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Employee vs Independent Contractor

IRS program allows for payroll tax relief…but concerns continue.

About a year ago, the IRS launched a program that allows employers to resolve past worker classification issues by voluntarily reclassifying their workers as employees rather than independent contractors. Under the Voluntary Classification Settlement Program, eligible employers can get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit. The employer must pay 10 percent of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year. No interest or penalties will be due, and the employer will not be audited on payroll taxes related to these workers for prior years. The employer must agree to treat the covered workers as employees instead of independent contractors going forward.

While the IRS has received about 700 applications so far, it also has been asked by taxpayers and taxpayer representatives to change some requirements that have acted as a barrier to participation in the program. In response, the agency has eased the eligibility requirements to eliminate the requirement that the taxpayer not be under any IRS audit and to drop the requirement that a taxpayer agree to a six-year instead of three-year period of limitations on assessment.

New Eligibility Rules, Continuing Concerns

Under the new rules, to be eligible, an applicant must:

  • Consistently have treated the workers in the past as nonemployees.
  • Have filed all required Forms 1099 for the past three years for the workers being reclassified (See special exception below.)
  • Not currently be under an employment tax audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.
  • Not be contesting in court the classification of the class of workers from a previous IRS or Department of Labor audit.
  • Be willing to enter into a closing agreement with the IRS.

Even the liberalized rules present some problems. To qualify, a taxpayer cannot currently be under an employment tax audit by the IRS. However, a taxpayer that is a member of an affiliated group will be ineligible if any member of the group is under an employment tax audit. This restriction is difficult to understand because each member of an affiliated group must file a separate employment tax return.

Some tax professionals also were disappointed that the IRS did not eliminate the requirement that an employer not be under a state government audit. For large companies that operate in many states, the no-audit requirement can be an absolute barrier to participating in the IRS voluntary classification settlement program.

Temporary Relief for Employers Who Did Not File All 1099s

The IRS also has developed a new, temporary initiative to allow employers who have not filed all required Forms 1099 for the previous three years for the workers to be reclassified. The program is only available through June 30, 2013. Like the regular program, the temporary program permits eligible employers to voluntarily reclassify their workers as employees for federal employment tax purposes. Under the temporary program, the employer must pay 25% of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year, rather than the 10% that is paid under the regular program.  The benefits are otherwise the same.

Classifying Workers a Difficult Exercise

Whether a worker is an employee or an independent contractor is determined under a 20-factor test  which examines whether the service recipient has the right to direct and control the worker. Statutory exceptions exist for some workers in sales and distribution occupations. In short, the determination of the proper worker classification status may not be clear, and it is difficult for employers to know whether they are complying with the rules. The consequences of misclassifying workers can be serious, so it is important for employers to seek professional guidance when making worker classification determinations.

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