I would like to thank Timothy Kershner, CPA for providing his accounting and tax expertise for this blog article.
Timothy Kershner, CPA is a partner at the accounting and consulting firm of Walz, Deihm, Geisenberger, Bucklen & Tennis, P.C. He has more than 20 years of experience in public accounting and operates as the partner in charge of the firm’s accounting and consulting division.
One important decision most business owners must confront is whether to treat certain workers as employees or independent contractors. An employer who makes the mistake of incorrectly classifying an employee as an independent contractor can face tax consequences and incur heavy penalties. Fortunately, the Internal Revenue Service ("IRS") has launched the Voluntary Classification Settlement Program (“VCSP”), which will enable many employers to reclassify workers as employees with minimal penalties. For those who are unsure of whether they are correctly classifying their workers and are concerned about possible audits, the VCSP can work as a "reset" button that offers a fresh start.
Employees vs. Independent Contractors
Before addressing the VCSP itself, it is important to understand a few basic concepts regarding tax reporting and withholding requirements for employers. If a worker is treated as an employee, the tax law requires the employer to withhold certain portions of the worker’s pay and pay those amounts directly to the federal government. The amounts withheld are generally reported to the IRS on payroll tax returns and to the employee on IRS Form W-2. In addition, the employer must remit their portion of payroll taxes.
However, with regard to payments made to independent contractors, there are no withholding requirements or payroll taxes. The amount paid to an independent contractor is reported on IRS Form 1099-Misc. The independent contractor is then responsible for the reporting of income and payment of self-employment taxes when filing his or her personal tax return.
When workers are hired on a contractual or short-term basis, employers might automatically designate them as independent contractors. However, determining whether a worker qualifies as an employee versus an independent contractor is not that simple. The IRS uses the following three characteristics in determining whether a worker is an employee or an independent contractor:
- Behavioral control asks whether the employer has a right to direct or control how the work is done through instruction, training or other means. A worker hired for a six-week period to complete a project would only be an independent contractor if he or she already had the skills required to complete such a project at the time of hire and was given free reign over the work from start to finish.
- Financial control asks whether the business has the right to direct or control the financial and business aspects of the worker’s job. Chances are, if a worker is compensated according to an employer’s pay scale and is directed to use or purchase certain resources in order to perform a job, the worker cannot be classified as an independent contractor.
- Type of relationship analyzes how the worker and the business owner perceive their relationship with regard to control. A good rule of thumb is that if you have the right to control and direct not only what is to be done, but also how it is to be done, then your worker is most likely an employee.
Employers who misclassify workers as independent contractors can end up with substantial tax bills for unpaid employment and payroll taxes. Additionally, they can face penalties for failing to file required tax forms. As a result, it is easy to see why making the right determination as to whether the worker is an employee or an independent contractor is important.
The VCSP is generally aimed at employers who think they may have been improperly treating a worker as an independent contractor. The employer can become compliant by voluntarily filing tax form 8952 “Application for Voluntary Classification Settlement Program” and paying ten percent (10%) of the employment tax liability that would have been due based on the employee’s compensation for the most recent fiscal year. In subsequent tax years, the employer must continue to treat the worker as an employee. In return, the IRS will not audit the employer for periods prior to the date of election to treat former independent contractors as employees and will forgo interest and penalties on the unpaid taxes. Thus, voluntarily filing under VCSP resets an employer’s record with the IRS regarding worker classification and protects them from retrospective violations.
There are a few eligibility requirements an employer must meet to participate in the VCSP.
- First, the employer must have consistently treated the worker as an independent contractor in the past.
- Second, the employer must have filed all required Form 1099s for the previous three (3) years.
- Finally, the employer cannot currently be under audit by the IRS, Department of Labor or a state agency concerning the classification of the worker. A taxpayer who had previously been audited by the IRS concerning the classification of its workers will only be eligible if it has complied with the results of the audit.
For employers currently under audit, the IRS has set up a Classification Settlement Program (“CSP”) that allows business and tax examiners to resolve the worker classification issue with a less stringent tax penalty if certain conditions are met. However, because they did not voluntarily turn themselves in, CSP participants are typically not shown as much leniency as VCSP participants.
The VCSP is a voluntary filing for employers only. The 10% payment by the employer is not credited to any individual employee’s “wage account,” as no individual employee information is provided to the IRS. Payments made by the payor (referred to above as “employer”) to the independent contractor for periods prior to the effective date of the reclassification continue to be reported to the independent contractor on Form 1099, and the independent contractor is responsible for all employment and payroll taxes thereon. Effective on the date of reclassification from independent contractor to an employee, all employment and payroll taxes will be the responsibility of the employer, including obtaining the necessary tax forms from the employee in order to withhold applicable federal taxes. The employer/employee relationship will then begin with all applicable rights and restrictions.
Making the wrong decision on whether a worker is an employee or an independent contractor can lead to negative consequences. These guidelines and the VCSP program apply to all employers, including tax-exempt organizations. Employers should seek the advice of a tax professional if they have any doubts about worker classification. In addition, the IRS website contains helpful information on this topic. The time it will take to reevaluate and correct any wrongly classified independent contractors/employees will be well worth the money saved and hassles avoided.
Matthew Grosh is an attorney at Russell, Krafft & Gruber, in Lancaster, Pennsylvania. He received his law degree from Villanova University and practices in a variety of areas including Business Law.