The IRS doesn’t make the laws, it just enforces them.
In the case of worker classification, the laws go back beyond the last century, to common law. They can vary in their application, and for many employers there’s no certainty that they’ve made the right decision. That’s why it’s refreshing that the IRS has introduced a voluntary worker classification program, which aims to cut through the confusion that is a part of established case law and legislation on the topic.
Treating a worker as an independent contractor rather than as an employee allows the employer to avoid FICA and FUTA matching, and income tax withholding. And 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 their immigration status.
There’s no bright-line test as to whether a worker is an employee or an independent contractor, but the consequences of misclassification, whether inadvertent or deliberate, can be severe. The employer may be liable for the employer’s share of employment taxes, as well as penalties and backup withholding.
Under the new Voluntary Worker Classification Settlement Program, taxpayers can prospectively reclassify their workers with very limited additional federal employment tax liability for past misclassification, said Mary Gorman, senior manager of tax controversy and risk management services at Ernst & Young LLP.
“The law isn’t settled,” she said. “There’s a hole in the guidance because of the Section 530 prohibition.”
Section 530 of the Revenue Act of 1978 provides a safe harbor for employers to classify workers as independent contractors, and 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,” Gorman added. “They vary industry by industry, and within industries, so it’s an area where you can get it wrong.”
“For people who need and want to resolve this issue, it’s probably the easiest and cheapest way to do it,” she said.
Gorman, a former assistant division counsel in the Office of Chief Counsel at the IRS, noted that employers that want to reclassify employees as of Jan. 1, 2012, need to apply for the program by Nov. 2, 2011. Form 8952, Application for Voluntary Classification Settlement Program, must be filed at least 60 days before they want to begin treating the workers as employees.
“They fill out the form and send 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,” she said. “The taxpayer signs it and sends it back with the amount owed, the IRS signs it, and it’s complete.”
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.”
So it’s a pretty good deal for employers losing sleep over the issue. 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.
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