Determining proper classification of workers, either as independent contractors or employees, can certainly be subjective and a challenge for employers. The determination of whether a worker is an employee or an independent contractor is based on the facts and circumstances surrounding the individual’s work for the employer. Generally, the more the employer is able to control and direct the worker, the more likely the worker should be classified as an employee. Furthermore, employment taxes are a significant source of revenue for the federal government; improper worker classification contributes to the tax gap, and so taxpayers face heavy scrutiny. Two IRS programs are designed to close the tax gap for federal employment taxes: National Research Program employment tax audits and the Voluntary Classification Settlement Program (VCSP).
IRS National Research Program Employment Tax Audits
The IRS National Research Program (NRP) began in 2000 to measure the difference between taxes voluntarily reported and paid by taxpayers compared with taxes the IRS has determined are actually due (commonly referred to as the “tax gap”). In the fall of 2010, the IRS expanded the NRP to include employment tax audits of thousands of randomly selected businesses. NRP audits are conducted by trained IRS examiners, and the scope of an NRP employment tax audit includes mandatory, required, and potential employment tax issues. Potential employment tax issues include worker classification. Therefore, NRP employment tax audits are intended, in part, to identify and resolve worker classification issues and bring noncompliant taxpayers into compliance with federal employment tax reporting.
As any taxpayer who has been selected for audit knows, the process can be time-consuming and costly. Worker classification issues uncovered in an audit can lead to costly assessments of past employment taxes, penalties, and interest for reclassified employees. Nontax exposure, such as reclassified workers’ benefit provisions, may also exist. Representatives and practitioners serving taxpayers at risk for worker reclassification should carefully consider the alternatives available to assist taxpayers in becoming compliant. One alternative is the Voluntary Classification Settlement Program (VCSP).
Voluntary Classification Settlement Program
In line with the IRS’s recent move toward voluntary taxpayer compliance, and, as part of its larger Fresh Start program, the IRS established the VCSP. The VCSP was initially established in 2011 (see Announcement 2011-64) and was most recently modified in Announcement 2012-45. The IRS reports that the VCSP has been well-received, and the IRS has received feedback from taxpayers and their representatives regarding certain requirements for participation in the program. The modifications contained in Announcement 2012-45 are a direct result of that feedback.
Before the VCSP was established, only taxpayers under audit could resolve worker classification issues and obtain relief from federal employment taxes through the IRS’s Classification Settlement Program (CSP). Similar to the Offshore Voluntary Disclosure Program (OVDP), which offers reduced penalties for taxpayers that may have violated foreign account disclosure requirements, the IRS established the VCSP to allow taxpayers to come into compliance prospectively while obtaining generous relief from liability for past federal employment taxes. In exchange for voluntary compliance and reclassification of workers as employees, the taxpayer receives the following relief:
1. The taxpayer pays 10% of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year (determined under the reduced rates of Sec. 3509(a));
2. The taxpayer is not liable for any interest and penalties on the liability; and
3. The taxpayer is not subject to an employment tax audit of the worker classification of the class or classes of workers for prior years.
Taxpayer Eligibility for VCSP
Announcement 2012-45 restates which taxpayers are eligible to participate in the VCSP. To participate in the program, a taxpayer must:
1. Want to voluntarily reclassify certain workers as employees for federal income tax withholding, Federal Insurance Contributions Act (FICA), and Federal Unemployment Tax Act (FUTA) purposes for future tax periods;
2. Be presently treating the workers it wants to reclassify as nonemployees;
3. Have filed all required Forms 1099 for each worker to be reclassified for the three preceding calendar years (or the period of time the worker worked for the taxpayer) ending before the date the taxpayer applies to participate in the VCSP;
4. Have consistently treated the workers as nonemployees;
5. Not be under IRS examination for employment taxes (if a member of an affiliated group, no member of the affiliated group can be under examination);
6. Not be under examination by the U.S. Department of Labor (DOL) or any state agency regarding classification of employees;
7. Not be contesting in court worker classification from a previous IRS or DOL audit; and
8. Either not have been examined previously by the IRS or DOL regarding classification of employees or have complied with the results of any prior examination.
Announcement 2012-45 modified the prior rules to permit a taxpayer under IRS audit, other than an employment tax audit, to be eligible to participate in the VCSP. In addition, Announcement 2012-45 eliminated the earlier requirement that a taxpayer agree to extend the period of limitation on assessment of employment taxes as part of the VCSP closing agreement. These modifications favor the taxpayer and further encourage participation in the VCSP.
To participate in the VCSP, eligible taxpayers must apply by filing Form 8952, Application for Voluntary Classification Settlement Program.
VCSP Temporary Eligibility Expansion
Announcement 2012-46 allowed taxpayers who were otherwise eligible, but had not filed all required Forms 1099, to apply for a modified version of the VCSP. This modified version was available only through June 30, 2013. Like the VCSP, the VCSP Temporary Eligibility Expansion allowed eligible taxpayers to voluntarily reclassify their workers as employees for FUTA purposes and obtain relief. Relief under the VCSP Temporary Eligibility Expansion differed from the VCSP as follows:
1. The taxpayer pays 25% instead of 10% of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year; and
2. The taxpayer pays a reduced, graduated penalty for unfiled Forms 1099 for the previous three years for the workers being reclassified (maximum stated penalty based on the number of nonfiled Forms 1099).
Announcement 2012-46 includes a worksheet detailing how the penalty for unfiled Forms 1099 was calculated under the temporary program.
Taxpayers seeking to participate in the VCSP Temporary Eligibility Expansion had to apply by submitting Form 8952 on or before June 30, 2013.
Taxpayers Under Audit and the Classification Settlement Program
There is still hope for partial relief for taxpayers who are currently under audit for employment taxes and cannot participate in the VCSP. The Classification Settlement Program (CSP) is available to taxpayers currently undergoing an employment tax audit. The relief under the CSP is similar to the VCSP and allows taxpayers and tax examiners to resolve worker classification cases as early in the administrative process as possible. Taxpayer representatives whose clients risk worker reclassification during an audit should consider discussing the CSP with the tax examiner to determine whether early settlement and partial relief may be available.
Considering the favorable relief available under the VCSP, taxpayers at risk for worker reclassification should consider the benefits of applying for and participating in the program. Participating in the program not only provides relief from penalties, but also provides taxpayers with a higher level of certainty about the proper classification of their workers.
A word of caution is in order, though. Most states do not coordinate with the IRS’s VCSP. As a result, state tax treatment of taxpayers who voluntarily participate in the federal program is uncertain.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, Texas. Amy Lehmkuhl is a principal with Ueltzen & Co. LLP in Sacramento, Calif. Prof. Chambers and Ms. Lehmkuhl are members of the AICPA IRS Practice & Procedures Committee. For more information about this column, contact Prof. Chambers at valrie.chambers@ tamucc.edu.