ISSUES & INSIGHTS's's

The IRS has announced a new pro-gram that allows eligible employers to voluntarily reclassify workers as employees, rather than independent contractors, for future tax periods. In exchange, the employers’ liability for past payroll tax obligations will be reduced to only a minimal payment. The Voluntary Classification Settle-ment Program (VCSP) is intended to increase tax compliance and reduce the tax and administrative burdens on employers with misclassified workers.

Employee vs. Independent Contrac-tor IssueAn employer enjoys several advan-tages when it classifies a worker as an independent contractor instead of an employee. For example, it isn’t re-quired to pay payroll taxes, withhold taxes, pay benefits or comply with most wage and hour laws. Independent contractors also are easier to terminate and typically don’t qualify for unem-ployment compensation.

However, there’s a potential downside: If the IRS determines that workers have been improperly classified as independent contractors rather than employees, the employer can be sub-ject to significant back taxes, interest and penalties.

According to the IRS, a worker isn’t an independent contractor unless the employer has the right to control or direct only the result of the work — as opposed to also controlling the de-tails of how the work is performed. To determine whether a worker is an

employee or an independent contractor, the IRS considers three categories of factors related to the degree of control and independence:

1. Behavioral. Does the employer control, or have the right to con-trol, what the worker does and how the worker does his or her job?

2. Financial. Does the employer control the business aspects of the worker’s job? For example, is the worker paid a salary? Does the employer reimburse the worker’s expenses? Does the employer provide the tools or supplies to do the job?

3. Type of relationship. Does the worker receive employee-type benefits? Will the relationship continue after the work is finished? Is the work a key aspect of the employer’s business?

In its announcement, the IRS acknowl-edged that the determination of the proper classification under these fac-tors may not always be clear.

For that reason, the IRS already of-fered the Classification Settlement Program (CSP), which allows qualified employers to prospectively reclassify workers as employees. However, the CSP is available only to employers undergoing an audit. The VCSP allows voluntary reclassification outside of the audit process and without the need to go through the normal administrative correction processes.

VCSP EligibilityThe VCSP is available to employers that currently treat their workers, or a class or group of workers, as indepen-dent contractors or other nonemploy-ees. To be eligible, the employer must

© 2011 Armanino McKenna LLP. All Rights Reserved.

IRS Offers Employers a Break on Misclassified Workers

ISSUES & INSIGHTS's's

have consistently treated the workers as nonemployees and have filed re-quired Form 1099s for the workers for the previous three years.

The employer cannot currently be under audit by the IRS or under audit concerning the classification of work-ers by the Department of Labor (DOL) or a state governmental agency. Em-ployers that were previously audited by the IRS or DOL on classification issues are eligible for the VCSP only if they complied with the audit’s results.

The employer isn’t required to reclas-sify all of its nonemployee workers as employees. But after an employer chooses to reclassify some of its work-ers, all workers in the same class must be treated as employees.

The Application ProcessEligible employers can apply for the VCSP by filing Form 8952, “Applica-tion for Voluntary Classification Settle-ment Program,” along with the name of a contact or authorized representa-tive with valid power of attorney. After the IRS has reviewed the application and verified eligibility, it will contact the employer or representative to com-plete the process.

If the application is accepted, the em-ployer will enter a closing agreement with the IRS to finalize the terms. The employer must make full and complete payment of any amount due when it returns the signed closing agreement.

The TermsIn exchange for reclassifying workers

as employees, the employer’s liability for past payroll obligations is cut to 10% of the employment tax liability that may have been due on compensa-tion paid to the workers for the most recent tax year, determined under Section 3509 of the Internal Revenue Code.

Under Sec. 3509, the tax rate for compensation up to the Social Security wage base ($106,800 for 2010 and 2011) is 10.68% in 2010 and 10.28% in 2011. The rate for compensation above the Social Security wage base is 3.24%. Because the amount due is based on compensation paid in the most recent tax year, the 10.68% rate applies under the VCSP in 2011, and the 10.28% rate applies in 2012. The 3.24% rate applies for both years.

The IRS provides the following example: Consider an employer that paid $1.5 million in 2010 to work-ers who are being reclassified, all of whom were compensated at or below $106,800. The employer submits its application on Oct. 1, 2011, and pro-poses to reclassify the workers begin-ning on Jan. 1, 2012. (The application must be filed at least 60 days before the desired reclassification date.) In that case, 2010 is the most recent tax year, so the employment taxes under Sec. 3509 would be $160,200 (10.68% of $1.5 million). Under the VCSP, the employer must pay only $16,020 (10% of $160,200).

In addition to enjoying significant tax savings, the employer won’t be liable for any interest or penalties and won’t

be subject to an employment tax audit on the classification of the workers in prior years. The employer will, how-ever, be subject to a special six-year statute of limitations on the assessment of employment taxes for the first three calendar years following the date of reclassification. This doubling of the usual three-year limit provides a strong incentive for employers to continue correctly classifying workers going forward.

Review your Worker Classifications NowJust days before announcing the VCSP, the IRS signed an agreement with the DOL to improve the coordination of their efforts to prevent employee mis-classification by sharing information and law enforcement. Labor commis-sioners and other agency leaders from seven states signed similar agreements with the DOL, and four other states are also scheduled to sign agreements.

With these agencies swapping informa-tion on employee misclassifications, your company must take greater care than ever to properly classify workers, because one agency investigation could easily trigger another. So the time to review your worker classifications is now. If your company needs help determining how to properly classify employees, please give us a call. We can also help you decide whether you could benefit from the VCSP.

If you need additional information re-garding this article, contact one of our tax experts at 925.790.2600 or through email at info@amllp.com.

© 2011 Armanino McKenna LLP. All Rights Reserved.