The Internal Revenue Service (the "IRS") launched a new program yesterday that will allow businesses the opportunity to resolve prior worker classification issues by voluntarily reclassifying their workers as employees for federal employment tax purposes. In a news release dated September 21, 2011 (IR-2011-95) and Announcement 2011-64, the IRS announced a voluntary classification program which will allow businesses to come into compliance by making a minimal payment covering past employment tax obligations without waiting for an IRS audit. In order to provide additional information on this new program, the IRS also released a set of Frequently Asked Questions and Answers (the "FAQ") (available here).
Officially called the "Voluntary Classification Settlement Program" (the "VCSP"), this new program is part of a larger "Fresh Start" initiative at the IRS to aid taxpayers and businesses in addressing their federal tax liabilities. The VCSP enables eligible businesses to reclassify their workers as employees on a voluntary basis and obtain relief similar to that offered in the current Classification Settlement Program (the "CSP"). IRS Commissioner Douglas Shulman stated that the VCSP "provides certainty and relief to employers in an important area." Commissioner Shulman further explained that the VCSP "is part of a wider effort to help taxpayers and businesses[,] to help give them a fresh start with their tax obligations."
Why Worker Classification Matters For Employment Tax Purposes
Classification of workers as independent contractors when the workers should have been classified as employees can leave a business with a substantial tax liability. Businesses are required to withhold income tax from all remuneration actually or constructively paid to employees. As such, the business is liable for the payment of income tax required to be deducted and withheld from wages paid to an employee. A business is also required to withhold Federal Insurance Contributions Act ("FICA") taxes from the employee's pay. If the business fails to withhold FICA taxes, it is still liable for payment of the employee's portion of FICA taxes. A business that misclassifies an employee as an independent contractor is also liable for the FICA and Federal Unemployment Tax Act ("FUTA") taxes that should have been paid with respect to the "employee." (Federal income tax withholding, FICA, FUTA, and Railroad Retirement Act taxes are collectively referred to as "Employment Tax").
In addition to employment taxes imposed on a business that mistakenly classifies a worker as an independent contractor (both the employer's and employee's share), it is likely that the IRS will also seek to impose penalties on the business. Civil penalties typically include:
- Penalties assessed for the late filing of a tax return or failure to pay either a tax shown on a return or a tax required to be shown on a return after notice and demand for payment thereof;
- Penalties assessed for failure to deposit employment taxes; and
- Penalties imposed when any part of any underpayment is due to negligence or intentional disregard of rules and regulations.
Historical Approaches by IRS and Increased Enforcement
Both federal and state governmental agencies apply a myriad of tests to determine whether a worker is classified as an employee or an independent contractor. For example, different tests are used by the Department of Labor, the National Labor Relations Board, the Equal Employment Opportunity Commission, individual states and their various agencies, and of course the IRS. Consequently, it is possible for a worker to be classified as an employee for one purpose, and at the same time be classified as an independent contractor for a different purpose.
Under Treasury Regulations § 31.3121(d)-1(c), "the relationship between employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished." The crux of the Treasury Regulation's definition of "employee" is whether the business for which the services are performed has the right to control the individual performing the services. Unfortunately, this ambiguous definition provides little concrete guidance for businesses (and the IRS).
In an attempt to provide some texture to the nebulous definition of "employee" found in the Treasury Regulations, the IRS issued a Revenue Ruling in 1987 ("Rev. Rul. 84-71") that contained 20 factors to help determine a worker's classification for wage withholding purposes. Several years ago, the IRS grouped the 20 factors into three broad categories, including: (1) behavioral control, which refers to the factors indicating a right to direct or control how the worker performs the work; (2) financial control, which refers to factors indicating whether or not the business has the right to control the economic aspects of the worker's task; and (3) the type of relationship between the parties, which refers to factors indicating how the worker and the business perceive their relationship with each other.
While Rev. Rul. 84-71 and its 20 factors are still valid today (as many courts still rely on them in making worker classifications), the IRS made some changes in 2008 to its worker classification analysis—the IRS has maintained the underlying policy behind each of the 20 factors and continues to use the three broad categories but has trimmed the 20 factors down to 11 or 13 factors, depending on which IRS publication or speech is relied on.
In 2009, the IRS established the CSP in order to help businesses already undergoing an IRS examination resolve worker classification cases as early in the administrative process as possible, hopefully reducing the taxpayer's burden. If certain criteria are met, the IRS will allow the employer to prospectively treat the workers as employees, with reduced federal employment tax liabilities for past nonemployee treatment. The CSP procedures also ensure that the taxpayer relief provisions under section 530 of the Revenue Act of 1978 are properly applied, meaning they will terminate the employer's Employment Tax liability, as well as any interest or penalties attributable to the liability for Employment Tax.
In early 2010, the IRS launched the "National Research Program" (the "NRP") - the IRS's first employment tax compliance study conducted since 1984. The NRP's overarching goal is to allow the IRS to become a better administrator of the nation's employment tax laws, as well as to design a more aggressive audit plan to deal with abuses in the employment tax arena. The NRP will result in the IRS conducting line-by-line reviews of a business's employment tax returns by some of the IRS's most experienced and recently trained auditors. The NRP audits will occur over a three-year period, with at least 2,000 businesses randomly selected each year for audit. Any employment tax issue that presents itself during the course of an NRP audit will be examined, in addition to worker classification, fringe benefits, executive compensation, backup withholding, and Form 1099 issues.
Finally, the IRS and the Department of Labor signed a memorandum of understanding on Monday of this week, which will lead to the exchange of information on worker classification and the referral to the IRS by the Department of Labor of cases to investigate.
Participation in the VCSP Can Provide Substantial Relief for Participants
In order to further the efficiency goals of the CSP, the IRS has provided taxpayers with the VCSP, a voluntary, pre-examination version of the CSP that would allow taxpayers to obtain relief similar to that obtained in the CSP. The IRS provided notice and details regarding the VCSP in Announcement 2011-64. In addition to reiterating the purpose behind the program, Announcement 2011-64 set forth the eligibility requirements for taxpayer participation in the VCSP. Generally, the VCSP is applicable to those taxpayers who are currently treating their workers (individually, as a class, or as a group) as independent contractors or other nonemployees for Employment Tax purposes but who want to prospectively treat the workers as employees.
In order to be eligible to participate in the VCSP, the taxpayer:
- MUST have consistently treated the workers as independent contractors or other nonemployees;
- MUST have filed all required Forms 1099 for the workers for the previous three years;
- MUST NOT currently be under examination by the IRS;
- MUST NOT currently be under examination concerning the classification of workers by the Department of Labor or by a state government agency; and
- MUST have complied with the results of any previous examination by the IRS or the Department of Labor concerning the classification of workers.
An eligible taxpayer who participates in the VCSP agrees to treat the employees at issue as employees for all future tax periods. In return, the taxpayer will pay only 10 percent 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 IRC Section 3509, had the taxpayer undergone an examination. In addition, the taxpayer will not be liable for any interest and penalties on the liability, nor will the taxpayer be subject to an Employment Tax audit for prior years with respect to the classification of the workers. Finally, a participating taxpayer will agree to extend the statute of limitations on the assessment of Employment Taxes by three years for the three calendar years beginning after the taxpayer has agreed to begin treating the workers as employees under the VCSP closing agreement.
Eligible businesses should consider taking advantage of this opportunity to limit their liability in this often unclear area of the tax law. Interested businesses can apply for the program by filing IRS Form 8952 (Application for Voluntary Classification Settlement Program), along with an IRS Form 2848 (Power of Attorney) if the business wishes to appoint a tax representative to deal with the IRS, at least 60 days before a business wants to begin classifying any workers as employees.
Labor & Employment and ERISA Considerations
Employees are granted certain legal protections that simply do not apply to independent contractors. For example, the Fair Labor Standards Act, the American with Disabilities Act, the Family Medical Leave Act, Title VII, and the Uniformed Services Employment and Reemployment Rights Act, among others, only apply to workers classified as "employees."
Businesses that hire employees also face risks associated with immigration issues. Independent contractors are not required to fill out a Form I-9, Employment Eligibility Verification, whereas employees are. A business that misclassifies its workers can be subject to potential fines for failure to obtain completed Form I-9s.
Independent contractors cannot participate in ERISA plans. Drastic consequences can result if a business's independent contractors are reclassified as employees, both at an individual worker level, as well as at the plan level. For instance, workers who are reclassified as employees may be entitled to retroactive benefits, such as restricted stock options. Further, the plan would have to be retested to ensure that it is a nondiscriminatory plan, as the newly classified employees would have to be taken into account.
Accordingly, in addition to the federal tax issues, businesses should carefully consider labor and ERISA issues before electing to participate in the VCSP.
This article was prepared by Jasper G. "Jack" Taylor III (email@example.com or 713 651 5670) and Michelle A. Spiegel (firstname.lastname@example.org or 713 651 5639) from Fulbright's Tax Controversies Practice Group.
If you have any questions or need any assistance related to these or any other tax controversy matters, please feel free to contact the authors listed above or Nancy T. Bowen, Jay M. Chadha (email@example.com or 713 651 3770), Charles W. Hall (firstname.lastname@example.org or 713 651 5268), Richard L. Hunn (email@example.com or 713 651 5293), Kathryn Keneally, Andrius R. Kontrimas (firstname.lastname@example.org or 713 651 5482), William S. Lee (email@example.com or 713 651 5633) or Robert C. Morris (firstname.lastname@example.org or 713 651 8404).
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