The proper classification of workers as employees or independent contractors is a constant source of friction between employers and the IRS.
The IRS has announced changes to the program that offer incentives to employers that have misclassified employees as independent contractors. Some employers who have not been filing required information returns will have to act by June 30, 2013, to take advantage of a reduced penalty offer.
Employers are required to withhold income taxes and FICA (Social Security and Medicare) taxes from employees, pay the employers’ share of the FICA taxes and pay federal and state unemployment taxes. Employers provide a Form W-2, Wage and Tax Statement, to the employee and to the IRS, reporting the employee’s compensation and withholding.
Independent contractors are responsible for paying their own income taxes. In addition, they may be required to pay self-employment tax – the equivalent of both the employee’s and the employer’s share of FICA taxes. The service recipient is supposed to provide independent contractors and the IRS with a Form 1099-MISC, Miscellaneous Income, reporting income of $600 or more paid to the contractor.
If the IRS determines that a worker has been inappropriately classified as an independent contractor, it can assess the employer for unpaid taxes plus interest and penalties for all years open for assessment, generally the current year and the prior three years.
In more recent years, and in two new announcements issued at the end of last year, the IRS has tried to encourage more employers to voluntarily correct their worker misclassifications.
After a 1978 change in the tax law intended to provide relief from prior employment tax liability for employers who misclassified workers as independent contractors using the common law facts and circumstances standards, the IRS developed the Classification Settlement Program. This program did little to encourage voluntary compliance since it was available only to enterprises under IRS audit.
In September 2011, the IRS announced a Voluntary Classification Settlement Program (VCSP) to encourage employers to voluntarily reclassify workers as employees outside of the audit process. The benefits of participating in the VCSP include:
- The required payment is only 10 percent of the additional employment tax liability that would have been due for the most recent tax year.
- No interest or penalties apply.
- No employment tax audit of the affected class of workers will be performed for prior years.
In a recent announcement (Announcement 2012-45), the IRS relaxed the eligibility requirements for the VCSP by allowing most businesses under IRS audit (other than an employment tax audit) to participate. The announcement also removes a requirement that the limitations period on assessment be extended as a condition of entering into a VCSP closing agreement.
However, many enterprises will still not qualify for the VCSP if they have not filed all required 1099 forms.
In a companion announcement (Announcement 2012-46), the IRS has temporarily modified the eligibility requirements for the VCSP to allow enterprises that have not filed all necessary 1099 forms to participate in a slightly modified version of the program, provided they file the required 1099 forms with the IRS and provide copies to the workers for the prior three years. This program is called the VCSP Temporary Eligibility Extension (VCSP-TEE).
Also, an enterprise that was previously audited by the IRS or the Department of Labor concerning the classification of the class of workers that is the subject of the VCSP-TEE is eligible to participate in this extension program if the enterprise has complied with the results of the audit and is not currently contesting the classification in court.
Under the modified terms of the VCSP-TEE, the enterprise must:
- Treat the class of workers identified in the application as employees going forward.
- Pay 25 percent of the employment taxes that would have been paid for those employees during the prior year.
- Pay a reduced penalty as specified in the announcements for failure to file all required 1099 forms for the prior three years.
The VCSP-TEE is available through June 30, 2013. Enterprises that meet the eligibility requirements can apply to participate by submitting Form 8952, Application for Voluntary Classification Settlement Program (VCSP), to the IRS by June 30, 2013, and writing "VCSP Temporary Eligibility Expansion" across the top of the form. Modified instructions for completing the form are contained in the new announcements.