In an era of constantly changing tax laws where provisions expire annually and congressional tinkering is constant, the worker classification system - whether a worker should be treated as an employee or an independent contractor - has remained relatively unchanged for years. Yet that system has generated so much uncertainty that calls for reform have been continuous over the same period of time.
While not addressing the fundamental issue of the difficulty of properly classifying workers, the Internal Revenue Service has now initiated a program, without an end date, to encourage businesses to change the classification of particular classes or all of their workers from independent contractor to employee, with sharply reduced exposure to back taxes and penalties for doing so.
The basic rules for classification of workers go back to common-law principles. An employment relationship is generally viewed to exist if the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. In Revenue Ruling 87-51, the IRS set forth these common-law principles as 20 factors to be considered, which has since come to be known as the 20-factor test. These 20 factors are not assigned any particular weight, nor is there any clear standard for how many of the factors need to be met for a worker to be classified as an employee.
While this common-law test remains the only test available for income tax purposes, Act Sec. 530 has provided a safe harbor for businesses since 1979 for employment tax purposes. Although it has been changed somewhat over the years, it basically provides that the business can safely treat a worker as an independent contractor for employment tax purposes if the business has a reasonable basis for not treating the worker as an employee, the business did not treat the worker or any other workers in a similar position as an employee for employment tax purposes, and the business filed all required federal tax returns, including information returns, consistent with that position. A reasonable basis can be established by reliance on a prior IRS audit, administrative or judicial precedent, long-standing industry practice, or any other reasonable basis.
Act Sec. 530 also prohibits the Treasury and the IRS from publishing guidance related to worker classification issues involving employment taxes. Although originally done to "keep it simple" and prevent the government from layering rule after rule onto what was considered a relatively simple framework, the result has also been confusion over how the basic guidelines under Act Sec. 530 were to apply to changing industries and workplace expectations.
In this uncertain environment, the IRS in late September announced a new program, the Voluntary Classification Settlement Program, to permit businesses to reclassify workers as employees for employment tax purposes for future tax periods with a "carrot" of significant relief from past employment taxes. The IRS also announced a few days earlier the "stick" part of the plan - a new partnership with the Department of Labor to work together to identify and curb worker misclassification issues. A number of states also signed agreements with the Department of Labor to address these issues at the state level.
To be eligible for the program, a taxpayer must have consistently treated the workers as independent contractors, and must have filed all required Forms 1099 for the workers at issue for the previous three years. This three-year rule is much less stringent than the Act Sec. 530 requirement of historical consistent treatment, and does not include the Act Sec. 530 requirement of having had a reasonable basis for the independent contractor classification. Also, the taxpayers cannot currently be under audit by the IRS, the Department of Labor, or a state government agency. If the IRS or DOL has previously audited the taxpayer on classification issues, the taxpayer must be in compliance with the results of that audit. Exempt and governmental organizations meeting these requirements may also participate.
In exchange for agreeing to treat the class of workers as employees for future tax periods, the taxpayer will only be required to pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, as determined under the reduced rates of Code Sec. 3509(a). In addition, the taxpayer will not be liable for any interest or penalties on the taxes, and the taxpayer will not be subject to an employment tax audit with respect to worker classification of the workers being reclassified for prior years. The taxpayer must agree to extend the statute of limitations for assessment of employment taxes for an additional three years for the first three years under the program in conjunction with entering into the closing statement with the IRS.
To apply for the VCSP, the taxpayer must complete a new Form 8952, filing it at least 60 days prior to the date that the taxpayer wants to begin treating its workers as employees. The IRS has issued a set of frequently asked questions to further explain the terms of the program. Among the issues addressed in the FAQ, it is clarified that the taxpayer may apply for the program with respect to any particular class of workers - it need not be all of their workers. The VCSP is not available to state and local government employers for workers covered under a Section 218 agreement. An exempt organization currently under a Form 990 series examination is considered to be under audit and is not eligible.
Taxpayers are to pay the sums due under the VCSP not at the time of application, but at the time of entering into the closing agreement with the IRS. Question 16 discusses how the payment is calculated. Taxpayers rejected from the program for lack of eligibility may re-apply at a later time.
This new Voluntary Classification Settlement Program from the IRS provides businesses seeking to reduce their worker classification exposure with an opportunity to come forward with relatively little penalty for past misdeeds. Businesses that have shifted toward treating more workers as independent contractors in this most recent economic downturn may not meet even the more relaxed three-year consistent treatment test for the program.
This new program does not address the continuing difficulties faced by businesses in trying to apply the 20-factor common-law test or even the Act Sec. 530 test to determine the proper classification of workers. The VCSP seems in that light to be akin to a quasi-tax-amnesty program, in which those businesses that realize that they don't have much of a chance of winning a classification dispute in favor of independent contractor status may want to participate.
Among those businesses with borderline arguments for independent contractor status, the VCSP also might promise enough "tax certainty" that signing on to "employee treatment" may be worth the assurance (or insurance) from further audit surprises. For those businesses (and tax-exempts) that believe they have a strong case for independent contractor status, however, the potential for tax savings in not "rolling over" but rather "rolling the dice" and litigating might remain a consideration.
President Obama has proposed restoring to the IRS the right to provide additional guidance to businesses and workers in this area. Most commentators feel that additional guidance is badly needed, while cautioning that, depending on the form of that guidance, more harm than good could result.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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