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"Tax Tips – IRS program offers relief to firms that may have misclassified employees," by Carl Grassi published in Crain’s Cleveland Business

Published in Crain’s Cleveland Business
December 12, 2011

The IRS has unveiled a new voluntary compliance program to offer relief from exposure to federal employment taxes to businesses that have improperly classified their workers as independent contractors.

Under this program, employers who voluntarily change the classification of their workers from independent contractors to employees essentially will not be penalized and will not be subject to audits for prior years.

The terms of this new program are extremely favorable and should be considered by any business using independent contractors whose status as such is questionable. 

Some businesses may characterize their workers as independent contractors in order to avoid paying employment taxes. If those workers should be 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.

The IRS and other governmental agencies have recognized 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 for prior years (and in many cases for multiple employees).

Partially in response to these concerns, the IRS announced a program under which employers will not have to worry about past federal tax issues caused by the misclassification as long as they are willing to treat the workers as employees on a go-forward basis.

In order to qualify for this program, the business must:

  • Be presently treating the workers as nonemployees.
  • 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.
  • Not have any current dispute with the IRS as to classification issues, nor be under examination by the IRS, Department of Labor or any state agency relating to classification issues.
  • Have complied with the results of any prior examination by the IRS, Department of Labor or state agency that addressed worker classification issues.

The firm must agree to pay 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year and agree to an extension of the statute of limitations.

The business will not be liable for any penalties or interest on this amount, and the business will not be subject to an employment tax audit with respect to the classification of the workers for prior years.

In order to apply for this program, a business should complete and file Form 8952 — Application for Voluntary Classification Settlement Program. While there are a number of requirements for qualification, the terms of this offer are very favorable.

For instance, if an employer chan-ges the classification of one employee, the status of all employees with the same duties must be reclassified.

Unlike other “safe harbor” provisions providing relief for employers who have misclassified workers, this program does not require that the business have a “reasonable basis” for treating the worker as an independent contractor.

Many advisers appropriately advise 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.

Misclassification of workers can lead to a number of issues not involving the IRS, including issues relating to employment laws, workers’ compensation and the Employee Retirement Income Security Act (ERISA). Employers still will be required to address any issues created in these areas by the misclassification of the worker.

In addition, the business will have a significantly higher employment tax burden going forward for those reclassified employees.

Despite these concerns, given that misclassification can create a significant tax exposure, employers should carefully evaluate whether to take advantage of this program.

Mr. Grassi is president of McDonald Hopkins LLC.