (CSP) a number of years ago to allow businesses and IRS to resolve worker classification cases as early in the examination process as possible. The CSP is available for businesses under examination, but is not available for businesses that voluntarily want to reclassify workers. Under the CSP, a series of graduated settlement offers are available.
- If the business meets the reporting consistency requirements of Section 530 of the Revenue Act of 1978 but either clearly does not meet the Section 530 substantive consistency requirement or clearly can not meet the Section 530 reasonable basis test, the offer will be a full employment tax assessment for one taxable year under examination, computed using Section 3509, if applicable.
- If the business meets the consistency reporting requirements and has a colorable argument that it meets the substantive consistency argument and the reasonable basis test, the offer will be an assessment of 25% of the employment tax liability for one taxable year under examination, computed using Section 3509, if applicable.
- In each instance, the business must agree to properly classify the workers prospectively, thus ensuring future compliance.
The settlement is done on the basis of each class of worker. Thus, the business and IRS could agree that one class of workers is independent contractors and another class is employees.
While the CSP has been a valuable tool for resolving worker classification cases under examination, it does not apply if a business wants to voluntarily reclassify certain workers as employees.
A business may decide to voluntarily reclassify a certain class of workers it is treating as independent contractors because its classification is subject to challenge by IRS. A business may also decide to reclassify a certain class of workers after receiving a letter from IRS, in response to a Form SS-8 inquiry, informing the business that IRS believes a particular worker or workers in a particular class are employees. Under IRS’s determination of worker status program, either a worker or a business can submit a Form SS-8 requesting IRS to determine a worker’s status for federal employment tax and income tax withholding purposes. When IRS receives a Form SS-8 from either a worker or business, it gives the other party an opportunity to respond. It will then send both parties a letter explaining its decision.
If IRS sends a business a letter stating that it believes a particular worker is an employee, and not an independent contractor, it will inform the business how to correct its treatment of the worker as an independent contractor. Because the determination in response to the Form SS-8 does not constitute an examination, the business is not obligated to correct its classification. If the business does want to correct the misclassification, however, it can not avail itself of the more favorable rates provided in the CSP.
Voluntary Classification Settlement Program. Because businesses can not avail themselves of the CSP if they want to voluntarily correct a potential misclassification, or want to comply with IRS’s determination of a worker’s classification in response to a Form SS-8, and to encourage voluntary compliance, IRS is now providing the VCSP. To be eligible for the VCSP, a business:
- must have filed all Forms 1099 for the workers for the previous three years;
- can not currently be under examination by IRS; and
- can not currently be under examination concerning the classification of workers by the Department of Labor or by a state government agency.
A business that was previously examined by IRS or the Department of Labor concerning the classification of the workers will be eligible only if the business has complied with the results of the examination.
A business will receive the following benefits from participating in the VCSP:
- it will pay 10% of the employment tax liability that may have been due on compensation paid to workers for the most recent tax year;
- the liability will be determined under the reduced rates of Section 3509;
- it will not be liable for any interest or penalties on the liability; and
- it will not be subject to an employment tax examination with respect to the worker classification of the workers for prior years.
The business will be required to enter into a closing agreement with IRS and to treat the class of workers subject to the VCSP as employees for future years. In addition, the business will be required to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.
To participate in the VCSP, an eligible business must complete and submit an application, using Form 8952, Application for Voluntary Classification Settlement Program. The application should be filed at least 60 days from the date the business wants to begin treating the workers as employees. As with the CSP, the VCSP is done on the basis of each class of workers. Once a business chooses to reclassify certain of its workers as employees, however, all workers in the same class of workers must be treated as employees for employment tax purposes.
IRS has posted the following information to its webpage:
For other articles on worker classification, see:
The VCSP is a very positive development for businesses that want to eliminate potential exposure for the classification of certain workers. McGuireWoods LLP has substantial experience in addressing worker classification issues and can assist businesses with the VCSP or other employment tax issues they may have.