Voluntary IRS program could carry unintended consequences for benefit plans
The Internal Revenue Service (IRS) announced a new voluntary correction program to allow employers to reclassify workers who are improperly classified as independent contractors as employees for employment tax purposes. The Voluntary Classification Settlement Program (VCSP), announced September 21, 2011 in IRS Announcement 2011-64, permits employers to voluntarily reclassify workers for future tax periods with limited federal employment tax liability for past non-employee treatment. The VCSP is similar to the current Classification Settlement Program which allows employers under examination to resolve classification issues discovered by an examining agent with reduced federal employment tax consequences. The VCSP, however, is available to employers outside of an IRS examination. In general, the program allows employers to eliminate years of past employment tax liabilities for “pennies on the dollar”: an amount equaling just over one percent of the wages paid to the reclassified workers for the past year. To participate in the VCSP, an employer must meet certain eligibility requirements, apply to participate in the VCSP and enter into a closing agreement with the IRS.
This program should be considered by employers that may have misclassified workers as independent contractors and now want to treat these workers as employees. Worker misclassification issues often are identified during an internal audit or when a worker makes a claim for benefits. Misclassification issues also are frequently identified when an employer decides to buy or sell a company or business division. The VCSP program may be especially useful for employers considering a corporate transaction; addressing a known employment tax liability before an acquisition or divestiture can reduce potential liabilities and administrative costs.
Federal Employment Tax Withholding Obligations for Employees and Independent Contractors
In general, employers have an obligation to withhold from the compensation or wages of employees what is collectively referred to as “employment taxes.” The terms employment taxes refer to the following: (1) the employee portion of taxes imposed by the Federal Insurance Contributions Act (FICA); and (2) income tax withholding on wages. The obligation to withhold employment taxes only applies to employees and does not extend to independent contractors. In addition, the employer must pay its portion of FICA and pay the tax imposed on employers under the Federal Unemployment Tax Act.
When an employee is misclassified, Code Section 3509 permits certain reductions to the employer’s employment tax liability provided the employer can demonstrate compliance with certain information return and good faith requirements. Liabilities for employment taxes also may be subject to interest and penalties. Additionally, payroll corrections often involve high administrative costs to the employer.
Relief Under the Classification Settlement Program
Available only for employers under IRS employment tax examination, the Classification Settlement Program (CSP) is available to resolve federal employment tax issues related to worker classification, if certain criteria are met. In order for an employer to gain relief under CSP, the employer must receive a CSP offer and agree to prospectively reclassify workers as employees. Acceptance of the CSP offer is voluntary. The CSP offer only applies to one tax year, and if the audit is expanded to other open tax years, the employer may not be entitled to the same, if any, CSP offer. If the employer is able to demonstrate compliance with certain tests, the CSP offer can limit employer liability to either 100% or 25% of the employment tax liability for one tax year.
Voluntary Classification Settlement Program
The VCSP is available for employers that want to voluntarily change the prospective classifications of their workers. The program applies to employers that are currently treating their workers (or a class or group of workers) as independent contractors or other non-employees and want to prospectively treat the workers as employees. Unlike CSP, the program is available outside the examination process. To be eligible, the employer:
- Must have treated its workers (or the class of workers) as non-employees;
- Must have filed all required Forms 1099 for the workers for the previous three years;
- Cannot currently be under audit by the IRS; and
- Cannot be currently under audit concerning the classification of the workers by the U.S. Department of Labor (DOL) or by a state government agency.
An employer who was previously audited by the IRS or the DOL concerning the classification of the workers only will be eligible if the employer has complied with results of that audit.
b. Effect of VCSP
Employers that participate in the VCSP will agree to prospectively treat all workers in the class as employees for future tax periods. In exchange, employers accepted into the program will receive the following relief:
- The employer only will be required to pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year determined under the reduced rates of Code Section 3509;
- No interest or penalties will be due on that tax liability; and
- Employers will not be subject to payroll tax audits related to these workers for prior years.
Participating employers will, for the first three years after the VCSP closing, be subject to a special six-year statute of limitations, rather than the usual three-year statute of limitations.
In effect, an employer participating in the program will pay an amount equaling just over one percent of the wages paid to the reclassified workers for the past year. An IRS example illustrates the potential savings:
Example: You paid $1,500,000 to workers that are the subject of the VCSP. Under Section 3509(a), the employment taxes applicable to $1,500,000 would be $160,200 (10.68% of $1,500,000). Under the VCSP, your payment would be 10% of $160,200, or $16,020.
c. Application Process
To participate in the VCSP, an employer must apply using Form 8952, Application for Voluntary Classification Settlement Program. The application should be filed at least 60 days before the date the employer wants to begin treating its workers as employees. Along with the application, the employer should provide the name of a contact or an authorized representative with a valid Power of Attorney (Form 2848). The IRS will contact the employer or authorized representative to complete the process after reviewing the application and verifying the employer’s eligibility. Eligible employers accepted into the VCSP will enter into a closing agreement with the IRS to finalize the terms of the VCSP, and will simultaneously make full and complete payment of any amount due under the closing agreement.
Employers that want to begin treating a class (or classes) of workers as employees for the fourth quarter of 2011 should file Form 8952 as soon as possible. The IRS says it will make every effort to process Form 8952 in time to allow for the voluntary reclassification on the requested date.
Worker Classification – Employee v. Independent Contractor
Whether a worker is performing services as an employee or as an independent contractor depends upon the facts and circumstances and is often determined under the multi-factor common law test, which includes the examination of issues such as whether the company has the right to direct and control the worker as to how to perform the services. A detailed explanation of the common law guidelines regarding worker classification is beyond the scope of this article.
Potential Unintended Consequences of Worker Reclassification for Employee Benefits Plans
a. Qualified Retirement Plans
Employers should be aware that reclassifying workers as employees for future tax purposes, as required for participation in the VCSP, may have unintended consequences regarding the employers’ qualified retirement plans. The VCSP does not grant relief for liabilities incurred in connection with misclassified employees for retirement plan purposes. To maintain tax qualified status, a retirement plan must comply with minimum coverage rules. A plan that defines “eligible employees” to include “all common law employees of the employer,” thus excluding independent contractors from participation, will experience an “operational failure” (resulting in possible plan disqualification) if excluded workers are later determined to be common law employees. While qualification failures resulting from the improper exclusion of workers from plan participation usually can be voluntarily corrected by applying to one of the IRS correction programs, corrections are costly. Generally, the plan sponsor will be required to make up the contributions that would have been made to the excluded employee.
Another unintended consequence could be a referral to the IRS Employee Plans division. Referral to the Employee Plan division is required when a CSP examiner is aware that employees have been reclassified or plan participants’ compensation has been adjusted. Referrals are not required under the VCSP, though nothing would prevent them. It is worth emphasizing that the programs are available to employers on different terms. The CSP is a program available to employers already undergoing examination. Participation in the CSP is voluntary; contact with the IRS is not. Participation in the VCSP, on the other hand, is completely voluntary. An IRS referral in connection with a voluntary correction program would appear to be inconsistent with the IRS’ larger initiative to help businesses address their tax responsibilities.
b. Health and Welfare Benefit Plans
Potential liabilities also may exist when employers have improperly excluded reclassified workers from health and welfare plans. For example an employee, previously misclassified as an independent contractor, could claim that he or she was actually eligible for health coverage under the terms during his or her term of employment and therefore may have a claim for incurred health claims. An erroneous health plan coverage exclusion also could give rise to a potential COBRA claim. Additionally, a worker could assert improper exclusion from short-term and long-term disability plans.
Other Potential Unintended Consequences of Worker Reclassification
In addition, for workers who are classified as employees, it is important to note that, unless employees are exempt from the overtime requirements of federal and state law, they must be paid overtime for all hours worked in excess of 40 each week. Federal law requires that overtime be paid at a rate of one and one-half the employee’s regular rate for all hours worked in excess of 40 each week. State laws may provide more generous overtime provisions. Many states also have various laws that govern when and how employees must be paid. Furthermore, employers should be careful to comply with the full panoply of workplace laws pertaining to employees, such as the Family and Medical Leave Act, Title VII, and the National Labor Relations Act, just to name a few.
Liability for State Employment Taxes
The VCSP only provides relief for federal employment tax obligations and not state income tax obligations. Employers utilizing the VCSP should be aware of the state tax law consequences for worker reclassification.
The VCSP is available to provide substantial employment tax liability relief for employers to address worker classification issues. Worker misclassification issues may be identified during an internal audit, as the result of a benefit claim, or in connection with a corporate transaction. This program should be considered by employers that may have misclassified workers as independent contractors and now want to treat these workers as employees. Employers, however, should exercise caution in applying for the program and address where any potential employee benefit plan or other employment law liabilities exist that may require a contemporaneous correction.