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Published in Crain's Cleveland Business

February 11, 2013

A little more than a year ago, the IRS announced a new voluntary compliance program to offer employment tax relief to businesses that improperly classify workers as independent contractors.

Two IRS notices issued in December expand the program in several meaningful ways. Some of these expanded benefits expire in a very short timeframe, so business owners should examine any worker classification issues now to determine whether they can benefit from the expanded program.

Some businesses may improperly characterize workers as independent contractors in order to avoid paying employment taxes, but more often that not, such classification occurs because business owners are simply not sure what types of workers need to be treated as employees.

If workers treated as independent contractors should instead have been classified as employees under the tax law, this creates a significant tax risk to the business. There has been significant focus by the IRS and other governmental agencies over the last few years on whether businesses are appropriately characterizing workers as employees or independent contractors.

Legislation has been proposed from time to time over the last several years to enhance penalties for failure to make the appropriate classification, and to take away the benefit of some of the exceptions to these penalties.

Recognizing that part of the misclassification problem is caused by employers who believe that they may have misclassified a worker, but who are reluctant to change the classification due to the exposure to additional taxes, the IRS announced a program in late 2011 called the Voluntary Classification Settlement Program, or VCSP.

Under the VCSP, employers who voluntarily change the classification of their workers from independent contractors to employees going forward essentially will not be penalized and will not be subject to audit for prior years.

Under the original program, two of the requirements were that the business must:

  • have satisfied the Form 1099 reporting requirements for these workers for the three years preceding the year that a request for participation in the program is filed; and
  • not be under audit by the IRS.

The recent announcements make beneficial changes to the program relating to these requirements. First, the IRS makes it clear that taxpayers can apply for this program even if they are under IRS audit for a different issue.

Many businesses do not focus on the worker classification issue, so often the issue only comes up when advisers are consulted to deal with other parts of the IRS audit. The rule continues to be that no participation is allowed for taxpayers who are currently being examined by the IRS or other government agency specifically with respect to worker classification issues. The incentive is therefore to obtain this relief before the issue comes up on audit.

The most significant change announced provides an exception to the requirement that Form 1099s have been filed for the prior three-year period. That is no longer required. This relief is only available through June 30 of this year. The IRS was made aware that many businesses wanted to participate in the VCSP but had not filed some or all of the necessary Forms 1099.

These businesses can now participate as long as they furnish to the workers and electronically file with the IRS all required Forms 1099, consistent with the non- employee treatment, with respect to the workers being reclassified for the previous three years prior to executing the closing agreement with the IRS.

The cost of this expanded program is more than the cost for an employer who did file the appropriate Form 1099s. However, this cost is still dramatically less than if the IRS determines upon audit that the workers were misclassified.

Many advisers have appropriately advised their clients to exercise caution with their decision to participate in this program. A business considering relief under this program must realize that it is not binding on any state or other governmental agency.

There was some concern that the IRS would share the information provided in the VCSP application with such agencies. Surprisingly, the IRS has indicated in its FAQ publication that it will not share the information with the Department of Labor or any state agency.

The expansion of this program is very favorable, especially with respect to businesses that previously did not qualify, either because they were currently under audit by the IRS or had not filed Form 1099 for the workers at issue. The terms of the expanded program should be considered by any business using independent contractors whose status as such may be in doubt.

Mr. Grassi is president of McDonald Hopkins LLC.