An issue that has been getting more attention from the IRS is worker classification. This issue deals with whether you treat people who provide services for your business as employees or as independent contractors. Generally, employers would rather treat service providers as independent contractors for the following reasons:
- employers do not have to pay payroll taxes on amounts paid to independent contractors
- employers do not have to provide employee benefits to independent contractors
- employers do not have to pay workers compensation premiums for independent contractors (assuming the independent contractor has her own workers compensation policy).
Whether a service provider is an employee or independent contractor depends on the amount of control the employer has over the service provider. A greater amount of control would tend to increase the likelihood that the service provider is an employee.
When an employer has been treating a service provider as an independent contractor, and the IRS later reclassifies the service provider as an employee, the employer will be liable for payroll taxes for the years at issue plus penalties and interest. This can be a substantial balance due.
Example: Over the past three years, ABC Corp has paid $600,000 to independent contractors. The IRS reclassifies the independent contractors as employees. ABC Corp is now liable for back payroll taxes of roughly $60,000 plus penalties and interest (which could amount to several thousand dollars more).
The Relief Provision
The IRS wants to encourage employers to voluntarily resolve their worker classification issues. The IRS recently added a program (the Voluntary Classification Settlement Program [VCSP]) that provides partial relief from federal payroll taxes for eligible employers who agree to prospectively treat service providers as employees.
A employer who participates in the VCSP will agree to prospectively treat the service providers as employees for future tax years. In exchange, the employer will pay 10% of the payroll tax liability that would have been due on amounts paid to independent contractors for the most recent year, determined under the reduced payroll tax rates (10.25% in 2011 and 10.68% in 2010).
The employer will not be liable for penalty or interest, and will not be subject to an workers classification audit for prior periods. However, the employer must agree to extend the period of limitations on assessments of employment taxes for three years for the first, second, and third years following the year the VCSP is approved.
Example: Same facts as in above example except that ABC enters into a VCSP in January 2012. ABC paid its service providers $200,000 in 2011. Under the VCSP, ABC owes $2,056 to the IRS. ABC will not be liable for penalties and interest. The $2,056 balance due is equal to the payments to service providers for the prior tax year of $200,000 multiplied by the reduced payroll tax rate of 10.25% times 10%. Under the VCSP, ABC is not liable for the payments to its service providers for 2009 and 2010. ABC will treat its service providers as employees beginning 2012.
To enter into a VCSP, the employer must:
- submit an application (Form 8952)
- have consistently treated the service providers as independent contractors
- have filed all Forms 1099 for the prior three years
- not be under IRS, Department of Labor, or state audit
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.