Classification warfare
taxnews
Treating a worker as an in-
dependent contractor rather
than an employee has its
advantages, say tax experts.
Companies that classify workers as independent contractors not only avoid FICA
and FUTA matching and income tax withholding, they also escape paying benefits
such as vacation pay, sick pay, and workers’
compensation. Moreover, workers may be
motivated to be misclassified as independent contractors so that they can be paid in
cash, avoid withholding of taxes, or avoid
proving immigration status.
Worker classification laws go back beyond the last century to common law. Because they vary in their application, for
many employers there’s no certainty that
they’ve made the right decision. And for
some, the decision can have extreme consequences. If an employer loses a challenge
on the status of a worker, it can be hit with
tax deficiencies exceeding 40 percent of
reclassified salary for the previous three
years. If the Internal Revenue Service finds
that the employer’s conduct was not willful,
it uses a lower rate of 11 percent.
Contrast this with the penalties levied
under the new IRS Voluntary Classification
Settlement Program, under which taxpayers can prospectively reclassify their workers with very limited additional federal
employment tax liability for past misclassification.
“For people who need and want to resolve
this issue, VCSP is probably the easiest and
cheapest way to do it,” said Mary Gorman,
senior manager in tax controversy and risk
management services at Big Four firm Ernst
& Young LLP.
However, there’s no bright-line test as to
whether a worker is an employee or an independent contractor.
“The law isn’t settled,” explained Gorman. “There’s a hole in the guidance
because of the Section 530 prohibition.”
Section 530 of the Revenue Act of 1978,
which provides a safe harbor for employers to classify workers as independent contractors, also prohibits the IRS from issuing
BY ROGER RUSSELL
New IRS program helps companies ease liabilities
revenue rulings or regulations in this area.
“In addition, the court cases are fact-inten-
sive and not at all uniform. They vary industry
by industry, and within industries, so it is an
area where you can get it wrong.”
She noted that Form 8952, Application for
Voluntary Classification Settlement Program,
must be filed at least 60 days before a com-
pany wants to begin treating the workers as
employees.
“The employer fills out the form and sends
it to the IRS; the IRS does an eligibility check,
and if the employer passes the check, the IRS
will prepare a closing agreement and send it
to the taxpayer to sign,” Gorman said. “The
taxpayer signs it and sends it back with the
amount owed, the IRS signs it and it’s complete.”
VCSP GUIDELINES
Under the program, the amount owed effectively equals just over 1 percent of the
wages paid to the reclassified workers for
the past year, with no interest or penalties.
(Specifically, 10 percent of employment
taxes computed under the reduced rates
of Internal Revenue Code section 3509(a).
Under this section, the effective tax rate
for compensation up to the Social Security wage base is 10.68 percent in 2010 or
10. 28 percent in 2011, and 3. 24 percent for
compensation above the Social Security
wage base.)
There’s no admission of guilt by partici-
pating in the program, Gorman emphasized.
“Part 5 of Form 8952 says that the taxpayer
wishes to voluntarily reclassify. It doesn’t say
that they have misclassified. It’s prospectively
changing how they treat their employees.”
Of course, employers who hire workers
may have legitimate reasons to treat them
as independent contractors. That’s where a
decision has to made, balancing the risk of
waiting for an audit or voluntarily coming
for ward and resolving things.
“If a taxpayer wants certainty, this is good
for them,” said Gorman.
the trap of misclassifying their workers. But
for those who do so intentionally, the consequences can be severe.
“For employers, there’s about a 25 percent
savings when someone is treated as an independent contractor, rather than an employee,” said Robert McKenzie, tax partner
at Chicago-based Arnstein & Lehr.
“The danger is that if you misclassify
and fail to participate in the program, it’s
a bet-your-company cost,” he said. “Even
if the misclassification was unintentional,
you can get hit with an audit amount of
11 percent of total compensation paid to
workers for three years, or 40 percent if the
misclassification was intentional. But if you
go forward with the voluntary program, you
pay one year at 1.1 percent.”
A drawback to participating in the program
is that it could put the employer at a com-
petitive disadvantage, he observed. “If the
employer’s major competitors are treating
employees as independent contractors, they
will enjoy a competitive cost advantage, so
it’s in their best interest to notify the IRS of a
competitor’s misconduct.”
STATE TAX REVENUES CLIMB,
LOCAL TAX MONEY SLIDES
ALBANY, N. Y. — State tax revenues
increased 10. 8 percent in the second
quarter of 2011, while revenues for local
governments headed south.
The Nelson A. Rockefeller Institute of
Government at the University of Albany
found that state tax revenues increased
8. 4 percent on an annual basis for 46
states in the past fiscal year, giving them
six consecutive quarters of growth and
the best annual performance since 2005.
Every state except New Hampshire
reported an increase in overall tax collections in the second quarter, compared
with the second quarter last year.
Preliminary figures for July and August
indicate continued growth, though not
as strong as in the second quarter. The
largest gains in the second quarter came
from personal income taxes, which rose
more than 16 percent compared with the
second quarter of last year.
CAUTION FLAGS
Because the delineation between an employee and an independent contractor is
vague, employers can inadvertently fall into
IMMIGRATION ISSUES
Moreover, the issue of illegal immigration is
a consideration in many employers’ hiring
classification. “If you’re hired in the U.S.,
you have a duty to establish that you are
here legally,” said McKenzie. “The employ-
ee must fill out a Form I- 9, and verify legal
working status. An independent contractor
does not have that duty.”
Another potential drawback to participa-
tion in the program is the fact that it does
not provide safety from potential misclassi-
fication liability from private lawsuits under
federal and state wage and hour laws, and
the federal employee benefits law, accord-
ing to Richard Reibstein, a partner in the
New York office of Pepper Hamilton LLP.
“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 allegedly owed unpaid
overtime under state or federal law, or unpaid benefits under a company’s employee
benefits plans,” he said. AT
OFFSHORE DISCLOSURE
PROGRAM BOOSTS COMPLIANCE
WASHINGTON, D.C. — The Internal Revenue Service’s Offshore Voluntary Disclosure Initiatives are generally effective at
convincing thousands of taxpayers with
foreign bank accounts to come forward
and disclose them to avoid heavy penalties and criminal prosecution, but some
improvements are needed, according to
a new report by the Treasury Inspector
General for Tax Administration, which
noted that the IRS’s 2009 Offshore Voluntary Disclosure Initiative prompted nearly
7,000 taxpayers in 2009 and over 10,000
taxpayers in 2010 with hidden offshore
assets and income to disclose them. The
IRS announced a 2011 OVDI in February
with stiffer penalties.
TIGTA recommended that IRS officials
implement a requirement for taxpayers to
provide a detailed reconciliation of their
unreported income. The IRS should also
develop a quality review process to ensure that all the data relating to voluntary
disclosures are properly transcribed for
future data mining, and require revenue
agents to initial each page of the voluntary disclosure agreement before submitting it to taxpayers for their signature.
