IRS Expands Voluntary Tax Program for Misclassified Workers

The IRS recently announced that it is expanding the “Voluntary Classification Settlement Program” (VCSP) so that it is available to more employers. (IR-2013-23) Under the VCSP, employers agree to reclassify workers as employees for future payroll tax purposes. However, before an employer jumps at the chance, it is important to consider the risks involved in participating in this — or a similar — IRS relief program.

The VCSP helps address a long-standing problem concerning the tax treatment of workers who are not clearly “independent contractors” or “employees.” Generally, employers are pre-disposed to treat borderline workers as independent contractors, rather than employees, to avoid paying payroll taxes and providing fringe benefits that are otherwise available to all eligible employees.

Thus, the IRS and employers often square off in court over classifications.

Background: As the name implies, the VCSP is a voluntary program giving employers the opportunity to reclassify workers as employees for payroll tax purposes in the future. In return, employers may benefit from partial tax relief. To participate in the VCSP, an employer must meet certain eligibility requirements and apply by filing an IRS form. Also, the employer is required to enter into a closing agreement with the tax agency.

Under the VCSP, an employer pays 10 percent of the amount of payroll taxes that would have been due on compensation paid to the workers being reclassified for the most recent tax year, calculated under reduced rates. In addition, the employer isn’t liable for any interest and penalties on payments made through the VCSP. Finally, and perhaps most significantly, an employer participating in the program will not be audited for payroll tax purposes for prior years with respect to worker classifications.

To be eligible for the VCSP, an employer must:

  • Currently be treating the workers as non-employees;
  • Consistently have treated the workers in the past as non-employees, including having filed required Forms 1099; and
  • Not currently be under audit on payroll tax issues by the IRS. In addition, the employer can’t currently be under audit by the Department of Labor or a state agency concerning the classification of these workers or contesting the classification of the workers in court.

The IRS says that almost 1,000 employers have applied for the VCSP. (The program is open to not-for-profit organizations and government entities in addition to for-profit employers.) And the tax agency now it is extending an olive branch to employers that may have otherwise been barred from the program.

Key changes: Under the new modifications announced by the IRS, an employer currently undergoing an IRS audit (other than a payroll tax audit) can still qualify for the VCSP. Furthermore, employers accepted into the program will no longer be subject to a special six-year statute of limitations, rather than the usual three-year period that normally applies to payroll taxes.

Generally, employers are barred from the VCSP if they failed to file required 1099s with respect to workers they are seeking to reclassify for the past three years. However, for a limited time period — specifically, until June 30, 2013 — the IRS is waiving this eligibility requirement. Employers may want to move fast to take advantage.

Employers accepted into the program can usually expect to pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. However, employers applying for the temporary relief program available for those who failed to file Forms 1099 will have to pay a slightly higher amount, plus some penalties. These employers will also need to file any unfiled 1099s for the workers they are seeking to reclassify.

Do You Need a “Fresh Start?”

The announcement from the IRS that it is expanding the VCSP comes on the heels of recent modifications to the “Fresh Start” program. This program is designed to help individuals and small businesses meet their tax obligations without adding unnecessary burdens.

Recent changes to the Fresh Start program include:

  • Significantly increasing the dollar threshold when liens are generally issued, resulting in fewer tax liens;
  • Making it easier for taxpayers to obtain lien withdrawals after paying a tax bill;
  • Withdrawing liens in most cases where a taxpayer enters into a Direct Debit Installment Agreement;
  • Creating easier access to Installment Agreements for more struggling small businesses; and;
  • Expanding a streamlined Offer in Compromise program to cover more taxpayers.

As with the VCSP, it is recommended that taxpayers weigh all the potential pros and cons of participating in the program.

This may sound like a pretty good deal for employers and it can be for some. But be aware that the VCSP is not without potential drawbacks. Consider the following risks that may be associated with this or a similar IRS initiative like the “Fresh Start” program for individuals and small businesses (see box).

  • Don’t assume that the VCSP will provide the best outcome for an employer. Other alternatives may be preferable. Before proceeding, it is imperative for employers to consult with their tax or legal professionals familiar with worker classification laws.
  • Participation in the voluntary IRS program might open an employer to audits and penalties by state agencies, which generally view participation as an admission of wrongdoing. Once a worker is classified as an employee, he or she may react against the employer. For example, an independent contractor worker whose status is changed to employee may consider making a claim against the employer for a variety of benefits, such as previously unreimbursed health insurance benefits, inclusion in an employer’s pension plan, and unreimbursed business-related expenses. In some cases, companies have been forced to make back retirement account contributions to workers who are deemed to be employees.
  • If workers didn’t pay self-employment taxes during the period they were inappropriately treated as independent contractors, they may have forfeited Social Security and Medicare credits. Although this may technically be their own fault, they might not see it that way.
  • Reclassifying an independent contractor as an employee can suddenly expose the employer to state legal liabilities. For example, an independent contractor injured while performing work for the employer would not be eligible for workers’ compensation benefits. Suppose that two months after incurring an injury, a worker is reclassified as an employee. That person now has an opportunity to claim workers’ compensation benefits.

These points highlight how important it is to obtain expert professional guidance in this area. After the options are examined, a well-informed decision can be made.