IRS Announces Settlement Program for Employers Using Independent Contractors Who Should Be Classified as Employees

The IRS announced an important settlement program on September 21, 2011 where the IRS will now give many employers substantial tax relief for treating employees as “independent contractors”.  Details of the settlement program were provided in Announcement 2011-64, which will officially be published in the Internal Revenue Bulletin 2011-41, to be issued October 11, 2011.

Whether a worker is performing services as an employee or independent contractor depends on the facts and circumstances and is generally determined under a multiple factor common law test focusing on whether the employer has the right to direct and control how the worker is to perform the services. In many situations, the determination of whether a worker is properly an employee or an independent contractor under the common law test is not clear.  The distinction of employee vs. independent contractor status for a worker may have significant importance to the employer.

If a worker is classified as an employee, the employer is required to withhold federal (and potentially state) employee income and employment taxes, and the employer is also required to separately pay a matching share of federal employment taxes.  The employee may also be eligible to participate in sometimes costly employer retirement and benefit plans, and the employer may also have to fund other state-based employee benefits and requirements, such as workers compensation insurance.  If a worker is treated as an independent contractor, by contrast, the employer is required to do none of these things for the worker and must simply pay the independent contractor the stated payment or other compensation for the worker’s services.

Under the new IRS Voluntary Classification Settlement Program (VCSP), the IRS will now allow employers to apply to prospectively change the status of workers (or a class or group of workers) from independent contractors to employees.  To be eligible, the employer must satisfy the following:

  • The employer must have consistently treated the workers as nonemployees;
  • The employer must have filed all required Forms 1099 for the workers for the previous three years;
  • The employer cannot currently be under audit by the IRS;
  • The employer cannot also be currently under audit concerning the classification of the workers by the Department of Labor or by a state government agency; and
  • If the employer was previously audited by the IRS or the Department of Labor concerning the classification of the workers, the employer must have complied with the results of that audit.

If the IRS accepts an application of an employer under the VCSP, the employer must agree to prospectively treat the workers as employees for future tax periods and agree to extend the applicable three-year statute of limitations period on assessment for employment taxes for the first, second and third calendar years beginning after the date on which the taxpayer enters the VCSP.  The IRS and the employer will sign a closing agreement to memorialize the VCSP settlement.

In exchange, the employer will be required to pay only 10 percent of the federal employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Section 3509 of the Internal Revenue Code and, importantly, the employer will also not be liable for any penalties or interest and not be subject to IRS employment tax audits related to worker classification of the workers for prior years.

While any employer may file for relief under the VCSP, the IRS has stated that it will still retain discretion whether to accept an employer’s application for the VCSP.   Relief, therefore, is not automatic.

Taxpayer Impact:

Employee/independent contractor issues have been one of the most important IRS audit issues now for years.  The IRS has devoted substantial time and resources in identifying non-complying employers, and, once found, the IRS will assert unpaid employment taxes going back years, together with hefty penalties and interest.  Once the IRS audit is completed, the employer then is often welcomed with a visit from the applicable state employment agency, which seeks its share of unpaid employee-related taxes, fees, and assessments.  These audits also have a tendency to expose the employer to worker lawsuits, especially when a worker retires or is injured on the job and finds he or she has no benefits.

While employer/independent contractor settlement programs have been used before by the IRS during actual audits, this is the first time the IRS has offered a broad and very attractive settlement program to the general public.  Employers using independent contractors with an uncertain classification should carefully consider applying under this new program, especially given the low, one-year, 10%  settlement payment, in exchange for essentially full employment tax forgiveness for these workers for all prior tax years.

About the Author

Erik P. Doerring
Erik leads the firm's economic development and tax practices. He is a business lawyer, with the skills of a tax litigator. Prior to joining McNair, Erik was an attorney with the IRS Office of Chief Counsel and the U.S. Department of Justice, Tax Division.