Employment Taxes
The IRS on September 21, 2011, unveiled a program that allows taxpayers to voluntarily reclassify independent contractors as employees and pay significantly reduced prior employment taxes (approximately 1% of one year’s worth of compensation), with no penalties or interest. The voluntary classification settlement program (VCSP) is part of a larger IRS “fresh start” initiative to help taxpayers address their tax responsibilities.
The VCSP is meant to encourage voluntary compliance with worker classification rules and signals an increased IRS focus on the issue. Just two days before announcing the program, the IRS and Department of Labor (DOL) stepped up enforcement efforts by signing a memorandum of understanding to strengthen information sharing on enforcement actions aimed at misclassified workers. Several states are also parties to the memorandum of understanding.
The VCSP is detailed in Announcement 2011-64, News Release IR 2011-95, and in frequently asked questions on the IRS website.
Worker Classification
Determining whether a worker is an independent contractor or employee for federal tax purposes is generally based on a common-law test that considers the facts and circumstances of the relationship. The primary criterion is the degree of control that can be exercised over the worker as to how to perform the services, regardless of whether the control is actually exercised.
The determination has important consequences for employment taxes. Employers are required to pay a 1.45% Medicare tax and 6.2% Social Security tax against employee wages. Employees pay Medicare tax and Social Security tax at these same rates, except that the employee Social Security tax rate was reduced to 4.2% for 2011. (At the time this item went to press, Congress had extended the reduced rate through February 29, 2012.) In 2012, Social Security tax applies up to an inflation-adjusted annual wage cap of $110,100 ($106,800 in 2011).
For independent contractors, taxpayers report payments for services to workers on a Form 1099-MISC, Miscellaneous Income, and pay no employment taxes. Workers are then responsible for paying self-employment taxes.
A taxpayer that the IRS determines under audit to have misclassified workers as independent contractors may be subject to previously unpaid employer and employee employment taxes, income tax withholding, penalties, and interest. If the misclassification was not due to intentional disregard to treat workers as employees, then the taxes are determined under Sec. 3509, which provides lower rates for income tax withholding and the employee shares of Social Security and Medicare taxes. A lesser reduction may apply to taxpayers that failed to issue Forms 1099-MISC.
VCSP Requirements
The VCSP is available for taxpayers who are currently treating workers or a class or group of workers as independent contractors but want to prospectively reclassify them as employees for federal employment tax purposes. Under the VCSP, a taxpayer does not have to reclassify all of its workers who are currently treated as nonemployees. However, once a taxpayer chooses to reclassify some of its workers as employees, it must reclassify all workers in the same class. A class of workers includes all workers who perform the same or similar services.
Example 1: ABC Co. is a construction company that contracts with its drywall installers, electricians, and plumbers to perform services at its construction sites. ABC treats these individuals as independent contractors, so it does not withhold or pay employment taxes on the compensation paid to the contractors. ABC determines that it wants to voluntarily reclassify the plumbers as employees under the VCSP. The VCSP requires ABC to treat all the plumbers as employees, but it does not require ABC to treat the drywall installers and electricians as employees.
To be eligible for the VCSP, taxpayers must:
- Consistently have treated the workers as nonemployees;
- Have filed all required Forms 1099 for the workers for the previous three years; and
- Not currently be under any IRS audit (regardless of whether the audit has identified worker classification as an issue) or under a worker classification audit by the DOL or a state agency.
As a result of the audit condition, large companies that are continually under audit by the IRS are effectively locked out of participation in the VCSP. If any member of a consolidated group of companies is under audit, the entire consolidated group is considered under audit. A taxpayer that was previously audited by the IRS or DOL concerning the classification of workers will be eligible for the VCSP only if the taxpayer has complied with the results of the audit.
Tax-exempt organizations and state and local governments may also be eligible. However, the VCSP is not available to state and local government employers that have employees covered by an agreement under Section 218 of the Social Security Act, i.e., a voluntary agreement between the state or local government and the Social Security Administration to provide Social Security and Medicare coverage or Medicare-only coverage for state and local employees.
Taxpayers apply for the program by filing Form 8952, Application for Voluntary Classification Settlement Program. The Form 8952 must be filed at least 60 days before the taxpayer wants to begin treating the workers as employees. The IRS reviews the Form 8952 and retains discretion over whether to accept the taxpayer into the program. Taxpayers must enter information about the workers on the Form 8952, including the number of workers and a description of the class or classes of workers to be reclassified.
Once the IRS accepts the taxpayer into the VCSP, the IRS will contact the taxpayer to enter into a VCSP closing agreement, under which the taxpayer must agree to extend the statute of limitation from three years to six years for the first three calendar years beginning after the closing agreement is signed. The taxpayer must also agree to treat the class or classes of workers as employees for future tax periods. If the IRS determines that the taxpayer is not eligible for the VCSP, the Service will notify the taxpayer that the application has been rejected.
The VCSP requires a payment of just over 1% of the compensation paid to the reclassified workers for the calendar year preceding the year in which the Form 8952 is filed. The payment is equal to 10% of the amount of employment taxes calculated under the reduced rates of Sec. 3509. Under Sec. 3509, the effective tax rate for wages up to the Social Security wage base was 10.28% in 2011. A 3.24% tax rate applies to the individual’s wages in excess of the wage base. Thus, taxpayers who apply to participate in the program in 2012 will generally pay taxes of only 1.028% of total compensation paid to the reclassified workers during 2011. For wages over the Social Security cap, taxpayers will pay 0.324%.
Example 2: ABC Co. files a Form 8952 in 2012 to apply for participation in the VCSP. The tax payable under the VCSP is based on the compensation paid to the reclassified workers during 2011, using the 2011 Sec. 3509 tax rates. In 2011, ABC paid $1,500,000 to workers who are being reclassified under the VCSP. Some of the workers were compensated above the 2011 Social Security wage base ($106,800) in the amount of $250,000. Under Sec. 3509, the employment tax applicable to $1,250,000 (the amount paid equal to or less than the wage base) is $128,500 (10.28% of $1,250,000). The employment tax applicable to the other $250,000 (i.e., the amount in excess of the wage base) is $8,100 (3.24% of $250,000). The tax payable under the VCSP is 10% of $136,600 ($128,500 + $8,100), or $13,660.
The taxpayer will not owe any interest and penalties and will not be subject to a federal employment tax audit on the workers for prior years. Currently, there is no expiration date for the VCSP.
Benefits of Participation in VCSP
One of the key benefits of the VCSP is the substantially reduced cost for reclassifying workers. The rules for determining whether a worker is an employee or contractor are complex and generally involve weighing the facts and circumstances of an employer relationship against a long list of factors, including the degree of control the taxpayer can exert over the workers. The uncertainty associated with applying the test can leave taxpayers exposed to the possibility of substantial future tax liability. Therefore, taxpayers who feel that they are at risk of losing a challenge on the issue may want to use the program.
In addition to financial considerations, taxpayers should consider whether a decision not to participate in the VCSP may increase their risk in the future. Now that the IRS offers the VCSP, it may not be very tolerant in future audits when it discovers misclassification situations. In addition, as the issue of worker classification gathers more publicity as a result of the VCSP and increasing government focus on the issue, workers who become aware of it and are classified as independent contractors may start to raise issues. They may even voice concerns to the IRS about their classification. The IRS already has a formal process for this and has used it to launch audits and inquiries into worker classification issues. Specifically, a worker can file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS to ask it to evaluate his or her classification with respect to prior periods (but not the future).
Another reason for taxpayers to consider participation in the VCSP relates to health care reform. Starting in 2014, an employer with an average of 50 or more full-time employees is subject to a penalty if at least one full-time employee qualifies for health care financial assistance from the federal government (Sec. 4980H). If that is the case, the employer will pay a penalty of $166.67 per month for all full-time employees in excess of 30. Thus, if a taxpayer classifies even one worker as an independent contractor and does not provide health care coverage to the worker, and the IRS successfully asserts that the worker is an employee, this penalty could apply for a large number of employees.
Potential Pitfalls of Participation in VCSP
Reclassifying workers as employees for federal employment tax purposes could raise worker relations issues. Taxpayers will presumably want to discuss reclassification with workers before filing under the VCSP, rather than unilaterally deciding to reclassify them. Even if the workers agree to the reclassification, they may later assert that they had rights to participate in the taxpayer’s benefit plans in prior years.
Taxpayers who are considering participation in the VCSP should consider the costs of reclassifying a worker as an employee, above and beyond the amount payable to participate in the VCSP. These costs include future employment taxes and that the workers may then be eligible to participate in the taxpayer’s health and welfare plans and retirement plans. In addition, the taxpayer will then be required to comply with wage and hour laws with respect to the workers, as well as various other employment laws, which may result in higher costs. Taxpayers must also consider potential legal liabilities associated with employees. For example, negligent acts by an employee may result in greater liability for the employer than those by an independent contractor.
Taxpayers should also consider Section 530 of the Revenue Act of 1978. Section 530 shields a taxpayer that has mistakenly classified workers as independent contractors from employment tax liability if the taxpayer had a reasonable basis for not treating the workers as employees and has filed all required federal employment tax returns on a basis consistent with this treatment. A taxpayer is treated as having a reasonable basis for not treating an individual as an employee if the taxpayer reasonably relied on any of the following: (1) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer; (2) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment (for employment tax purposes) of the individuals holding positions substantially similar to the position held by this individual; or (3) long-standing recognized practice of a significant segment of the industry in which the individual was engaged.
Congress enacted Section 530 to alleviate what it perceived as the overly zealous pursuit and assessment of taxes and penalties against taxpayers who had in good faith misclassified their employees as independent contractors. Taxpayers who feel that they have Section 530 protection are likely to feel little or no need to participate in the VCSP.
Participants in the VCSP may be concerned that the IRS will notify and share information with other agencies concerning the taxpayer’s participation in the VCSP, which may raise the likelihood of audit by the other agencies. In frequently asked questions posted on the IRS’s website, the IRS said that it will not share information about the VCSP with the DOL or with state agencies. The IRS also stated that it will not make any determination regarding the employment status of workers for prior years and that taxpayers are not making any representation as to a worker’s proper status for prior years for federal employment tax purposes. However, if a state selects a taxpayer for audit and that taxpayer has participated in the VCSP, the state may take the position that VCSP participation constitutes an admission of guilt by the taxpayer with respect to the prior classification of the workers for state employment tax purposes; this could open the door for substantial penalties assessed by the state.
Conclusion
The rules surrounding whether a worker is an employee or independent contractor are complex and, in many instances, difficult to apply. This leaves taxpayers uncertain about whether they have properly classified workers as independent contractors. Taxpayers are concerned about the potentially substantial penalties that may be imposed for misclassifying workers. The VCSP allows these taxpayers to reclassify workers at an initial cost that is much less than the potential penalties that may follow an IRS examination. However, taxpayers should consider all of the effects, including future costs and potential liabilities, of reclassifying a worker as an employee before making a final determination of the merits of participating in the VCSP.
EditorNotes
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@us.gt.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.
