Worker classification has long been an area only vaguely understood by many employers. The law is not only not settled -- it is unclear from the start, with its origins in the common law of England going back centuries.

Of course, Robin Hood had no problem deciding who to send a Form 1099 to. The classification initially dealt with the relationship between a provider of services and the one to whom the services were provided, often defined in terms of a master-servant relationship. The purpose of the classification was to define the rights and obligations of each party in the relationship.

For most CPAs of today, however, the classification relates to the obligations of the employer to the taxing authorities. There are benefits to treating a worker as an independent contractor, rather than as an employee. 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. 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 immigration status.

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.

 

What we know

Generally, under common-law principles a person is an employee if they are subject to another's right to control the manner and means of performing the work, while independent contractors obtain customers on their own to provide services to, and are not subject to control over the manner in which they perform their services.

In order to simplify the body of common law surrounding degree of control, the Internal Revenue Service came up with 20 factors that go to determine the degree of control in a worker relationship. The 20 factors were further compressed in 2001 into three categories: behavioral control, financial control, and the relationship of the parties. None of these factors provides a definitive test as to whether a particular worker is an employee or independent contractor.

Congress, while not providing a definitive template to determine worker status, did come up with a safe harbor for employers in the Revenue Act of 1978. The provision, footnoted in the Internal Revenue Code but not a part of it, prevents the IRS from retroactively reclassifying workers as employees, if the employer meets three conditions:

  • It must have consistently treated the workers as independent contractors;
  • It must have complied with the Form 1099 reporting requirement with respect to the compensation paid the workers for the tax years at issue; and,
  • It must have had a reasonable basis for treating the workers as independent contractors.

The IRS introduced its Classification Settlement Program to encourage employers to prospectively reclassify workers as employees more than a decade ago. It has since re-introduced the program as the Voluntary Classification Settlement Program. For employers that suspect that they are paying individuals as independent contractors who might be considered employees, the VCSP has been in place since 2011, allowing taxpayers to prospectively reclassify their workers with very limited additional federal employment tax liability for past misclassification.
 

The latest developments

Several eligibility requirements have been eased, making it possible for more employers, especially larger ones, to apply. And employers accepted into the program will no longer be subject to a special six-year statute of limitations rather than the usual three years that applies to payroll taxes. So far, nearly 1,000 employers have applied for the VCSP, according to the IRS.

Under the revamped program, employers under IRS audit, other than an employment tax audit, can qualify for the VCSP. And while employers are normally barred from the VCSP if they failed to file required Forms 1099 with respect to workers whom they are seeking to reclassify for the past three years, the IRS is waiving this eligibility requirement until June 30, 2013.

Employers accepted into the program generally pay an amount just over 1 percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Those employers applying under the temporary relief program who failed to file Forms 1099 for the workers in question will pay a slightly higher amount, plus some penalties, and will need to file any unfiled Forms 1099 for the workers they are seeking to reclassify. Since the ramifications of misclassifying can amount to close to a 40 percent penalty of total compensation paid to workers over three years, the VCSP is a great deal - provided there are legitimate concerns over workers' status. And for those that want to participate for workers for whom no Form 1099s have been filed, the clock is running: The expanded eligibility runs until June 30, 2013.

 

Is it for your clients?

But it makes sense to give careful thought to whether you really need to reclassify, Knoxville CPA Edgar Gee said. "[The IRS] says you have to always have treated the workers as independent contractors and consistently issued them Form 1099s. What they don't tell people is that if you had consistently treated workers as independent contractors and consistently issued them 1099s, guess what? You've met the first two prongs of Section 530. And if you have met the first two prongs, then any reasonable basis under Section 530 satisfies the test." It's something like baseball, Gee analogized. "If you have met the conditions of treatment and of reporting, it's as if you're on third base with no outs, and the three people coming up to bat are the three best hitters in the league. There are lots of ways to get home from third base. What the service is trying to get you to do is fall on your sword. They want you to decide that you don't have a chance so you might as well get picked off third base."

If a business is using independent contractors, then they have made a business decision to do that, observed Willis Jackson, a Knoxville attorney who, with Gee, has litigated the matter in 27 different states both at the federal and state level. "They have decided that it's the best way to do business. For you to reclassify them as employees is to cause you as a business owner to change a fundamental method of doing business. If you do that, the service is now dictating your method of doing business."

"The reclassification program may cause you to make a business decision that is not in your best interest," he concluded.

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