Settle Your Worker Classification Problems with No Penalties

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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One of the thorniest issues in taxes is determining whether a worker is an employee or independent contractor. The stakes are high for getting the answer right. If you mistakenly call a worker an independent contractor but the IRS or your state labor department later reclassifies the worker as an employee, you can owe back payroll taxes, plus interest and penalties. You can also owe back unemployment insurance and workers’ compensation, as well as any fringe benefits you normally give to employees, such as health care and retirement plan contributions for the reclassified workers.

Now the IRS has made it simple for employees on the fence about their worker classification to make things right…easily and with no penalties. Here is how the new worker classification program works and some pointers to help you decide whether this option is right for you.

About the Program

The new program is called the Voluntary Classification Settlement Program (VCSP). As the name implies, participation is voluntary. You can choose to participate if:

• You consistently have treated the workers in the past as independent contractors;
• You have filed all Forms 1099-MISC for these workers for the previous three years; and
• You are not currently under audit by the IRS, the Department of Labor, or any other state agency concerning the classification of these workers.

The cost to you for participating in the program is only 10 percent of the employment taxes due on wages paid to the reclassified workers for the past year. There is no interest and no penalties. You will not be audited on payroll taxes related to these workers for prior years. And you will not have any legal and accounting fees that would occur if you have to fight a challenge to your worker classification at the federal or state level.

However, if you participate, you will be subject to a special six-year statute of limitations for the first three years of the program, rather than the usual three years that usually applies to payroll taxes. This will allow the IRS to keep a close watch to make sure that you continue to treat reclassified workers as employees.

How to Participate

If you decide that you want to participate, you must apply by filing IRS Form 8952, Application for Voluntary Classification Settlement Program, with the IRS at least 60 days before you begin treating the workers as employees.

No payment is made with this application. Payment will be made when you are accepted into the program and sign a VCSP closing agreement.

The IRS will notify you that you have or have not been accepted into the program. If you are rejected, you can reapply at a later time.

Should You Participate?

Since the program is voluntary, it is up to you to decide whether it makes sense for your company. Here are some factors to consider:

• Selective reclassification. You can decide which workers to reclassify and which to leave as independent contractors. However, if you reclassify a worker in a particular class (i.e., doing a certain type of work), then you must reclassify all workers within that class. The IRS gives this example: A construction company works with drywall installers, electricians, and plumbers. It wants to reclassify drywall installers as employees. It must reclassify all such workers; this does not include electricians and plumbers.
• Previous audit. If you have already had an audit from the IRS or Department of Labor concerning classification, you are not barred from this program. However, if your classification of workers as independent contractors has survived an audit, you may not want to participate.
• Extent of reclassification. Once you agree to reclassify a worker as an employee, this reclassification applies not only for federal employment taxes going forward, but also for other federal and state employment laws, including federal and state wage and hour laws, unemployment compensation laws, anti-discrimination laws, and other laws and regulations applicable to employees.

Final Word

It is highly advisable to discuss your situation with your tax advisor to make the best decision for your company. You may also want to review questions and answers about the program provided by the IRS.