Over the years, the Internal Revenue Service (IRS) has cracked down on employers during audits for misclassifying workers as contractors to avoid paying payroll tax. To boost tax revenues, the IRS has set its sights on more than 6,000 employers to investigate.

With the introduction of the Voluntary Worker Classification Settlement Program (VCSP) in 2011 came relief for some taxpayers dealing with misclassified workers, but not all. However, recently the IRS announced the expansion of VCSP to more businesses, tax-exempt organizations and government entities.

Under the revamped program, employers under IRS audit (with the exclusion of an employment tax audit) can qualify for the VCSP, and eligible employers are permitted to reclassify independent contractors as employees with less burden. A general rule-of-thumb is that employers will pay an amount effectively equaling just over 1 percent of the wages paid to the reclassified workers for only the prior year.

To avoid the threat of payroll audit, you can apply to be entered into the VCSP program if:

  • You are currently treating workers as nonemployees
  • You have consistently treated the workers in the past as nonemployees and filed the proper Form 1099s
  • You are not currently under audit on payroll tax issues by the IRS or under audit by Department of Labor or a state agency concerning the classification of these workers.

Why Classification Is Important

The distinction is important for employment tax reasons. With an employee, the business and the employee share the responsibility for Social Security and Medicare (FICA) taxes on the employee’s earnings. The business also must pay unemployment taxes for the worker. With an independent contractor, the contractor is fully liable for his or her own self-employment taxes. FICA taxes do not apply, and unemployment taxes are not required.
Benefits are another consideration. A company’s health and retirement plans must cover an employee once the employee meets plan eligibility requirements. An independent contractor typically does not receive benefits.

How to Decide

To answer the worker classification question for federal tax purposes, a company should analyze its entire relationship with the worker, focusing on the degree of direction and control the company exercises. The more control, the more likely it is that a worker is an employee. Three elements come into play:

  1. Behavioral control over what work is done and how it is done (sequence of work tasks, detailed instructions regarding how to perform the job, etc.)
  2. Financial control over the business aspects of the job (who provides tools/supplies, how the worker is paid, whether expenses are reimbursed, etc.)
  3. Type of relationship (whether it is ongoing, written contracts, provision of benefits, etc.)

Businesses that would like the IRS to determine a worker’s status for purposes of federal employment taxes and income-tax withholding can file Form SS-8. The IRS advises that it could take as long as six months to get a determination.

Statute Says

Federal law specifically classifies certain workers as employees for FICA purposes, even if they are not subject to an employer’s control. These include certain agent and commission drivers, a life insurance company’s sales agents, home workers, and full-time traveling or city salespeople. Similarly, two categories of workers are considered statutory nonemployees (i.e., self-employed): direct sellers and licensed real estate agents (requirements apply).

A Little Relief

In some situations, the IRS may relieve a business from having to pay employment taxes for an incorrectly classified worker. The business must have a reasonable basis for not treating the worker as an employee and must have been consistent in its treatment.

To find out more about whether you are classifying workers correctly and how to take advantage of the VCSP, contact our dedicated Tax Group, with CPAs in Troy, Mich., and Houston, Texas.