Many businesses approach classifying workers as a tax strategy: classify someone who performs services for you as an employee, and the employer must withhold federal income taxes, withhold and pay social security and Medicare taxes, and pay unemployment tax on wages paid to an employee. Classify that same worker as an independent contractor, and the worker, not the business, is responsible for the related employment taxes. Seem like an easy decision? Think again. A mere label does not determine the employer-employee relationship for tax purposes, and misclassification can result in potentially crippling tax liabilities.
So what do you do if you think you’ve misclassified your employees as independent contractors? Fortunately, the IRS recently issued an amnesty program for employers dealing with such issues.
In September 2011, the IRS announced the Voluntary Classification Settlement Program to assist employers in correcting worker misclassifications. Employers who meet the criteria and voluntarily come forward must agree to prospectively treat the class of workers as employees for future tax periods and agree to a special six-year statute of limitations period (extended from the usual three-year period of limitations on assessment of employment taxes) beginning after the date on which the taxpayer has agreed under the closing agreement to begin treating the workers as employees. In exchange, the employer obtains substantial relief from federal payroll taxes they may have owed for the past, if they prospectively treat workers as employees.
The IRS identifies four types of business relationships between employers and the persons performing work for them: independent contractors, common law employees, statutory employees and non-statutory employees.
Whether workers are employees or independent contractors depends on the facts in each case. Generally, an individual is an independent contractor if the employer/business has the right to control or direct the result of the work only, and not the means and methods of accomplishing the result. It is the substance of the working relationship, and not the label, that governs the worker’s status, and it does not matter whether the individual is employed full time or part time.
More specifically, to determine whether a person performing services for your business is an independent contractor or an employee under common law, you must examine the relationship between the worker and the business. The IRS considers three categories when examining evidence of control and independence of the working relationship – Behavioral Control, Financial Control, and the Type of Relationship.
Behavioral Control considers facts that show whether the business retains the right to direct or control how the work is done, through instructions, training, or other means.
Financial Control considers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:
• The extent to which the worker has unreimbursed business expenses;
• The extent of the worker’s investment in the facilities used in performing services;
• The extent to which the worker makes his or her services available to the relevant market;
• How the business pays the worker (salary? Agreed upon fee?); and • The extent to which the worker can realize a profit or incur a loss.
Type of Relationship considers facts that illustrate how the parties perceive their relationship. This includes:
• Written contracts describing the relationship the parties intended to create;
• The extent to which the worker is available to perform services for other, similar businesses;
• Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay;
• The permanency of the relationship; and • The extent that the service performed by the worker is vital to the regular business of the company.
If you believe you’ve misclassified your workers as independent contractors, you should seek professional advice as to whether you qualify for the IRS’s VCSP. According to the Internal Revenue Service’s IR-2011-95, issued on September 21, 2011, employers accepted into the new amnesty program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three years that generally applies to payroll taxes.
For more information on employee classification, eligibility requirements for the related IRS amnesty program, or other tax issues, contact us for a free consultation with an experienced Tax Attorney.