Stick or Carrot? New IRS Program Allows Reclassification of Independent Contractors

A newly-announced IRS program allows businesses to prospectively reclassify independent contractors as employees, and in doing so, may allow some businesses to avoid certain tax penalties which could possibly exceed 40% of the reclassified worker’s compensation for the prior 3 years. However, the program, dubbed the Voluntary Classification Settlement Program or “VCSP”, does have its drawbacks.

To be initial eligible to participate in the VCSP, the taxpayer must:

  • Have consistently treated the workers (or class of certain workers) as non-employees;
  • Have filed all appropriate 1099s for the workers;
  • Not be currently under audit with the IRS, the Department of Labor, or a state-level agency regarding the classification of the workers in question; and
  • Complete the IRS’ form to apply for the VCSP benefits.

If eligible and the IRS accepts the taxpayers application, the taxpayer must prospectively agree to treat the class of workers to be reclassified as employees. Under the VCSP, the taxpayer: (1) will pay 10% of the employment tax liability that may be due for the most recent tax year; (2) will not be liable for any interest or penalties; (3) will not be subject to an employment tax audit for prior years with respect to the reclassified workers; and (4) will agree to extend the statute of limitations on employment taxes for the three years after the VCSP program begins.

The VCSP is not for everyone. Often, a business’ classification of a worker as an independent contractor is appropriate and entirely supported by federal and state law. In such instances, it would not be appropriate for a business to reclassify a worker as an employee, and doing so would unnecessarily increase the business’ costs and taxes. However, if a business determines that it may have inappropriately classified workers as independent contractors in the past but is fearful of the significant tax penalties if it changes the workers’ employment classification, the VCSP may offer a significant benefit.

The bottom line – we recommend a careful analysis of independent contractors in light of the parameters of existing law in order to determine whether a worker should be classified as an employee or independent contractor.

One final caveat – the VCSP is a federal program only. If a business has exposure to state-level taxes, the VCSP will offer no relief.