Solving contractor misclassification

Some businesses that have classified workers as independent contractors realize that when or if the IRS audits them on this issue they will lose. Losing means a large tax bill including penalties and interest. At the same time they worry that if they change their classification of their workers and start to treat them as employees this will attract attention and the IRS will audit them for previous years. They find themselves between a rock and a hard place and remain frozen in indecision.

Previously there have been some ways of escape: the Section 530 safe harbor and the Classification Settlement Program. Both of these are attempts to control the damage of an IRS audit. Starting in 2011 another voluntary program is available.

Section 530 is a relief provision which can help taxpayers who have a reasonable basis for treating their workers as independent contractors, even if such treatment is later found to be mistaken. IRS guidelines in the Internal Revenue Manual state the safe harbor must be considered as the first step in any IRS audit involving worker classification.

The taxpayer can come under the safe harbor if it:

* Had a reasonable basis for not treating workers as employees;

* Was consistent in its treatment of any similar workers as contractors; and

* Consistently filed any required Form 1099s with the IRS.

In cases where the business clearly meets the Section 530 requirements, the business may continue treating its workers as independent contractors under Section 530. However, Section 530 is not part of the Internal Revenue Code; it is a section of the Revenue Act of 1978. It was meant to provide short-term help not become a permanent part of tax law and there have been some indications that President Obama is considering modifying this relief provision.

Another way a business can settle worker classification issues with the IRS is through a Classification Settlement Program. This program offers employers that are under audit by the IRS the opportunity to pay only a portion of the employment taxes due for the year the workers were misclassified.

The discount amount offered to the employer by the IRS depends on how closely they mirror the Section 530 requirements. It will be difficult to get a discount if the workers have not been consistently issued Form 1099s by the company. The best deal an employer can get is an assessment of 25 percent of the employment tax liability for the audit year (i.e. FUTA, employer's share of FICA Taxes and employee's share of FICA taxes and Federal Income Tax Withholding) for the reclassified workers. In addition, the business must agree to treat the workers as employees prospectively.

In 2011 a new program was issued by the IRS for those businesses that want to come out from the shadows but not be eviscerated by taxes and penalties. It is called the Voluntary Classification Settlement Program or VCSP and it allows for the reclassification of workers as employees before an audit by the IRS is started.

Please understand this is not a complete amnesty program where all is forgiven with no consequences. The taxpayer agrees to prospectively treat the class of workers as employees and will only pay about 10 percent of the prior year payroll tax on compensation paid to the workers. In exchange, they will not be subject to an employment tax audit regarding the classification issue for prior years and they will not be liable for interest and penalties.

Not all businesses will qualify of course. To be eligible to enter the VCSP the taxpayer must have consistently treated workers as independent contractors, must have filed all Form 1099s for the workers for the last three years and must not currently be under an employment tax audit by the IRS, the Department of Labor or a state agency concerning the classification of workers.

To encourage participation in the program last month the IRS modified the VCSP and has temporarily waived the Form 1099 requirement through June 30, 2013. Now for a limited time taxpayers who would not meet this requirement are able to resolve not only worker misclassification issues, but also the failure to file the required Form 1099s, all on favorable terms.

While the VCSP may be a good deal for employment tax purposes there are other considerations that a business should make prior to volunteering to change their worker's status to employees. For example, this program provides a way out for federal- employment taxes. And while the IRS indicates they will not share any information about the reclassification with the Department of Labor or state government agencies, somehow the states might find out. It is a risk to be considered. Currently neither the State of Nevada nor the State of California is offering similar relief programs for employment taxes. If a California business has been around for 15 years and has never filed with the California Employment Development Department and suddenly they start reporting they have 40 employees this may raise a red flag that the cash-strapped State of California can't resist.

In addition, there are other non-tax issues that should be carefully considered. How might workers react? Do they have a claim for past benefits? The answers to these questions and how they would impact the business should be known and addressed. Employers are encouraged to seek professional assistance including legal counsel to evaluate the benefits and consequences of entering into the VCSP.

In summary, while the IRS has the power to audit a company on the worker classification issue taxpayers are not powerless; they have tools they can use to protect themselves. As is true with all situations, the trick is having the right tool for the job.

For assistance in exploring your options please contact your tax advisor.

Susan Van Plew, CPA is a senior manager with Kafoury, Armstrong & Co. For more information, contact her at 775-689-9100 or visit www.kafoury.com.