Volume 23 Issue 5 -- September/October 2011
Many small businesses designate workers as “independent contractors,” regardless of whether they are really employees, to avoid paying the employer’s portion of Social Security and dealing with employee tax withholding and the related paperwork and reporting.
The practice of classifying workers as independent contractors may have grown in the recent past perhaps because there have been relatively fewer IRS employment tax audits. Nevertheless, this is still a risk to businesses.
The IRS has announced a new program to promote voluntary reclassification of workers treated as “independent contractors” but that are in reality “employees.” The announcement may be seen as a tacit acknowledgement that the IRS lacks the staff to do employment tax audits on a large scale.
The IRS calls its new procedure a Voluntary Classification Settlement Program or “VCSP.” The VCSP program is intended by the IRS to provide relief to businesses with misclassified workers similar to the relief available for businesses current under employment tax audit through what the IRS calls the “Collective Settlement Procedure.”
To be eligible to voluntarily reclassify for future years workers that are currently being treated as independent contractors, two criteria must be met:
¨ The workers must have consistently been treated as independent contractors in the past and have received Forms 1099 for the past three years.
¨ The taxpayer-business cannot currently be under audit by the IRS or by the Department of Labor or any state government agency concerning the classification of its workers.
Businesses that have gone through prior employment tax audits must have fully complied with those audit results.
Eligible businesses that wish to reclassify their workers voluntarily on a prospective basis must pay 10% of the employment tax liability due on the compensation paid to the workers for the most recent tax year, using reduced rates under Internal Revenue Code (IRC) § 3509. Such businesses will not be required to pay interest or penalties on this 10% tax liability, and they will not be subject to employment tax audits with respect to those workers for prior years.
There is one other condition that may not be that important in most circumstances. The statute of limitations on employment tax auditing is normally three years after a return is filed. In order to participate in the VCSP, the business must agree to extend the statute of limitations from three to six years. This applies to employment tax audits with respect to the first three years after the date the workers are reclassified.
Eligible businesses must submit a new form, Form 8952, entitled “Application for Voluntary Classification Settlement Program,” consisting of two pages. The first page has questions relating to identification of the business, the contact person, and
information about the workers to be reclassified. Page 2 has a section for calculating what the tax liability would be on the past year’s workers using the reduced rates of IRC § 3509(a).
The 10% payment is not made with Form 8952 but rather is submitted with a signed “closing agreement,” prepared presumably by the IRS. A Closing Agreement is a procedure that binds all parties, including the IRS.
Businesses that wish to apply need to allow at least a 60-day waiting period after Form 8952 is submitted before the reclassified workers can be treated as employees. For example, if a business wants to begin treating its workers as employees on January 1, 2012, Form 8952 needs to be submitted on or before Nov. 2, 2011.
Stated differently, the business needs to think ahead and file the form at least sixty days (two months) before the beginning of the period for which they want to treat the workers as employees. Both the form and the instructions are available on the IRS website.
There are two significant benefits from the VCSP. First, it allows businesses with misclassified workers the chance to reclassify them prospectively and eliminate the risk of an audit for the past three years.
Second, the financial cost of doing this requires paying only 10% of the employment taxes that otherwise would have been due for just the past year while at the same time avoiding additional tax, interest and penalties with respect to the past three years.
Businesses that are currently not filing Forms 1099 for independent contractors will not be eligible to participate in the VCSP.
It is possible that some, perhaps many, small businesses will not want to, or cannot qualify to, participate in the VCSP program. Some businesses have already determined that it is impossible for them to reclassify workers as “employees” and still compete effectively against businesses which do pay employment taxes.
If you need assistance in determining whether or if a client should participate in the VCSP, please contact Tax & Business Professionals.
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