By Raj Grewal
Spurred by considerations of fair play, the need for higher revenue, and the relaxed compliance records of many businesses, Congress, the IRS, the Department of Labor, and several states have started to take more decisive action with regard to the misclassification of employees. On September 21, 2011, the IRS began a new Voluntary Classification Settlement Program (“VCSP”) to allow employers who have misclassified their employees as independent contractors in the past to voluntarily reclassify their workers for future tax periods. Although the VCSP is a promising solution to address the chronic problem of employee misclassification, businesses are best advised to wait for the program to more fully develop before plunging into a new voluntary program fraught with the risk of dissemination of information beyond the IRS, opening taxpayers up to stiff penalties with the Department of Labor and state agencies.
Background on Employee Classification
A worker must be classified as an employee if the employer exercises control and direction over her. The IRS has provided a list of 20 factors in Revenue Ruling 87-41 to help determine whether “control” exists (for convenience, the 20 factors are attached as Exhibit A). These 20 factors can be sorted into three broad categories: behavioralcontrol (determining time and place of work, training, and other details of the worker’s performance), financial control (business aspects of worker’s job, such as travel and other expenses), and the relationship of the parties (whether evidenced by written contract, benefits such as paid vacation and health coverage, permanency of the position, and extent to which services performed are a key aspect of the company’s regular business). If workers are properly classified as employees, then the employer must withhold federal income tax under Chapter 24, Medicare tax under the auspices of the Federal Insurance Contributions Act, and Social Security tax under Subchapter A of Chapter 21. If any employer fails to withhold such taxes, then it risks opening itself up to liability for a deficiency assessment and statutory penalties for the negligent or willful failure to withhold taxes.
The Voluntary Classification Settlement Program
From a purely federal employment tax standpoint, the VCSP is a great deal for taxpayers. A taxpayer who chooses to reclassify its employees will pay only 10% of the amount of employment taxes due under the already reduced rates of Section 3509(a) applied to taxpayers who did not intentionally disregard the requirement to deduct and withhold employment taxes. The combined effective tax rate under Section 3509(a) for 2011 is 10.28% up to the Social Security wage base. This covers Social Security and Medicare taxes (employer’s and employee’s share) and federal income tax withholding. That means the payment required to enter the VCSP in 2012 is a mere 1.28% of the total wages paid to workers in 2011 only, a pittance compared to the amount that would be owed if the misclassification is caught by the IRS in audit. The taxpayer is not required to pay any interest or penalties. And, most importantly, the taxpayer can be certain that it will not be liable for past failures to collect employment taxes, as the IRS will agree not to audit the taxpayer for employment tax purposes.
The taxpayer must, however, treat the workers or class of workers under consideration as employees for employment tax purposes in future years, making the taxpayer responsible for collecting the full amount of federal income tax withholding, Medicare tax, and Social Security tax going forward. In addition, the taxpayer must have filed the required Form 1099 for each such worker for the past three years and must also extend the period of limitations on assessment of employment taxes by three years for the first, second, and third calendar years after entering the VCSP. Taxpayers who have not stayed current in their 1099 filings are not eligible for the VCSP.
The Problem of State Enforcement and Interaction with the Department of Labor
The IRS has made a policy decision (conveyed on its website and in statements from its employees, but not in any formal ruling or publication) not to share taxpayer information gathered from the VCSP with the Department of Labor or with state taxing and labor authorities. This position is in sharp contrast to the memoranda of understanding adopted September 19, a mere two days prior to creating the VCSP, with the Department of Labor and at least thirty states in which the IRS agreed to share similar information gathered in its normal audit process. Still, it may be very difficult as a practical matter to fully comply with the VCSP and at the same time keep state authorities in the dark about the voluntary disclosure. The obligation to properly classify employees going forward may in and of itself be problematic for taxpayers not wishing to raise alarm bells with state authorities.
In New York, Governor Cuomo started a Joint Task Force spanning the New York State Department of Labor, Department of Taxation and Finance, Workers’ Compensation Board, the Attorney General’s office, and the Comptroller of the City of New York to aggressively enforce employee classification rules. It was his second Executive Order after entering office. Employers found to have misclassified employees are responsible not only for taxes that should have been withheld, but also for missed payments into the unemployment insurance trust fund, statutory fines for inadequate worker’s compensation contributions, and potential wage disputes related to overtime pay and other pay issues. One business, a bakery in the Bronx, was even prosecuted criminally by the Task Force for falsifying business records, failure to pay wages, and making false statements or representations pertaining to unemployment insurance. In addition to paying back wages, taxes, and worker’s compensation related penalties, the defendant was sentenced to thirty days in prison and five years probation. Participating in the VCSP provides absolutely no protection against such penalties at the state level or even against independent investigations by the federal Department of Labor, which assesses its own penalties.
The VCSP represents a real step forward in leveling the playing field between compliant and noncompliant businesses as well as providing certainty in an area that affects nearly all employers. Those businesses in targeted industries, like restaurants and construction companies, or businesses likely to be challenged for unemployment benefits by recently laid off workers, might wish to take advantage of the VCSP considering its low entry cost. However, many other businesses may wish to wait for a global disclosure regime covering state taxing authorities to develop, much as it did with the Offshore Voluntary Disclosure Program, in which the IRS offered incentives similar to those under the VCSP to taxpayers who came forward voluntarily and reported their previously undisclosed foreign accounts and assets. Many states created complimentary offshore account and asset disclosure programs. And, unlike the Offshore Voluntary Disclosure Program, the VCSP is not time limited, making a wait-and-see approach that much more attractive.
Exhibit A: 20 Factors from Revenue Ruling 87-41
(1) Instructions. An employee must comply with instructions about when, where and how to work. The control factor is present if the employer has the right to require compliance with the instructions.
(2) Training. An employee receives on-going training from, or at the direction of, the employer. Independent contractors use their own methods and receive no training from the purchasers of their services.
(3) Integration. An employee’s services are integrated into the business operations because the services are important to the business. This shows that the worker is subject to direction and control of the employer.
(4) Services rendered personally. If the services must be rendered personally, presumably the employer is interested in the methods used to accomplish the work as well as the end results. An employee often does not have the ability to assign their work to other employees, an independent contractor may assign the work to others.
(5) Hiring, supervising and paying assistants. If an employer hires, supervises and pays assistants, the worker is generally categorized as an employee. An independent contractor hires, supervises and pays assistants under a contract that requires him or her to provide materials and labor and to be responsible only for the result.
(6) Continuing relationship. A continuing relationship between the worker and the employer indicates that an employer-employee relationship exists. The IRS has found that a continuing relationship may exist where work is performed at frequently recurring intervals, even if the intervals are irregular.
(7) Set hours of work. A worker who has set hours of work established by an employer is generally an employee. An independent contractor sets his/her own schedule.
(8) Full time required. An employee normally works full time for an employer. An independent contractor is free to work when and for whom he or she chooses.
(9) Work done on premises. Work performed on the premises of the employer for whom the services are performed suggests employer control, and therefore, the worker may be an employee. Independent Contractor may perform the work wherever they desire as long as the contract requirements are performed.
(10) Order or sequence set. A worker who must perform services in the order or sequence set by an employer is generally an employee. Independent Contractor performs the work in whatever order or sequence they may desire.
(11) Oral or written reports. A requirement that the worker submit regular or written reports to the employer indicates a degree of control by the employer.
(12) Payments by hour, week or month. Payments by the hour, week or month generally point to an employer-employee relationship.
(13) Payment of expenses. If the employer ordinarily pays the worker’s business and/or travel expenses, the worker is ordinarily an employee.
(14) Furnishing of tools and materials. If the employer furnishes significant tools, materials and other equipment by an employer, the worker is generally an employee.
(15) Significant investment. If a worker has a significant investment in the facilities where the worker performs services, the worker may be an independent contractor.
(16) Profit or loss. If the worker can make a profit or suffer a loss, the worker may be an independent contractor. Employees are typically paid for their time and labor and have no liability for business expenses.
(17) Working for more than one firm at a time. If a worker performs services for a multiple of unrelated firms at the same time, the worker may be an independent contractor.
(18) Making services available to the general public. If a worker makes his or her services available to the general public on a regular and consistent basis, the worker may be an independent contractor.
(19) Right to discharge. The employer’s right to discharge a worker is a factor indicating that the worker is an employee.
(20) Right to terminate. If the worker can quit work at any time without incurring liability, the worker is generally an employee.
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