IRS launches worker classification settlement program.

• Author: Adkins, G. Edgar, Jr.

The IRS on September 21, 2011, unveiled a program that allows taxpayers to voluntarily reclassify independent contractors as employees and pay significantly reduced prior employment taxes (approximately 1% of one year's worth of compensation), with no penalties or interest. The voluntary classification settlement program (VCSP) is part of a larger IRS "fresh start" initiative to help taxpayers address their tax responsibilities.

The VCSP is meant to encourage voluntary compliance with worker classification rules and signals an increased IRS focus on the issue. Just two days before announcing the program, the IRS and Department of Labor (DOL) stepped up enforcement efforts by signing a memorandum of understanding to strengthen information sharing on enforcement actions aimed at misclassified workers. Several states are also parties to the memorandum of understanding.

The VCSP is detailed in Announcement 2011-64, News Release IR 2011-95, and in frequently asked questions on the IRS website at http://tinyurl.com/IRS-VCSP.

Worker Classification

Determining whether a worker is an independent contractor or employee for federal tax purposes is generally based on a common-law test that considers the facts and circumstances of the relationship. The primary criterion is the degree of control that can be exercised over the worker as to how to perform the services, regardless of whether the control is actually exercised.

The determination has important consequences for employment taxes. Employers are required to pay a 1.45% Medicare tax and 6.2% Social Security tax against employee wages. Employees pay Medicare tax and Social Security tax at these same rates, except that the employee Social Security tax rate was reduced to 4.2% for 201 1. (At the time this item went to press, Congress had extended the reduced rate through February 29, 2012.) In 2012, Social Security tax applies up to an inflation-adjusted annual wage cap of $110,100 ($106,800 in 2011).

For independent contractors, taxpayers report payments for services to workers on a Form 1099-MISC, Miscellaneous Income, and pay no employment taxes. Workers are then responsible for paying self-employment taxes.

A taxpayer that the IRS determines under audit to have misclassified workers as independent contractors may be subject to previously unpaid employer and employee employment taxes, income tax withholding, penalties, and interest. If the misclassification was not due to intentional disregard to treat workers as employees, then the taxes are determined under Sec. 3509, which provides lower rates for income tax withholding and the employee shares of Social Security and Medicare taxes. A lesser reduction may apply to taxpayers that failed to issue Forms 1099-MISC.

VCSP Requirements

The VCSP is available for taxpayers who arc currently treating workers or a class or group of workers as independent contractors but want to prospectively reclassify them as employees for federal employment tax purposes. Under the VCSP, a taxpayer does not have to reclassify all of its workers who are currently treated as nonemployees. However...