Treating a worker as an independent contractor rather than an employee has its advantages, say tax experts.

Companies that classify workers as independent contractors not only avoid FICA and FUTA matching and income tax withholding, they also escape paying benefits such as vacation pay, sick pay, and workers' compensation. Moreover, workers may be motivated to be misclassified as independent contractors so that they can be paid in cash, avoid withholding of taxes, or avoid proving immigration status.

Worker classification laws go back beyond the last century to common law. Because they vary in their application, for many employers there's no certainty that they've made the right decision. And for some, the decision can have extreme consequences. If an employer loses a challenge on the status of a worker, it can be hit with tax deficiencies exceeding 40 percent of reclassified salary for the previous three years. If the Internal Revenue Service finds that the employer's conduct was not willful, it uses a lower rate of 11 percent.

Contrast this with the penalties levied under the new IRS Voluntary Classification Settlement Program, under which taxpayers can prospectively reclassify their workers with very limited additional federal employment tax liability for past misclassification.

"For people who need and want to resolve this issue, VCSP is probably the easiest and cheapest way to do it," said Mary Gorman, senior manager in tax controversy and risk management services at Big Four firm Ernst & Young LLP.

However, there's no bright-line test as to whether a worker is an employee or an independent contractor.

"The law isn't settled," explained Gorman. "There's a hole in the guidance because of the Section 530 prohibition." Section 530 of the Revenue Act of 1978, which provides a safe harbor for employers to classify workers as independent contractors, also prohibits the IRS from issuing revenue rulings or regulations in this area. "In addition, the court cases are fact-intensive and not at all uniform. They vary industry by industry, and within industries, so it is an area where you can get it wrong."

She noted that Form 8952, Application for Voluntary Classification Settlement Program, must be filed at least 60 days before a company wants to begin treating the workers as employees.

"The employer fills out the form and sends it to the IRS; the IRS does an eligibility check, and if the employer passes the check, the IRS will prepare a closing agreement and send it to the taxpayer to sign," Gorman said. "The taxpayer signs it and sends it back with the amount owed, the IRS signs it and it's complete."

 

VCSP GUIDELINES

Under the program, the amount owed effectively equals just over 1 percent of the wages paid to the reclassified workers for the past year, with no interest or penalties. (Specifically, 10 percent of employment taxes computed under the reduced rates of Internal Revenue Code section 3509(a). Under this section, the effective tax rate for compensation up to the Social Security wage base is 10.68 percent in 2010 or 10.28 percent in 2011, and 3.24 percent for compensation above the Social Security wage base.)

There's no admission of guilt by participating in the program, Gorman emphasized. "Part 5 of Form 8952 says that the taxpayer wishes to voluntarily reclassify. It doesn't say that they have misclassified. It's prospectively changing how they treat their employees."

Of course, employers who hire workers may have legitimate reasons to treat them as independent contractors. That's where a decision has to made, balancing the risk of waiting for an audit or voluntarily coming forward and resolving things.

"If a taxpayer wants certainty, this is good for them," said Gorman.

 

CAUTION FLAGS

Because the delineation between an employee and an independent contractor is vague, employers can inadvertently fall into the trap of misclassifying their workers. But for those who do so intentionally, the consequences can be severe.

"For employers, there's about a 25 percent savings when someone is treated as an independent contractor, rather than an employee," said Robert McKenzie, tax partner at Chicago-based Arnstein & Lehr.

"The danger is that if you misclassify and fail to participate in the program, it's a bet-your-company cost," he said. "Even if the misclassification was unintentional, you can get hit with an audit amount of 11 percent of total compensation paid to workers for three years, or 40 percent if the misclassification was intentional. But if you go forward with the voluntary program, you pay one year at 1.1 percent."

A drawback to participating in the program is that it could put the employer at a competitive disadvantage, he observed. "If the employer's major competitors are treating employees as independent contractors, they will enjoy a competitive cost advantage, so it's in their best interest to notify the IRS of a competitor's misconduct."

 

IMMIGRATION ISSUES

Moreover, the issue of illegal immigration is a consideration in many employers' hiring classification. "If you're hired in the U.S., you have a duty to establish that you are here legally," said McKenzie. "The employee must fill out a Form I-9, and verify legal working status. An independent contractor does not have that duty."

Another potential drawback to participation in the program is the fact that it does not provide safety from potential misclassification liability from private lawsuits under federal and state wage and hour laws, and the federal employee benefits law, according to Richard Reibstein, a partner in the New York office of Pepper Hamilton LLP.

"Many companies remain concerned about potential exposure to private class-action lawsuits by workers who may claim that they have been improperly paid on a 1099 basis and are allegedly owed unpaid overtime under state or federal law, or unpaid benefits under a company's employee benefits plans," he said.

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