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Barry Rosen: Amnesty offered for misclassified workers

The correct classification of a worker as an employee or independent contractor has been a continuing area of dispute between many health care and non-health care employers on the one hand, and the IRS on the other. The determination carries with it significant potential costs to an employer.

For example, employers are required to pay a 6.2 percent Social Security tax and a 1.45 percent Medicare tax against employee wages. While the Social Security tax has an inflation-adjusted annual wage cap ($110,100 in 2012), there is no cap on the Medicare tax.

The employer must also pay state unemployment taxes. In addition, the employer must also withhold federal and state income taxes on the employee’s compensation, as well as the employee’s share of the Social Security and Medicare taxes.

If the worker is an independent contractor, however, the employer simply reports payments for services to workers on a Form 1099-MISC and pays no employment taxes. The worker is responsible for paying his or her self-employment taxes.

There are also nontax consequences of the classification. For example, an employee, unlike an independent contractor, may be eligible for other company fringe benefits, such as health insurance and retirement plan benefits.

The determination of whether a worker is a W-2 employee or a 1099 independent contractor is based on a common law test that requires significant discretion. Generally, if an employer has the right to direct and to control how a worker performs services for the employer, that worker is classified as an employee.

However, the IRS uses a 20-factor test to make that determination. Due to the absence of a bright line standard, employers are often uncertain that they have made the right decision.

The consequences of being wrong can be severe. In addition to being liable for the taxes noted above, a misclassification may subject the employer to penalties and backup withholding.

VCSP

In an effort to “push” employers into accepting employee classification for their workers, the IRS, in Announcement 2011-64, rolled out its new Voluntary Classification Settlement Program (VCSP), an amnesty program dealing with the past misclassification of employees.

The VCSP is available to many health care providers and other businesses, tax-exempt organizations and even government entities that currently, erroneously treat their workers, or a class or group of workers, as independent contractors and now want to correctly treat those workers as employees.

Under the new federal program, employers have an opportunity to reclassify these contractors as employees, and make a very small payment to cover past payroll taxes and to settle any potential employment tax liability. According to the IRS, this initiative is part of a wider effort to help give taxpayers and businesses a “fresh start” with their tax obligations.

The VCSP is the carrot; the stick is stepped-up enforcement. For example, just two days before announcing the VCSP, the IRS and the Department of Labor signed a memorandum of understanding strengthening information sharing on enforcement actions aimed at misclassified workers.

Employers that choose to participate in the amnesty program and voluntarily reclassify workers as employees for future tax periods will only have to pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year. Tax professionals have estimated this cost to be just over 1 percent of the employee’s salary.

The employer will not be liable for any interest and penalties on the one-time liability. The IRS will also agree not to audit the participating employer with respect to the classification of those workers in any prior years which might still be open or subject to audit.

In exchange, employers must agree prospectively to adopt employee classification for these workers for future tax periods, and pay their share and withhold the employee’s share of the required taxes.

To be eligible for the VCSP, the employer (i) must have consistently treated the workers as nonemployees and filed Forms 1099 for them for the previous three years, and (ii) cannot currently be under audit by the IRS (regardless of whether the audit involves a worker classification issue) or under a worker classification audit by the Labor Department or a state agency.

If the employer was previously audited by either the IRS or the Labor Department for worker classification, it is eligible for the VCSP only if it has subsequently complied with the results of that audit.

Applications for the VCSP must be filed on Form 8952 at least 60 days before the employer begins treating the workers as employees. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three.

Other risks and routes

While for many employers the amnesty program sounds too good to ignore, the VCSP covers only the employment taxes overseen by the IRS. Amounts owing to workers’ compensation insurance carriers, state taxing authorities and the labor department are not being forgiven through the amnesty.

Even the newly classified employees themselves may assert claims for state wage and hour law violations, including unpaid overtime, and other statutory benefits, such as unpaid leave under the Family and Medical Leave Act.

Many businesses that have been treating their workers as independent contractors, rather than employees, and properly issuing and filing forms 1099, believe their workers are independent contractors. These businesses are unlikely to participate in the VCSP because they do not think they have done anything wrong.

Other businesses may choose to claim the already existing special relief provided under Section 530 of the Revenue Act of 1978. That section allows an employer to escape employment tax liability for misclassified workers, if the employer (1) always treated the workers as independent contractors; (2) filed all returns required for the workers consistent with independent contractor status; and (3) had a reasonable basis for treating the workers as independent contractors.

In a very “pro-taxpayer” manner, “reasonable basis” can be satisfied in several different ways. For example, it can be established by a past IRS audit of the taxpayer in which there was no employment tax assessment attributable to the treatment of individuals holding substantially similar positions.

It can also be established by judicial precedent, published rulings or a private letter ruling issued to the taxpayer. Even more helpful for some taxpayers, reasonable basis can be satisfied by a long-standing recognized practice of a significant segment of an industry in which the individual worked.

Most important, under Section 530, the employer can continue its independent contractor classification even if it is wrong.

Notwithstanding the favorable terms offered under the VCSP, one of the principal “cons” in the minds of many tax advisors when the program was announced last fall was the concern that the IRS would share information about their client’s participation in the VCSP with other agencies.

That concern, however, has been substantially mitigated. In the Frequently Asked Questions to the VCSP posted on the IRS website (FAQs 18 and 19), the IRS says that it will not share information about the program with either the Department of Labor or with state agencies.

In summary, while the VCSP will be advantageous for many employers, it is not for everyone. Each client’s situation is different, as well as their comfort levels and alternative routes of relief. Nevertheless, the VCSP is well worth considering.

Barry F. Rosen is the Chairman and CEO of the law firm of Gordon Feinblatt LLC, leads the Firm’s Health Care Practice, and can be reached at 410-576-4224 or brosen@gfrlaw.com. Steven M. Gevarter is the Chair of Gordon Feinblatt’s Tax Department, and he can be reached at 410-576-4260 or sgevarter@gfrlaw.com.