Employer / Contractor Misclassification – IRS Offers Companies Penalty Relief

Coming in from the Cold – Time to Treat Workers as Employees

On September 21, 2011 the IRS announced a new program designed to reduce penalties for companies who have historically classified workers and independent contractors (ICs) rather than employees. Dubbed the “Voluntary Classification Settlement Program” (VECP) the program offers companies relief from penalties and some back payroll taxes that could be assessed if the company was audited by the Department of Labor and found to be incorrectly classifying workers as ICs when the company should have been treating the workers as employees. Under the new IRS initiative, called the Voluntary Worker Classification Settlement Program, firms will owe 10% of employment taxes liability for reclassified workers in the most recent tax year, with no interest or penalties due. In addition, the company must have consistently treated workers in the past as non-employees and filed 1099s for all ICs for the previous three years. Under the new provisions, companies who come in from the cold and enter the program will not be subject to employee classification employment audit for prior years.IRS Application for Voluntary Classification Settlement

For Small Businesses – This is a big issue.

For years the determination of whether a worker could be treated as an IC rather than an employee has been a gray area and employers have used the “20 factor test” to determine the best classification. The GAO has estimated that in 2009 misclassification cost the government 2.7 billion in underpaid federal taxes, workers comp and unemployment insurance. It is estimated that up to 30% of companies may be incorrectly misclassifying workers as ICs rather than employees.The 20 Factor Test for Independent Contractor Status

Employees or Independent Contractors – Pros and Cons

There are numerous advantages for companies to treat workers as Independent Contractors if the type of work arrangement needed allows it. Treating workers as ICs rather than employees relieves the company of collecting and remitting employment related taxes and unemployment insurance. Workers’ compensation insurance costs are the responsibility of the IC, not the hiring company. Lastly, the minefield of employment related risks for are reduced or eliminated. This can include wage and overtime DOL violations and wrongful termination suits. For workers there are some advantages and disadvantages of the IC classification. Advantages include the ability to expense items related to the work engagement and the ability to maximize contributions to pre-tax SEP IRA accounts up to $49,000 per year versus $5,000 in an individual IRA when the employer does not offer a 401K. Disadvantages for the IC are that the worker does not have protections for unemployment insurance and must be self-disciplined about making quarterly tax payments to the IRS for self employment taxes (for both the employee and employer portion). Many people who accept work as ICs are unaware of the tax and reporting implications of being an IC and find themselves in trouble with the IRS at tax time.

The 20 factor test has long been the best guideline for small employers to use when assessing how to pay their workers. For most companies, running a business and passing the 20 factor test (for independent contractor treatment) is not viable. Some companies choose to ignore the 20 factor test and treat workers as 1099 ICs and do so at their own peril of running afoul with the IRS and the Department of Labor.Outsourcing Risk and Administration to a Professional Employer Organization

For most small companies who cannot treat workers as independent contactors or who decide that that using ICs is not in the best interests of their long term plans, outsourcing their employment to a PEO offers the best of both worlds. A PEO offers full IRS compliance and the advantages for having employees without the risks associated with treating workers as independent contractors. Hiring a PEO offers a way to be compliant and also be efficient.

Companies who may have incorrectly treated workers as 1099 contrators and now want to apply for the Voluntary Classification Settlement Program can use IRS form 8952.

IRS form 8952