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Independent Contractor or Employee?
IRS Will Now Settle Employment Taxes

Independent contractor or employee

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After receiving much success from its Voluntary Offshore Bank Account Disclosure Program, the Internal Revenue Service (“IRS”) has now decided to provide an opportunity for businesses to come clean by reclassifying workers as employees for federal employment tax purposes. The IRS announced on September 21, 2011 that it has developed the Voluntary Classification Settlement Program (“VCSP”). This program now allows business taxpayers to obtain relief from wrongly classifying employees as independent contractors, thereby potentially saving business taxpayers thousands of dollars in employment taxes, penalties, and interest.


Workers are constantly misclassified by businesses for various reasons, either purposely to save money, or on accident because owners are unaware of the surrounding tax laws. Whether a worker is an employee or an independent contractor is largely a facts and circumstances analysis and is generally determined under the common law test of whether the business owner has the right to control and direct how the worker performs his or her services. The IRS has determined that because self-employed independent contractors are far less tax compliant than W-2 employees, the misclassification of workers costs the U.S. Treasury over $1 billion per year.

IRS Audits

Since 2009, the IRS has enlarged its efforts to curb worker misclassification by steadily increasing the number of employer examinations performed by the IRS. If the IRS determines that a business wrongly classified employees as independent contractors after performing an employment tax audit, the business can face large employment tax deficiencies. These tax adjustments can range anywhere from 10% up to 40% of the prior three years’ salaries, depending on whether the IRS determines the misclassification was willful. In order to assist voluntary resolution of worker misclassification issues and increase tax compliance and certainty for both taxpayers and the government, the IRS has determined that it would be helpful to provide business owners with a program that allows voluntary reclassification of independent contractors as employees without the need to go through the lengthy and expensive process of IRS audits. Hence, IRS announces the VCSP.

VCSP Eligibility

The VCSP is available for business taxpayers that wish to voluntarily change the classification of their workers going forth. In exchange for agreeing to treat workers as employees, businesses will now be liable for only 10% of the tax liability due for the most recent tax years and will not be liable for any penalties or interest, both of which can add up quickly. Additionally, the IRS has stated that it will not subject a taxpayer who participates in this new program to audit for employment tax issues. To be eligible for relief under the VCSP, a business owner must have consistently treated the workers as nonemployees (i.e., independent contractors), and must have filed Forms 1099 for the workers for the previous three years. Furthermore, the business cannot currently be under audit by the IRS, the Department of Labor, or any state agency. If a business was previously audited by the IRS or the Department of Labor, it can only be eligible if it has complied with the results of that audit. Businesses that apply under this program and are accepted into it will sign a closing agreement with IRS agreeing to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years after the date of the agreement.


To illustrate the benefits of the VCSP, a business that paid $1,500,000 to workers in 2010 now wishes to correctly classify its workers as employees. The business submits the VCSP application on October 1, 2011 and requests the beginning date for treating its workers as employees to be January 1, 2012. Because the employment taxes applicable to $1,500,000 would be $160,200 (10.68% of $1,500,000), the settlement with IRS under the VCSP would be only 10% of $160,200, or $16,200. Had IRS decided to audit the business before it made an application under the VCSP, and IRS determined the misclassifications were willful, the business would potentially be at risk for past employment taxes, penalties, and interest of up to $1 million. 


In summary, the VCSP allows employers who have misclassified their workers as independent contractors an opportunity to voluntarily resolve this issue prospectively with limited cost and known risk. All business owners who classify workers as independent contractors should seek the advice of a tax professional in determining whether filing an application under the VCSP is appropriate.