In recent years, the Internal Revenue Service (IRS) has stepped up audits of companies that it believes have misclassified W-2 employees as 1099 contractors. Because contractor wages are not subject to tax withholding, the Government Accountability Office estimates that misclassification has cost the government $4 billion in unpaid federal taxes alone. In an effort to recoup some of these losses, in 2011 the IRS implemented its Voluntary Classification Settlement Program (VCSP). The program offers employers the opportunity to prospectively reclassify 1099 workers as W-2 employees, pay a small percentage of back taxes and penalties that would otherwise be due and avoid an IRS audit.
For employers who believe that certain workers have been misclassified, the VCSP provides a chance for a fresh start at a substantial discount. As discussed below, however, there are strings attached that must be considered in deciding whether to participate in this program.
An employer who qualifies for the VCSP will pay 10 percent of the employment taxes that would have otherwise been due on compensation paid to the reclassified workers for the most recent tax year, calculated under section 3509(a) of the Internal Revenue Code. The employer will not be liable for interest and penalties on the payment made under the VCSP and will not be audited for employment tax purposes with respect to the workers’ classification. In return, the employer must reclassify all workers in the same class or classes for employment tax purposes and treat them as employees going forward.
In order to qualify for the VCSP, a taxpayer must have consistently treated the workers in question as nonemployees, including by filing Form 1099 with respect to their compensation for the previous three years. Taxpayers who are currently under an IRS or Department of Labor employment law audit will not be permitted to participate in the VCSP.
Employers who wish to apply for the VCSP must file Form 8952 with the IRS at least 60 days before the prospective change in worker classification is to occur. Form 8952 requires a description of the classes of workers to be reclassified, a calculation of the payment due and various taxpayer representations to be made under penalty of perjury. The IRS will review the application and determine whether the employer is eligible for the program, then contact the taxpayer and make arrangements for payment of the amounts that are due.
The tax savings may be substantial. Under section 3509(a) of the Internal Revenue Code, employers are assessed income tax withholding, social security tax, and Medicare tax of 10.68 percent of employee wages up to the social security wage base (currently $118,500 per person) and 3.24 percent of wages over the social security wage base. If an employer paid $1.5 million to workers who were subject to the VCSP (all of whom earned less than the social security wage base), the applicable payment under section 3509(a) would be $154,200. Under the VCSP, the employer’s payment to the IRS would be only $15,420.
There is a significant downside to participation in the VCSP, however.
The VCSP provides relief only for federal tax purposes; potential state and local tax liability is not reduced. In addition, there are a number of federal laws that protect employees, but not independent contractors. An employer’s agreement to treat workers as W-2 employees may lead to claims under the Fair Labor Standards Act, federal anti-discrimination laws, the National Labor Relations Act, ERISA and state workers’ compensation and unemployment statutes. Workers who are reclassified on a going-forward basis may claim that they were misclassified in the past and assert claims going back for years.
While the VCSP may provide substantial tax relief to an employer that believes it has misclassified workers in the past and wants to head off a tax audit, taxpayers should consider the big picture and determine whether the tax savings are offset by potential liability to the newly reclassified employees.