This comes from the December newsletter published by my friend Mark Vorsatz and his company of tax advisors, WTAS.
Did you treat someone as an independent contractor not subject to employment tax withholding? With increasing frequency, IRS is assessing tax, interest and penalties in situations where they believe workers have been incorrectly treated as independent contractors. For example, IRS has been successful in reclassifying thousands of software engineers as employees at one employer and dozens of attorneys at a law firm. In addition, part-time employees, nannies, home health care workers and personal drivers are favorite targets.
The decision of whether to treat someone working for you as an employee or an independent contractor is not always crystal clear. Employers usually prefer the independent contractor classification but that isn’t always the right decision. The benefits of having an independent contractor rather than an employee include not having to withhold income taxes, pay Social Security and Medicare taxes, or pay unemployment tax. An independent contractor is also not subject to and does not benefit from labor laws such as overtime pay and minimum wage requirements. However, the employer is at risk if they classify someone as an independent contractor when they really are an employee.
Generally speaking, an individual is an employee if the employer has the right to tell him how to do the job and has control over the worker. In order to determine if an employer has control over a worker, IRS looks to a twenty factor test. These factors include whether training is provided, whether the employee can hire and supervise assistants, and whether the hours of work are set by the employer. There are a few categories of statutory employees (home workers, traveling salespeople, life insurance salespeople, among others) and a few categories of statutory independent contractors (real estate agents and some direct sellers), but for those jobs outside of these categories, the classification is not as clear and the control test must be considered.
A Government Accountability Office report from 2009 found that in 2006, the classification of employees as independent contractors cost the government close to $3 billion in unpaid taxes. Given the current deficit, it is understandable that the government would want to do what it can to lessen this problem. As a result, IRS has stepped in and created an opportunity for employers to reclassify those independent contractors who should be employees. Employers that participate in this program will only have to pay a fraction of the past payroll taxes. The flip-side is that IRS is going to be more suspicious going forward and will be looking closely at those employers claiming independent contractor status for their workers.
This program, called the Voluntary Classification Settlement Program (VCSP), is only for employers who agree to prospectively treat their workers as employees. A 1099-MISC must have been filed for the previous three years for that worker in order to be eligible for the program. An employer that is under audit by IRS is not eligible for the program. Once the decision is made to convert from an independent contractor to an employee, all the other workers in that same class must also be converted. For example, if you have two housekeepers and you submit to the program for one housekeeper, both housekeepers must be treated as employees going forward.
The program allows the taxpayer to pay only 10% of the employment tax liability on compensation paid to the worker for the most recent tax year, calculated using reduced rates. All interest and penalties related to the employment taxes, which can be substantial, are waived. IRS also agrees not to audit the employment status for any previous years.
This is a great opportunity for those employers who are concerned their worker should really be considered an employee. The costs of having an employee rather than an independent contractor are, of course, higher. So before the decision is made to convert, you should carefully consider the facts and consequences.