A Critical Business Decision – Independent Contractor or Employee? 

By John Frey, CPA
Director, Assurance Services

Worker classifications issues have become a major tax administration focus in Washington.  On September 19, 2011 the Internal Revenue Service (“IRS”) and the Department of Labor’s Wage and Hour Division signed a memorandum of understanding to share information on investigations involving employment tax compliance.  The IRS announced it will be paying more attention to worker classification issues as the number of workers being classified as independent contractors is steadily increasing. 

Classification issues arise when the business owner treats a worker as an independent contractor rather than as an employee and thereby avoids paying Social Security, Medicare, and unemployment tax.

Two very high profile cases of abusing the tax code in this way have been that of courier service provider Fed Ex and insurance giant Northwestern Mutual. Fed Ex received a fine of over $300 million whereas Northwestern Mutual was slapped with a fine of over $200 million. Although you might never see fines of this magnitude in your business, you could find out that your tax liability has doubled under Internal Revenue Code (“IRC”) 6672 which defines a willful failure to collect and pay taxes, or attempt to evade or defeat tax.

There is relief, and in the past, employers who failed to classify workers properly as employees often did not suffer significant penalties. Further, where penalties were imposed, section 3509 was available to reduce the penalties and section 530 was available to permit employers to treat workers as independent contractors, if you meet the relief requirements: 

1)  You had a reasonable basis for not treating the worker as an employee,

2)  You treated the worker, and any similar workers as independent contractors, and

3)  You must have filed Form 1099-MISC for each worker unless they earned less than $600.

Going forward, in the event of an audit, taxpayers can expect the IRS to propose penalties that may be significantly greater than penalties taxpayers have been accustomed to for these audits. Taxpayers will likely have fewer opportunities for mitigating proposed adjustments and penalties through administrative settlement, as exemplified by the likely diminished availability of the section 530 and 3509 relief provisions.

In light of the increase scrutiny and potential penalties, on September 21, 2011 the IRS issued announcement 2011-64 establishing a new Voluntary Classification Settlement Program (“VCSP”).  To be eligible for the VCSP, a taxpayer must have consistently treated the workers (or a class or group of workers) as non-employees, and must have filed all required IRS Forms 1099 for the workers for the previous three years. The taxpayer cannot currently be under audit by the IRS, or under audit concerning the classification of workers by the Department of Labor or any state government agency. A taxpayer who was previously audited by the IRS or the Department of Labor concerning the classification of the workers will only be eligible for the VCSP if the taxpayer has complied with the results of that audit. Exempt organizations and governmental entities may participate in the VCSP if they meet all of the eligibility requirements.

To participate in the VCSP, a taxpayer must apply using IRS Form 8952, Application for Voluntary Classification Settlement Program. This Form should be filed at least sixty (60) days prior to the date the taxpayer wants to begin treating the subject workers as employees. A taxpayer participating in the VCSP will need to agree to treat the class of workers as employees for future periods. In exchange, the taxpayer will need to pay only ten percent (10%) of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Internal Revenue Code (the “Code”) Section 3509. The taxpayer will not be liable for any interest and penalties on the liability, and will not be subject to an employment tax audit with respect to the worker classifications of those workers for prior years.

For example, assume that in the year 2010, a taxpayer paid $1,500,000 to workers that are the subject of the VCSP. Assume that all of these workers were compensated at or below the Social Security wage base (under $106,800 for the year 2010). The taxpayer submits the VCSP application on October 1, 2011 and wants the beginning date of the quarter for which it wishes to treat the class or classes of workers as employees to be January 1, 2012. The taxpayer looks to the amounts paid to the workers in 2010 for purposes of calculating the VCSP amount, since 2010 is the most recently completed tax year at the time the VCSP application is filed. Under Code Section 3509(a), the employment taxes applicable to $1,500,000 would be $160,200 (10.68% of $1,500,000). Under the VCSP, the taxpayer’s payment would be ten percent (10%) of $160,200, or $16,020.

If you are just starting your business, hiring additional employees, or have been selected for an employment tax examination and have questions, please contact John Frey, CPA,  847-733-7182 or email at jfrey@bkl-cpa.com