Pepper Hamilton LLP: Independent Contractor Misclassification Update: IRS’s New Voluntary Classification Program Adds Another Choice for Companies Concerned About Their 1099ers

Pepper Hamilton LLP: Independent Contractor Misclassification Update: IRS’s New Voluntary Classification Program Adds Another Choice for Companies Concerned About Their 1099ers

By Richard J. Reibstein, Lisa B. Petkun, and Andrew J. Rudolph

The Internal Revenue Service (IRS) announced earlier this week a new program to permit taxpayers to voluntarily reclassify independent contractors as employees for federal employment tax purposes.

The program, called the Voluntary Classification Settlement Program (VCSP), would allow businesses to voluntarily reclassify workers who currently receive 1099s from the company by making what is referred to by the IRS as a "minimal payment covering past payroll tax obligations." That payment to the IRS would be "10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of section 3509 of the Internal Revenue Code," according to the IRS Announcement published September 21, 2011 on the IRS Web site. Participation in the VCSP would also eliminate interest and penalties on the liability and, most importantly, exempt companies from an employment tax audit for worker misclassification in prior years.

This IRS voluntary program is another alternative means of achieving compliance with federal tax laws governing employee misclassification. Those alternatives have been discussed in prior articles and blog posts by the authors, and include bona fide restructuring of the relationship between companies and workers paid on a 1099 basis, the use of an employee leasing or staffing company, and reclassification outside of any government program - using IC Diagnostics and other proprietary compliance tools of Pepper Hamilton's Independent Contractor Compliance Practice.

Employers that have misclassified workers in the past may also be eligible for a safe haven from liability for employment taxes under Section 530 of the Revenue Act of 1978. To be eligible, a business (other than one utilizing certain technical service workers) must have had a reasonable basis for treating workers as independent contractors, must have consistently treated the workers as independent contractors, and must not have treated any substantially similar workers as employees. A bill introduced in Congress last year, the Fair Playing Field Act of 2010, would have eliminated Section 530 relief prospectively, but no action was taken on that proposed legislation and the bill has not been re-introduced by this Congress. While Section 530 remains in effect, the IRS's new voluntary program may be less attractive than Section 530 relief to those companies that believe they qualify for this safe haven.

While there are advantages to participation in this new voluntary program, there will likely be some genuine concerns by companies that this new IRS program may backfire and actually increase, rather than minimize, potential misclassification liability.

In a September 22, 2011 telephone conversation with the principal author of the IRS Announcement, we raised one of the most pressing concerns that companies are likely to face: would the IRS share information about a company's participation in the program with the U.S. Department of Labor and state labor and tax commissioners under the IRS's existing information-sharing agreements with other federal and state agencies under programs recently published by the IRS and U.S. Labor Department?

We noted that a business may be concerned that any sharing of information by the IRS with other federal and state agencies about a company's participation in the IRS's new voluntary program may lead to an unwanted array of enforcement actions by those other government agencies. Enforcement actions may include investigations, audits, administrative proceedings and government-initiated lawsuits for allegedly past unpaid overtime wages, unemployment taxes, workers compensation premiums, and state tax liabilities - all of which could expose a company participating in the VCSP to even greater financial costs than were saved with the IRS. The principal author of the IRS Announcement was unable to say definitively whether information about participants in VCSP would or would not be shared by the IRS with other federal or state agencies.

Another concern about the new voluntary IRS program is that it does not provide safety from potential misclassification liability stemming from private lawsuits under federal and state wage and hour laws and the federal employee benefits law. (Nor does the safe haven under Section 530, for that matter.) Many companies remain concerned about potential exposure to private class action lawsuits by workers who may claim that they have been improperly paid on a 1099 basis and are owed allegedly unpaid overtime under state or federal law or benefits under a company's employee benefit plans. Such companies may prefer one of the other alternatives noted above in order to enhance independent contractor compliance. Those alternatives reduce or eliminate prospective exposure to misclassification liability not only in the tax context but also in the labor and benefits arenas.

Yet another potential objection to the new IRS program is that companies that reclassify individuals who previously received 1099s may worry that reclassification is a form of "admission" of past misclassification, as well as an invitation to those receiving 1099s from the company to challenge their past classification as independent contractors. Pepper has advised companies how to properly reclassify workers in a manner to minimize this concern, but changing a worker's tax treatment may remain a choice of last resort for many businesses.

We will provide further analysis of the VCSP in the future, including any information published by the IRS regarding the information-sharing issue discussed above. Questions about this matter can be addressed to the authors.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

This article is republished with permission of Pepper Hamilton LLP. Further duplication without the permission of Pepper Hamilton LLP is prohibited. All rights reserved.

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