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Can Your Business Benefit from the IRS Voluntary Classification Settlement Program?

Does your business use independent contractors? You may run the risk of potentially significant assessments in the event of an Internal Revenue Service (IRS) employment tax audit. We have found that reclassification of independent contractors to employees is often the primary focus of IRS employment tax audits. The IRS has developed the new Voluntary Classification Settlement Program (VCSP) to help businesses address this issue.

To state the obvious, every business enterprise accomplishes tasks through people. A business generally has two options when engaging individuals to perform these tasks. It can hire “employees,” which requires paying wages and employee benefits, withholding and paying employment taxes, adhering to employment laws, and liability for employees’ negligent acts committed in the course of employment. Another option is to retain them as independent contractors. This generally gives rise only to the obligation to pay the independent contractor for services rendered.

Both employees and independent contractors can perform very similar services. The IRS routinely challenges individuals’ status as independent contractors. This is partly because the determination is often subjective, but also because recharacterizing independent contractors as employees results in greater tax revenue for the government. IRS scrutiny can arise from, for example, an individual making an inquiry with the IRS as to his employment status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, or through an IRS employment tax audit, both of which are becoming more common. Due to the higher levels of unemployment, we have also seen an increase in cases where an “independent contractor” applied for unemployment benefits with his/her state giving rise to an audit by that state’s unemployment tax division.

Costs of Reclassification
Taking into account only employment taxes, an IRS reclassification of independent contractors to employees is costly for the business. It may result in an assessment of both the employer and employee share of the following:

  • Federal Insurance Contributions Act tax (6.2 percent for each share of the Social Security wage base of up to $106,800 in 2011, and 1.45 percent for each share of the Medicare wage base which has no maximum);
  • Federal income tax withholding (with individual income tax rates ranging up to 35 percent); and,
  • Federal Unemployment Tax (currently 6 percent up to the first $7,000 of wages). The IRS will also assess interest, and likely penalties (e.g., failure to file or pay, etc.).

Reclassification can have other ramifications as well, e.g., employee benefit plans and exposure to liability resulting from employees’ actions. Accordingly, these costs should also be taken into consideration. There are opportunities and mechanisms, however, to mitigate an employment tax assessment resulting from a reclassification.

IRS’s Voluntary Classification Settlement Program
The IRS recently began the VCSP, whereby an eligible company not currently under IRS audit for employment taxes may voluntarily reclassify workers from independent contractors to employees and obtain meaningful relief from exposure to potential employment tax assessments for prior taxable years. The program requires payment of 10 percent of the estimated employment tax liability computed under reduced rates (10.28 percent for Social Security wages and 3.24 percent for amounts above such wages for 2011) for the most recent complete tax year with no interest or penalties, with the IRS agreeing not to reclassify the involved individuals for prior years. Going forward, however, the company must treat the individuals as employees and undertake all required withholdings.

Is the VCSP Right for My Business?
Whether or not the VCSP makes sense for any particular business requires evaluating the risk that the IRS may reclassify its independent contractors as employees. As to back years, the VCSP is a pretty good deal. But, going forward, the business will be subject to a markedly increased tax burden and other non-tax obligations. Ask yourself: How solid is our position that our independent contractors are properly classified? What is our tax and non-tax exposure? Is certainty for prior years’ worth increased costs going forward? With the VCSP as an option, however, now is the time to reevaluate your company’s position and make an informed decision regarding whether to exercise that option.

Employers should also be aware that the Department of Labor is targeting employee misclassification. For information regarding classification of workers and an evaluation as to whether the VCSP makes sense for your business, please contact Mark A. Loyd  at Bingham Greenebaum Doll.

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