In September 2011, the IRS unveiled the Voluntary Classification Settlement Program (VCSP) to address worker misclassification, specifically the practice of improperly designating workers as independent contractors (ICs) rather than as employees.
The VCSP offers partial relief from employment tax liability to employers who come forward to reclassify and prospectively treat ICs (or other nonemployees) as employees (for future tax periods) for employment tax purposes. Employers who participate in the VCSP pay only 10% of the employment tax liability that may have been due on compensation paid to the reclassified workers for the most recent year, without any interest or penalties, and also gain exemption from employment tax audits for prior years with respect to the reclassified workers. In return, for the first three calendar years after joining the VCSP, participants agree to extend the period of time in which the IRS can assess employment taxes from three years to six years.
To participate in the VCSP, employers must meet eligibility requirements (discussed below), apply voluntarily, and enter into an agreement with the IRS.
Employers who are misclassifying workers and do not participate in the VCSP remain subject to IRS audit and potential resulting liabilities, including payment of back taxes, interest, and penalties.
In recent years, increased joblessness has caused unemployment claims to surge, bringing misclassification to light as a widespread issue. Various government agencies (e.g., the IRS, Department of Labor, state tax authorities, state department of labor, and unemployment compensation agencies) are trying to reconcile unemployment claims with competing claims from employers defending their classification of workers as non-employees.
When a government agency discovers misclassification, the consequences can be serious. Employers could face significant potential claims relating to unpaid taxes, unpaid overtime, minimum wage, ERISA employee benefits, workers’ compensation, unemployment, Social Security, and Medicare, as well as penalties and interest.
For some employers, misclassification may be more a product of oversight than bad faith, but not for all: many businesses have adopted a “when in doubt, go IC” worker classification policy. Enticed by the immediate legal, financial, and administrative advantages of treating workers as ICs, employers may have taken the bait without fully realizing the ramifications of their short-sighted decisions; i.e., possible audits and overall larger resulting financial liabilities through interest and penalties.
It can be difficult to determine or prove that a worker is an IC and not an employee. A worker may be an IC under one set of laws and an employee under a different set. Generally though, determining worker classification hinges on fact-specific tests that involve a number of common factors. Across the board, the main thrust remains consistent: it’s all about control.
Overall, employees are subject to greater financial and behavioral control than ICs. Employers typically have the right to dictate when, where, and how employees work. ICs, on the other hand, are ordinarily free to control various aspects of their performance.
Of course, with control often comes obligation. Modern income tax and employment benefit laws require employers to withhold and pay over income taxes on wages, pay for employment-related employee benefits, pay 50% of Social Security and Medicare taxes, and pay other payroll taxes, such as workers’ compensation, unemployment, and statutory disability.
Employers should view the VCSP as both a caution and an opportunity.
- Undertake a comprehensive and situation-specific analysis of your employer-worker relationship. Engage a professional to assess the degree of control you have over your workers.
- Re-evaluate your classification decisions regularly. Keep in mind that facts and laws change, but
your responsibility to classify workers properly does not.
If worker misclassification seems likely or even possible, consider applying for the VCSP. The IRS rarely offers relief of this extent or nature.
The VCSP eligibility requirements are as follows:
- Employers must currently treat their workers (or a class or group of workers) as ICs or other nonemployees and wish to treat them prospectively as employees.
- Employers must have treated the relevant class of workers as nonemployees and filed all required information returns for the workers (e.g., 1099s) for the three previous years.
- Employers must not be under audit by the IRS or Department of Labor for worker misclassification at the time of application.
- Employers who have been audited previously must have complied with the requirements of the audit.