IRS Provides Program for Voluntary Reclassification of Independent Contractors as Employees

November 9, 2011

The IRS and employers have dramatically different interests in the classification of workers.  From the perspective of potential liability for the worker’s actions, as well as from the perspective of the restrictions around discipline and termination and the cost of employee benefits, the employer has fewer costs and more flexibility if the worker is an independent contractor.  The IRS is more likely to collect the correct amount of income and employment tax and to collect tax sooner if the worker is classified as an employee.

In an effort to persuade employers to reclassify workers as employees, the IRS this fall announced a Voluntary Classification Settlement Program (the “VCSP”) under which an employer may apply to reclassify independent contractors as employees.  The “carrot” is a reduction in the amount of uncollected tax for which the employer is responsible.

The employer is responsible for all unpaid income and employment tax if the IRS successfully establishes that a worker the employer treated as an independent contractor is an employee. So, if the independent contractor failed to pay income tax and the 15.3% self-employment tax, the employer is liable for that tax, plus interest and penalties.  Under the VCSP the employer is liable for a small amount of tax (described below) and is not subject to interest and penalties on that tax.

What is the result of voluntary reclassification?

  • The employer pays an amount equal to 10% of the employment tax that would have been due on the reclassified workers’ compensation in the employer’s most recently completed tax year.  The IRS estimates that the amount will be 1% of the compensation.
  • The employer is not liable for interest and penalties on the 10% amount.
  • The IRS will not audit the employer for prior years for employment tax on the reclassified workers.
  • The statute of limitations for employment tax audits for the employer will be six years instead of three years for each of the first three years after the reclassification.

What is the deadline for participating in the VCSP?

  • Currently, there is no termination date for the program.  Application to participate should be made at least 60 days before the date the employer wishes to start treating the workers as employees.

What makes an employer eligible to participate in the VCSP?

  • The employer must have consistently treated the workers in the class of workers to be reclassified as independent contractors.
  • The employer must have filed all required Forms 1099 for the workers for the previous three years.
  • The employer must not currently be under any audit by the IRS, and must not currently be under audit concerning the classification of workers by the Department of Labor (the “DOL”) or any state government agency.
  • The employer must have complied with the results of any previous audit by the IRS or DOL concerning the classification of workers.

How does the employer apply to participate in the VCSP?

  • The employer files a Form 8952 (instructions found here)  and, if the employer will be represented by outside counsel, a Form 2848 Power of Attorney.
  • If the IRS determines the employer meets the eligibility requirements and the employer is accepted into the VCSP, the employer will enter into a closing agreement with the IRS to finalize the terms of the VCSP and simultaneously pay the tax required.

Planning Point

Commentators are stressing that an employer needs to weigh carefully the tax and non-tax costs of participating in the VCSP.  In addition to liability, DOL and employee benefits ramifications, the employer needs to consider the impact of participation on its state law treatment of workers and possible reactions by employees (including possible claims based on  past treatment as independent contractors).  Employers who have a strong position that their treatment of workers as independent contractors is supported by industry practice and meet the other requirements for Section 530 relief from reclassification of workers as employees will be less likely to participate than those who do not qualify for relief under Section 530.