IRS Offers Employee Reclassification Agreement

Employers may reclassify independent contractors as employees and limit the resulting federal payroll taxes for their most recent tax year, plus avoid related penalties and interest for prior years, under an IRS program announced Wednesday.

In Announcement 2011-64, the IRS outlined its new Voluntary Classification Settlement Program (VCSP). Unlike an existing settlement program for employers under an IRS examination, the VCSP allows eligible taxpayers to voluntarily enter into an agreement with the IRS.

Generally, if an employer has the right to direct and control how a worker performs services for the employer, that worker is properly classified as an employee and the employer must withhold FICA and income taxes from wages and other compensation and pay the employer’s share of FICA tax. Proper classification of workers has been a perennial concern for employers, employees and the government. Last year, the IRS launched a national research project in which it sent thousands of audit letters to employers. On Monday, the IRS signed a memorandum of understanding with the U.S. Department of Labor to share information between them to reduce misclassification.

To participate in the VCSP, employers must submit an application and agree to prospectively treat their workers or a class or group of workers as employees for federal employment tax purposes in future tax periods. Employers must also agree to extend the period of limitation on assessment of employment taxes for three years for each of the three calendar years beginning after the date of the agreement.

In return, employers will pay 10% of the employment tax liability otherwise due for the most recent tax year, which will not be subject to interest or penalties. In addition, the IRS will not conduct an employment tax audit with respect to the employer’s worker classification for prior years. The employment tax liability for the most recent year is determined under the reduced rates of IRC § 3509, which provides that for failure to deduct and withhold taxes arising from a worker misclassification, the employer’s liability for the employee’s portion of FICA tax is limited to 20% of the normal employee FICA tax. This percentage is doubled for disregard or willful neglect of reporting requirements.

To be eligible for the program, employers must not currently be under audit by the IRS, the Labor Department or a state agency concerning worker classification. Employers whose worker classification has been previously audited must have complied with results of the audit. Also, employers must have consistently treated workers as nonemployees, for whom they must have filed all required Forms 1099 for the previous three years.

Employers can apply for the program using Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees.

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