A significant part of the risk management process for any business enterprise is the proper classification of its work force for federal employment tax purposes as either employees or independent contractors.
“The risks from misclassification are a potentially significant underpayment of employer Social Security, Medicare and unemployment taxes, as well as the interest and penalty from failure to pay such employer taxes and for failure to withhold income taxes,” says Walter McGrail, senior manager, Cendrowski Corporate Advisors LLC.
Employers, he says, are responsible for withholding taxes for employees, but they are not responsible for such taxes on independent contractors.
Smart Business spoke with McGrail about the Voluntary Classification Settlement Program (VCSP) and how it can be used to a business’s advantage.
What are the factors for determining work force classification?
For more than 20 years, the IRS has adopted the so-called ‘common-law’ test for classification of workers as employees or independent contractors. The common-law test for classification is used to determine whether business managers have the right to direct the ‘means and details’ of the services being performed. Under the ‘means and details’ standard, it doesn’t matter whether the business managers actually direct the means and details, only whether they have the right to do so. The IRS has published a list of the ‘20 factors’ used to make the common-law determination of classification. Generally, such factors fall into one of three categories: behavioral control, financial control and the relationship of the parties.
What is the IRS Voluntary Classification Settlement Program?
Work force classification has long been a source of acrimony between the IRS and taxpayers. For prospective employers, classification of its work force using independent contractor status has some obvious advantages: lower employment tax costs, less burdensome reporting (1099s vs. W-2s) and non-inclusion in employee benefit programs. While the IRS has a real economic incentive to audit potential employers for taxes, interest and penalties related to prior years can be very costly for the IRS to conduct.
In an effort to coax voluntary compliance from taxpayers, the IRS has rolled out what amounts to a relatively inexpensive amnesty program, the VCSP. In exchange for taxpayers’ agreement to voluntarily treat their work force as employees for federal employment tax purposes going forward, the IRS will limit the exposure of qualifying employers to employment taxes on previous periods to a one-time surcharge equal to approximately 1 percent of the most previous year’s wages. The surcharge can be a bargain compared to the actual cost of tax, interest and penalty for all years open to IRS inspection, as well as the cost of defending an IRS audit.
How do employers qualify for the program?
In the event that a taxpayer’s risk management analysis demonstrates that the VCSP is a cost-effective means of managing its employment tax risk, the employer must meet the following qualifications: the taxpayer must enter into a closing agreement and pay the entire surcharge at closing; the taxpayer must have treated its work force as independent contractors for the previous three years; the taxpayer must have filed U.S. Form 1099 reporting the payments to such work force as non-employee compensation; and the taxpayer or its business must not be currently under audit.
What additional risk assessment might be required before taking advantage of the VCSP?
For any employer that has assessed its exposure to employment taxes, and related interest and penalties for misclassifying its work force in a prior year, there are other risks to assess. First, and as suggested, the VCSP requires full funding of the amount due at closing. To the extent that a taxpayer is in financial difficulty, they should assess whether it makes sense to even apply for the VCSP.
Secondly, taxpayers opting under the VCSP must agree to keep the statute of limitations for audits open for six years after the first year a taxpayer participates in the program. Normally, a taxpayer’s statue of limitations period for assessment of employment taxes closes after three years.
Third, the VCSP in its current form does not necessarily shelter the work force from assessment by the IRS from penalty or interest with regard to personal tax returns. While it is unclear that the IRS would pursue any claims against such employees, the IRS would have authority to do so if it chose to. The possible cost to employees should at least be considered.
Finally, each state provides for its own employment and withholding tax requirements. As it currently stands, the VCSP does not preclude a state or local taxing authority from relying on participation in the VCSP as an admission by the employer of responsibility for such state and local employment taxes for any open year.
For each of these reasons, any employer that has weighed the cost and benefit of complying with IRS guidelines for registering its work force for employment taxes must evaluate all of the risks associated with participating in the VCSP. Contact a CPA to assist you with the difficult task of properly executing the risk management process for employment taxes.
Walter McGrail is senior manager of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or firstname.lastname@example.org.