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New Settlement Program for Worker Misclassification: Reducing Employment Audit Liability by Proactively Reclassifying Workers

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| Legal Advisory

In recognition of the difficulty of properly classifying workers as employees or independent contractors, the Internal Revenue Service recently announced the institution of the Voluntary Worker Classification Settlement Program (“VWCSP”). The VWCSP provides relief to employers that may have liability for back payroll taxes for employees who were misclassified as independent contractors rather than employees. It allows employers to pay a reduced portion of prior period employment taxes and avoid penalties, interest and the possibility of an employment tax audit on prior years in exchange for agreeing to classify such workers prospectively as employees.  

Misclassifying workers as independent contractors is one of the easiest mistakes for a business to make. The fact specific, complicated legal analysis of whether a worker providing services to your company is an independent contractor, for whom you do not need to withhold income taxes or pay FICA (Medicare and Social Security) taxes, or an employee, on whose behalf you are legally obligated to withhold and pay such taxes, may shift as the worker’s role within the organization changes over time. For example, workers who start as independent contractors of businesses or as volunteers for tax-exempt organizations may become employees as their responsibilities and compensation structures change.

Is our company eligible for the VWCSP?

For-profit and tax-exempt entities that want to reclassify their workers as employees prospectively are eligible to participate in the VWCSP. An entity must not currently be under audit by the IRS for any matter or by the U.S. Department of Labor or a state government agency for worker classification issues. To qualify, an entity must have consistently treated the relevant workers as independent contractors or other non-employee service providers and must have filed all required Form 1099s for the past three years.

Why would we participate in the VWCSP?

Reduce potential tax liability. Under the VWCSP, an employer will pay ten percent of amounts (income tax and FICA – both the employee and employer portion) that ordinarily would be due upon the reclassification of a worker. This reduced tax, equal to approximately 1% of the compensation earned by the relevant worker for the prior year, is significantly less than an employer would have to pay if a worker was reclassified in the course of an IRS audit. The employer will not be liable for interest or penalties relating to the federal tax and will not be subject to further employment tax audit by the IRS for the pre-correction period. In exchange for this relief, the IRS requires that an employer participating in the VWCSP enter into a closing agreement, pay the amounts due upon signing the closing agreement and extend the period during which the IRS has the right to review the entity’s employment tax practices from three to six years for the three years following the reclassification.

Prospective reclassification of workers. When an employer decides to participate in the VWCSP it is not required to state that a worker was misclassified previously, simply that it intends to treat the worker prospectively as an employee for employment tax purposes absent a material change in the service relationship. An employer does not have to reclassify all of its workers as employees, but it must treat all workers in same class in the same manner. An application to participate in the VWCSP must be submitted at least sixty days prior to the date on which the employer intends to change the worker’s classification.

Limit audit exposure. The VWCSP provides employers with a pro-active avenue for addressing past employment tax issues before an IRS audit is initiated. As noted above, the VWCSP is available to employers who are not currently being audited. If an employer is under IRS audit, a separate Classification Settlement Program is available to resolve worker classification issues in an early and efficient manner. By making worker classification issue resolution available to those employers who are not currently being audited, the IRS has given employers an opportunity to reduce their potential exposure to an employment tax audit.

Open Issues

Earlier this week, the IRS announced that it intends to issue additional guidance to address questions that have arisen under the VWCSP.  Some of the open issues that will need to be addressed include:

  • How participating in the VWCSP will affect a worker’s employee benefit plan eligibility;
  • Whether the IRS will share information with state taxing authorities and how participation will affect a worker’s classification under state tax law; and
  • How participating in the VWCSP will affect an employer’s federal unemployment insurance (including FUTA) and workers’ compensation obligations.

This advisory was prepared by the Tax practice group at Nutter McClennen & Fish LLP. For more information or assistance with respect to worker classification, the VWCSP or other employment and employee benefit matters, please contact a member of the Tax practice group or your Nutter attorney at 617.439.2000.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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