The IRS is becoming more aggressive in enforcement of
employment classification and is scrutinizing the distinctions between
employees and independent contractors with an increasing level of focus. The
question of whether a worker is an independent contractor or employee for
federal income and employment tax purposes is a complex one. It is intensely
factual, and the stakes are high. As you may know, if a worker is an employee
the employer must withhold federal income and payroll taxes, pay the employer's
share of FICA taxes on the wages plus FUTA tax, and often provide the worker
with fringe benefits it makes available to other employees. There may be state
tax obligations as well. However, these obligations do not apply to independent
contractors and the business's only tax reporting obligation is to send the
independent contractor a Form 1099-MISC for the year showing what he or she was
paid (if it amounts to $600 or more).
Despite the favorable tax advantages, using independent
contractors can be risky for many businesses. It is a complex issue whose
determination hinges on the facts and circumstances of each case and one that
the Internal Revenue Service closely monitors. Improper classification can
generate significant penalties and financial hardship for the unwary business
owner, particularly if it involves a large number of misclassified workers over
a period of several years.
Rest assured, the IRS will aggressively pursue collection
activities against firms that inappropriately classify employees as independent
contractors, and consequently fail to remit payroll taxes as required by law.
As payroll taxes are deemed trust fund taxes, civil penalties may apply to
those responsible for collection and remittance. Therefore, it is essential to
understand the factors the IRS uses to accurately classify workers.
Who is an "employee"? There is no uniform
definition of the term.
Under the common-law rules (so-called because they
originate from court cases rather than from the tax code), an individual
generally is an employee if the enterprise he works for has the right to control
and direct the worker regarding the job assigned and related performance. Other
factors include whether the work is substantial, regular or continuous, and
whether the services performed require someone to comply with the employer's
The IRS uses the following three categories of
factors-also known as the 20-factor test-to determine if a worker is an
employee or an independent contractor:
All three categories should be considered when
classifying a worker as an employee or independent contractor. It is important
to keep in mind that the specific facts of each case stand on their own and
determine the weight the IRS may give to a particular factor. Although some
factors may indicate the worker is an employee, other factors may signify that
the worker is an independent contractor. No bright-line test or "set"
number of factors must be satisfied to determine if the worker is an employee
or an independent contractor, and no single factor stands alone in making the
determination. Seeking counsel from experienced tax professionals when faced
with this issue may be beneficial.
National Research Program
The IRS is in its second year of an intensive employment
tax research study of 6,000 randomly selected taxpayers as part of a national
research program (NRP) aimed at investigating tax compliance issues related to
employment taxes and independent contractor classification, among other tax
reporting issues. These in-depth examinations, which are effectively audits,
can be burdensome for those selected to be included in the study. Due to the
initiative's broad scope, many businesses may find themselves in the unenviable
position of undergoing examination.
The IRS is using various data sources as part of the
audit process-including information from Forms 1099 and W-2 filed with the
IRS-to determine audit strategies concerning the compliance characteristics of
firms filing employment tax returns. Although there are no surefire ways to
avoid being targeted, businesses can take certain measures to help minimize
Businesses should consider reviewing their current
payroll practices, specifically focusing on the areas identified by the NRP
initiative. Documentation and record-keeping procedures should be assessed and
updated if necessary. Businesses may also want to review their three most
recent years' employment tax returns, including Forms 1099 and all supporting
documents and records. In many cases, the company's third-party payroll
administrator can assist with this process.
Taxpayers may also wish to engage a tax professional to
conduct a "simulated audit" for the purposes of reviewing
record-keeping policies and existing tax positions and obtaining guidance on
correcting problems or deficiencies that would be likely targets in the event
of an actual IRS examination.
The fourth quarter is a particularly good time to review
employment data to ascertain whether employees are properly classified, before
it is too late to make any required changes. A fourth quarter review can help
prevent any potential misclassification issues and the wrath of the IRS. This
is particularly true now, as the IRS recently partnered with the U.S.
Department of Labor to allow eligible employers relief from past federal
payroll tax liabilities if they prospectively treat workers who have been
improperly classified as independent contractors as employees.
Voluntary Classification Settlement Program
For businesses who have been misclassifying workers there
is relief. In September 2011 the IRS announced that employers who participate
in the Voluntary Classification Settlement Program (VCSP) will enjoy partial
relief from federal employment taxes, provided they agree to prospectively
treat improperly classified workers as employees for all future tax periods. To
participate in the VCSP, a taxpayer must apply to participate in the VCSP and
enter into a closing agreement with the IRS. However the taxpayer must first
meet all of the following eligibility requirements:
As a result of their participation, employers who agree
to prospectively treat workers as employees for future tax periods will pay
only 10 percent of the employment tax liability that may have been due on
compensation paid to the workers for the most recent tax year; will not be
liable for any interest and penalties on the liability and will not be subject
to an employment tax audit with respect to employees improperly classified in
In addition, a taxpayer participating in the program must
agree to extend the statute on assessment of employment taxes for three years
for the first, second and third calendar years beginning after the date on
which the taxpayer has agreed to begin treating any improperly classified
workers as employees.
Taxpayers who wish to participate in the VCSP are
required to submit the recently published Form 8952 (Application for Voluntary
Classification Settlement Program) at least 60 days before they want to begin
treating the workers as employees. The IRS will contact the taxpayer once it
has reviewed Form 8952 and verified the taxpayer's eligibility.
The VCSP offers employers who have misclassified their
workers an opportunity to voluntarily correct this issue prospectively with
limited exposure for the past liabilities. However, the impact of reclassifying
workers as employees may have a significant impact on the taxpayer's ERISA
covered plans in that such plans may need to be amended to cover reclassified
workers for the prospective period only. All taxpayers who classify workers as
non-employees should consider reviewing that classification and determining
whether a filing under the VCSP is appropriate.
It is vital to document the factors considered and the
conclusions reached when classifying a worker, particularly in light of the
IRS's continued focus in this area. Employers may also want to seek the
guidance of a qualified tax professional to discuss these complex rules and
factors, and to determine if filing a VCSP application is appropriate.
For Further Information
If you have any questions regarding this Alert, or
for further information, please contact Steven M.
Packer, CPA, manager in the Tax Accounting Group;
Adams, CPA, manager in the Tax Accounting Group;
Gillen, CPA, director in the Tax Accounting Group;
or the practitioner with whom you are regularly in contact.
As required by U.S. Treasury Regulations, the
reader should be aware that this communication is not intended by the sender to
be used, and it cannot be used, for the purpose of avoiding penalties under
U.S. federal tax laws.
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