IRS Giving Employers a Chance to Right their Misclassification Wrongs with Voluntary Classification Settlement Program

In the continuing, uphill battle against employee misclassification — or “classification fraud” — the IRS has announced a new program, the Voluntary Classification Settlement Program (VCSP), which would allow employers to reclassify independent contractors as employees for future tax periods. In exchange, the liability for past payroll obligations will be cut to 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year.

Employee misclassification produces a “triple jeopardy” effect by hurting misclassified workers, businesses that play by the rules, and the government which loses tax revenue. When employees are labeled as independent contractors instead of employees it shifts responsibility for tax deductions to the worker. While not every independent contractor is misclassified, there is a thin line between the two worlds. The IRS currently uses these three factors to determine if a worker is an employee or an independent contractor.

• Behavioral. Does the employer control, or have the right to control, what the worker does and how the worker does his or her job?

• Financial. Does the employer control the business aspects of the worker’s job? For example, is the worker paid a salary? Does the employer reimburse the worker’s expenses? Does the employer provide the tools or supplies to do the job?

• Type of relationship. Does the worker receive employee-type benefits? Will the relationship continue after the work is finished? Is the work a key aspect of the employer’s business?

According to IRS standards, a worker isn’t an independent contractor unless the employer has the right to control or direct only the result of the work — as opposed to also controlling the details of how the work is performed.

To be eligible for the VCSP employers must have classified workers or groups of workers as independent contractors for the previous three years. Employers currently being audited by the IRS or Department of Labor for classification violations are not eligible. The IRS gives the following example of how an employer could benefit by voluntarily reclassifying workers.

Consider an employer that paid $1.5 million in 2010 to workers who are being reclassified, all of whom were compensated at or below $106,800. The employer submits its application on Oct. 1, 2011, and proposes to reclassify the workers beginning on Jan. 1, 2012. (The application must be filed at least 60 days before the desired reclassification date.) In that case, 2010 is the most recent tax year, so the employment taxes under Sec. 3509 would be $160,200 (10.68 percent of $1.5 million). Under the VCSP, the employer must pay only $16,020 (10 percent of $160,200).

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