Worker Misclassification: Getting Right with the IRS

Woods Rogers Vandeventer Black
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About a year ago, I wrote an article on Virginia’s new initiative to address worker misclassification regarding employment and income taxes. The Virginia program is an enforcement initiative backed by substantial penalties. Nationally, the IRS has a Voluntary Classification Settlement Program designed to bring taxpayers (employers) into compliance on worker classification matters without substantial penalties, if the taxpayer voluntarily steps forward.

While a business might pay an independent contractor for the same or similar work as an employee, there are key legal and tax differences between the two types of workers. Business owners need to correctly determine whether the individuals providing services are employees or independent contractors.

Independent contractor vs. employee

An employee is generally considered anyone who performs services for a business if the business can control what work will be done, how it will be done, and has the right to control the details of how the worker’s services are performed. Independent contractors are individuals in an independent trade, business or profession who offer their services directly to the public.

As noted in the article addressing Virginia’s worker misclassification program, whether a worker is an independent contractor or an employee depends on the relationship between the worker and the business. The IRS guidelines for classifying workers fall into three categories:

  1. Behavioral control − Does the company control or have the right to control what the worker does and how the worker does the job?
  2. Financial control − Does the business direct or control the financial and business aspects of the worker’s job?
  3. Relationship of the parties − Are there written contracts or employee-type benefits such as a retirement plan, life insurance, or vacation pay? Will the relationship continue and is the work performed a key aspect of the business?

The misclassified worker

While the IRS is not known for its paternalism, the IRS correctly notes that misclassifying workers as independent contractors adversely affects employees because the employer’s share of taxes is not paid, and the employee’s share is not withheld. Generally, an employer must withhold and pay income taxes, Social Security and Medicare taxes, as well as unemployment taxes.

Workers who believe they have been improperly classified as independent contractors may seek help from the IRS by requesting a determination of worker status from the IRS. The workers then can use Form 8919, Uncollected Social Security and Medicare Tax on Wages, to figure and report their share of uncollected Social Security and Medicare taxes due on their compensation.

Voluntary Classification Settlement Program

Rather than using the “stick” of audits and penalties (see the Virginia program noted above), the IRS has created the Voluntary Classification Settlement Program (a “carrot”) that provides businesses with an opportunity to reclassify their workers as employees for future employment tax purposes. This program offers partial relief from federal employment taxes for eligible businesses who agree to prospectively treat their workers as employees. An applicant business must meet certain eligibility requirements and apply by filing Form 8952, Application for Voluntary Classification Settlement Program (VCSP).

Eligibility for VCSP

The VCSP is available for taxpayers who want to voluntarily change the prospective classification of their workers. The program applies to taxpayers who are currently treating their workers (or a class or group of workers) as independent contractors or other nonemployees and want to prospectively treat the workers as employees.

A taxpayer must have consistently treated the workers to be reclassified as independent contractors or other nonemployees, including having filed all required Forms 1099 for the workers to be reclassified under the VCSP for the previous three years to participate.

Additionally, the taxpayer filing a Form 8952 to participate in the VCSP cannot currently be under employment tax audit by the IRS, and the taxpayer cannot be currently under audit concerning the classification of the workers by the Department of Labor or by a state government agency.

If the IRS or the Department of Labor has previously audited a taxpayer concerning the classification of the workers, the taxpayer will be eligible only if the taxpayer has complied with the results of that audit and is not currently contesting the classification in court.

VCSP Agreements

A taxpayer participating in the VCSP must agree to prospectively treat the class or classes of workers as employees for future tax periods. By participating in the VCSP, the taxpayer will:

(1) Pay 10 percent of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of section 3509(a) of the Internal Revenue Code. See the Instructions to Form 8952;

(2) Not be liable for any interest and penalties on the amount; and

(3) Not be subject to an employment tax audit with respect to the worker classification of the workers being reclassified under the VCSP for prior years.

Applying for VCSP

As noted earlier in this article, to participate in the VCSP, a taxpayer must apply using Form 8952, Application for Voluntary Classification Settlement Program. The application should be filed at least 60 days prior to the date the taxpayer wants to begin treating its workers as employees.

Eligible taxpayers accepted into the VCSP must enter into a closing agreement with the IRS to finalize the terms reached under the VCSP, and must make full and complete payment of any amount due under the closing agreement.

Conclusion

The worker protection initiatives by the IRS and Virginia mean that employers need to be particularly careful when making determinations to classify and treat individuals as employees or independent contractors. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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