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IRS Employment Tax Disclosure Initiative for Misclassified Workers

The IRS over the last few years has poured considerable resources in investigating employers’ characterization of workers as either employees or independent contractors. For tax purposes, classifying a worker as an independent contractor allows the employer to forgo withholding income tax and from having to pay Social Security, Medicare and unemployment taxes.

The IRS has created a questionable employment tax practices program, with one of its core goals of increasing correct voluntary compliance with employment taxes. This has resulted in increased audits on employers. It has also resulted in increased information sharing with state taxing authorities and labor departments on employment tax issues, including audits. Most recently, the IRS has entered into a memorandum of understanding with the Federal Department of Labor increasing information sharing between the two departments.

The level of control an employer has over an worker is the key to determining if the worker is an employee or an independent contractor. Each state has a different set of common law (court created law) that pertains to whether a worker is an employee or independent contractor. The IRS will take into consideration the characterization under state law, but also has its own set factors in determining if the level of control amounts to an employee/employer relationship.

This is one area of the law that many taxpayers intentionally or negligently ignore, and the IRS has targeted it as having large collection potential. For taxpayers who have simply made a mistake, there is some relief during the audit process under Section 530 of the ’ 78 Revenue Act. This relief, however, is only available for employers being audited, and only to limited employers who meet certain, somewhat difficult requirements.

In Ann. 2011-64, the IRS has announced a new voluntary compliance program for employers who have erroneously classified workers as independent contractors and are willing to prospectively reclassify their workers as employees. To be eligible for the voluntary classification settlement program (VCSP), an employer must be currently treating its workers as independent contractors, must have filed all required 1099 for the last three years, and must not be currently under audit by the IRS or the Department of Labor.

A taxpayer who applies for relief under VCSP and is accepted will only pay 10% of the employment tax liability that would have been due in only the most recent year. There will be no liability for interest or penalties, and will not be subject to audit on employment taxes for prior years.

There are obviously various federal tax and federal law considerations in making such a disclosure, and there are important state implications; however, employers who are uncertain about their classification, or know they have been misclassifying workers, should strongly consider investigating this disclosure opportunity. Please contact one of the attorneys in our business department or tax department for more information regarding VCSP.