If the situation is not clear, with opposing arguments for treating a worker as an employee or as an independent contractor, a business (and the practitioner) faces a dilemma. It can reclassify the worker as an employee and risk triggering an audit and resulting penalties. Alternatively, the business may decide to not reclassify the worker and attempt to strengthen the case for independent contractor status.
The business can simply reclassify an independent contractor as an employee. While this strategy cuts the losses for future assessments, it may risk a tax audit, an employee lawsuit for forgone employee benefits, or both. While the IRS may view such a change in status as an admission of employer wrongdoing, the business can counter by maintaining the relationship has changed. When reclassifying a worker as an employee, the business should:
- Change the terms of the relationship to exercise more control: The business should first document the arguments for the business's prior treatment of the worker as an independent contractor. Then, the business should document how current changes in the relationship alter the worker's status.
- Consider making the reclassification effective Jan. 1: This tactic avoids the worker's receipt of both a Form 1099 and a Form W-2 from the same company in the same year. However, using this date may not make the change in worker classification between years less noticeable or reduce the chances of employee lawsuits (for lost overtime, etc.).
Example 1. Reclassify the worker as an employee: G Corp. treats all of its computer programmers as independent contractors. On Sept. 1, 2015, G determines that Programmer X arguably does not qualify as an independent contractor. Under the terms of X's contract (which was renegotiated several months ago), G sets X's hours, pays his expenses, and pays him a guaranteed minimum salary (although X also receives a significant royalty if his software is successful). G's controller decides that, rather than risk significant additional tax assessments and penalties, he wants to reclassify X as an employee for all future years.
First, G should document its prior treatment of X and its arguments for independent contractor treatment during that period. Then, G should describe the recent changes in X's employment relationship that have created an employee role. X's recently renegotiated contract seems to be the pivotal point around which the change in classification should be centered. A memo to the file discussing the employment changes resulting from the renegotiated contract may prove helpful later if the IRS inquires about the matter. The shift to employee status should be prefaced by a written offer of employment that highlights X's additional responsibilities as an employee and informs X of new work policies he is obligated to follow as an employee.
Next, G should consider making the reclassification effective Jan. 1, 2016. (September is late in the calendar year, and no federal income tax withholding or Federal Insurance Contributions Act withholding or payments would have occurred during the first eight months of 2015.) By waiting until Jan. 1, 2016, G avoids X's receipt of both a Form 1099 and Form W-2, Wage and Tax Statement, from the same company in the same year.
Maintain Contractor Status and Strengthen Position
Rather than change the worker's tax status and risk tax audits and employee lawsuits, the business may instead decide a reasonable basis exists for treating a worker as an independent contractor. In doing so, the business may want to continue treating the worker as an independent contractor while taking steps to strengthen the evidence supporting its position.
The strategy to strengthen the evidence supporting the business's position should include establishing that the business has relinquished control over how the work is performed. If the IRS audits the business within three years of the relinquishment of control, the business may find defending its prior position difficult, since audits focus on the past rather than the present and future relationship.
Example 2. Maintain contractor status and strengthen position: Assume the same facts as in Example 1; however, G's controller decides a defensible position exists for retaining X's independent contractor classification and wants to strengthen G's support for it. One way to do this is to renegotiate X's contract to remove some elements of G's control over his duties and activities. For example, G could forgo its right to set X's hours in exchange for his promise to be available on an as-needed basis. Or G might attempt to convince X to forgo his guaranteed minimum salary in exchange for a higher royalty percentage. G should also specify independent contractor status in X's contract and maintain separate vendor files for its transactions with him.
Voluntary Classification Settlement Program
In 2011, the IRS rolled out the Voluntary Classification Settlement Program (VCSP), which allows employers to voluntarily reclassify workers as employees, which it later modified in December 2012 in Announcement 2012-45. To be eligible, a business must have consistently treated the workers as nonemployees and must have filed all required Forms 1099 for the workers for the previous three years. The business cannot currently be under an employment tax audit by the IRS or be involved in an audit by a state labor department addressing worker classification. The reclassification has long-term consequences as the employer must agree to prospectively treat the class of workers as employees for future tax periods.
The VCSP permits taxpayers to reclassify some or all of their workers. However, once a taxpayer chooses to reclassify certain workers as employees, all workers in the same class must be treated as employees for employment tax purposes.
A business that reclassifies workers under the VCSP must pay 10% of the employment tax liability that would have been due on wages paid to the workers for the most recent tax year using the rules in Sec. 3509.
This case study has been adapted from PPC's Tax Planning Guide—Closely Held Corporations, 28th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.