Many small businesses attempt to save taxes and employee benefit cost by classifying their workers as independent contractors. When business owners classify workers as independent contractors they do not pay the employer’s share of Social Security and Medicare costs, state employer taxes, state unemployment insurance taxes, and workers’ compensation insurance premiums. Independent contractors also do not receive employee benefits or paid time off.
In many circumstances, this independent contractor status is frivolous. The IRS estimates that unemployment taxes are almost 20% of the suspected annual $345 billion “tax gap”. (The tax gap is the difference between taxes that are voluntarily reported, versus the taxes that are actually owed with full reporting.)
The IRS is offering a generous amnesty program regarding past misclassification of employees. IRS Announcement 2011-64 describes this new program as follows:
“The Internal Revenue Service (IRS) has developed a new program to permit taxpayers to voluntarily reclassify workers as employees for federal employment tax purposes. The Voluntary Classification Settlement Program (VCSP) allows eligible taxpayers to voluntarily reclassify their workers for federal employment tax purposes.”
Announcement 2011-64 provides the qualifications for program participation as follows:
“The VCSP is available for taxpayers who want to voluntarily change the prospective classification of their workers. The program applies to taxpayers who are currently treating their workers (or a class or group of workers) as independent contractors or other nonemployees and want to prospectively treat the workers as employees. To be eligible, a taxpayer must have consistently treated the workers as nonemployees, and must have filed all required Forms 1099 for the workers for the previous three years. The taxpayer cannot currently be under audit by the IRS … the Department of Labor or by a state government agency. A taxpayer who was previously audited by the IRS or the Department of Labor concerning the classification of the workers will only be eligible if the taxpayer has complied with the results of that audit.”
Putting aside other possible consequences (discussed below), the VCSP is shockingly generous. A taxpayer who participates in the VCSP must agree to:
- Prospectively treat the workers as employees for future tax periods.
- Pay only ten percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year. The employer will not be liable for any interest and penalties on any liability; and will not be subject to an employment tax audit with respect to the worker classification of the workers for prior years. As a rule of thumb, the amount owed will probably be a little over one percent of the last year’s amount paid to the reclassified workers.
- For the next three years, agree to extend the statute of limitations on assessment of employment taxes for an additional three years. Absent the VCSP, the statute of limitations would be three years.
Surprisingly, the IRS announcement does not provide any VCSP time limitation or expiration.
To participate in the program, a business needs to complete IRS Form 8952. The IRS will contact the taxpayer or authorized representative to complete the process once it has reviewed the application and verified the taxpayer’s eligibility. Taxpayers whose application has been accepted will enter into a closing agreement with the IRS. A business should anticipate that the closing process will take at least two months.
DOL, State Employment Taxes, Workers’ Compensation Insurance, and Litigation Concerns
Importantly, the VCSP program covers only the IRS. Amounts owing to workers compensation insurance carriers, state taxing authorities and the department of Labor (DOL) are NOT being forgiven through the VCSP. Consequently, participation in the VCSP is significantly complicated by other risks that occur when a worker is misclassified.
Presumably, the IRS closing agreement will include a clause specifying that the business is not admitting to any past wrongful conduct. Nevertheless, every worker that is re-classified as an employee will be alerted to the potential past misclassification, and any state performing a payroll tax audit will learn of the VCSP. Additionally, any participating state and the DOL will be notified of the changed reporting (see below for details). Each of these will likely pursue whatever state taxes and back wages/benefits would become payable if the worker were retroactively reclassified. For this reason the real cost of the VCSP might indirectly become much larger.
The Department of Labor (DOL) has regulatory authority over a wide range of federal employment laws that are effective once a worker is an employee. For this reason, the DOL is interested in employee misclassification. Similarly, most states have payroll taxes that are not collected as long as a worker is classified as an independent contractor.
At roughly the same time as the IRS announcement of the VCSP program, on September 19, 2011, the IRS and Department of Labor issued a press release entitled “Labor secretary, IRS commissioner sign memorandum of understanding to improve agencies’ coordination on employee misclassification compliance and education”. The memorandums of understanding enable the U.S. Department of Labor, the IRS, and participating states to share information and coordinate law enforcement.
The press release claims that the new agreement will
“…level the playing field for law-abiding employers and ensure that employees receive the protections to which they are entitled under federal and state law. According to DOL Secretary Solis, ‘We’re here today to sign a series of agreements that together send a coordinated message: We’re standing united to end the practice of misclassifying employees. We are taking important steps toward making sure that the American dream is still available for all employees and responsible employers alike.’”
Although the IRS is being quite lenient under its VCSP program, the DOL has promised no such leniency. The new memorandum raises the possibility that participation in the VCSP program will trigger DOL action.
Classification of a worker as an employee vs. and independent contractor also has importance regarding the (i) applicability of state wage and hour laws and (ii) responsibility for workers compensation insurance. Alleged misclassification has created a number of class action lawsuits that contend workers should receive additional pay and/or benefits based on the independent contractors being instead classified as employees. If successful, these cases generate substantial damages.
The above estimates are just the impact on the federal government. Unpaid state taxes are additional billions of dollars.
When is a Worker an Independent Contractor?
The determination of whether a worker is an employee or an independent contractor is based on a common law test that requires significant judgment. If litigation is required, the presentation can usually be improved with a testifying accountant who can both (i) present the business’s situation, and (ii) draw comparisons to other economic situations that provide important insights as to the correct answer.
The IRS current guidance regarding the classification of employees vs. independent contractors, as accumulated from a number of IRS website pages, is as follows: (Some editing occurs in the following for grammar, to eliminate duplication, and for understandability)
“In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.
Facts that provide evidence of the degree of control and independence fall into three categories:
1. Behavioral: Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done – as long as the employer has the right to direct and control the work.
The behavioral control factors fall into the categories of (a) Type of instructions given, (b) Degree of instruction, (c) Evaluation systems, and (d) Training:
a. Types of Instructions Given – An employee is generally subject to the business’s instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work.
i. When and where to do the work.
ii. What tools or equipment to use.
iii. What workers to hire or to assist with the work.
iv. Where to purchase supplies and services.
v. What work must be performed by a specified individual.
vi. What order or sequence to follow when performing the work.
b. Degree of Instruction – Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
c. Evaluation System – If an evaluation system measures the details of how the work is performed, then these factors would point to an employee. If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.
d. Training – If the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way. This is strong evidence that the worker is an employee. Periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship. However, independent contractors ordinarily use their own methods.
2. Financial: Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job. The financial control factors fall into the categories of (a) Significant investment, (b) Unreimbursed expenses, (c) Opportunity for profit or loss, (d) Services available to the market, and (e) Method of payment.
a. Significant investment – An independent contractor often has a significant investment in the equipment he or she uses in working for someone else. However, in many occupations, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees. There are no precise dollar limits that must be met in order to have a significant investment. Furthermore, a significant investment is not necessary for independent contractor status as some types of work simply do not require large expenditures.
b. Unreimbursed expenses – Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.
c. Opportunity for profit or loss – The opportunity to make a profit or loss is another important factor. If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money (i.e., their expenses will exceed their income from the work). Having the possibility of incurring a loss indicates that the worker is an independent contractor.
d. Services available to the market – An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
e. Method of payment – An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
3. Type of Relationship: Type of relationship refers to facts that show how the worker and business perceive their relationship to each other. The factors, for the type of relationship between two parties, generally fall into the categories of: (a) Written contracts, (b) Employee benefits, (c) Permanency of the relationship, and (d) Services provided as key activity of the business.
a. Written Contracts – Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker’s status. The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.
b. Employee Benefits – Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.
c. Permanency of the Relationship – If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
d. Services Provided as Key Activity of the Business – If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.”
The above guidance is a substantial reworking of Revenue Ruling 87-41, which provides the following twenty factor test which is sometimes cited in court cases:
1. Is the worker required to comply with instructions about when, where and how the work is done?
2. Is the worker provided training that would enable him/her to perform a job in a particular method or manner?
3. Are the services provided by the worker an integral part of the operations?
4. Must the services be rendered personally?
5. Does the business hire, supervise, or pay assistants to help the worker on the job?
6. Is there a continuing relationship between the worker and the person for whom the services are performed?
7. Does the recipient of the services set the work schedule?
8. Is the worker required to devote his/her full time to the person he/she performs services for?
9. Is the work performed at the place of business of the company or at specific places set by the company?
10. Does the recipient of the services direct the sequence in which the work must be done?
11. Are regular oral or written reports required to be submitted by the worker?
12. Is the method of payment hourly, weekly, monthly (as opposed to commission or by the job?)
13. Are business and/or traveling expenses reimbursed?
14. Does the company furnish tools and materials used by the worker?
15. Has the worker failed to invest in equipment or facilities used to provide the services?
16. Does the arrangement put the person in a position of realizing either a profit or loss on the work?
17. Does the worker perform services exclusively for the company rather than working for a number of companies at the same time?
18. Does the worker in fact make his/her services regularly available to the general public?
19. Is the worker subject to dismissal for reasons other than non-performance of the contract specifications?
20. Can the worker terminate his/her relationship without incurring a liability for failure to complete the job?
A “yes” answer to any the above questions may mean the worker is an employee (except question 16, for which a no answer indicates that the worker may be an employee). Fortunately, no single answer is determinative, since practically all independent contractors will fail at least one of the tests.
In a recent case, the employer refused to settle and won its position at both the trial and appellate levels. In Cristler v. Express Messenger Systems, Inc., 2009 Cal. App. (Fourth Appellate District) the appellate court ruled that the instructions provided to the jury correctly stated the applicable legal principles. The case involved a messenger service that converted their employee drivers to independent contractors. The jury determined that the drivers working under contractor agreements were properly classified as independent contractors. The class-action plaintiff appealed the jury’s verdict, arguing that the jury was improperly instructed as to the legal standards for analyzing whether a worker is an employee or an independent contractor.
In this case, the jury instructions were as follows:
“In determining whether the Plaintiffs and other class members (“drivers”) were employees or independent contractors, you must consider a number of factors. You will need to weigh all of these factors based on the evidence that you have heard. The most important factor to consider is the extent to which the Defendant has the right to control the details of the work performed.
The following additional factors are to be considered:
The right to discharge at will without cause;
Whether the drivers are engaged in a distinct occupation or business;
The skill required in this occupation;
Whether the driver or [the employer] pays for vehicles, equipment, and business expenses;
The length of time for which the services are to be performed;
The method of payment to drivers, whether by the hour or by the job;
Whether or not the work done by drivers is part of the regular business;
Whether or not the parties believe they are creating an employer-employee relationship;
The driver’s opportunity for entrepreneurial profit or loss depending upon his/her managerial skill;
The drivers’ use of helpers/replacements: and
The degree of permanence of the working relationship.
These individual factors cannot be applied mechanically as separate tests; they are intertwined and their weight depends often upon particular combinations.”
These tests usually require the assemblage of underlying data as a basis for then applying significant judgment. If the business decides to not accept the current program, in light of employers’ risk under both tax and employment laws, companies and their legal advisors should proactively review this area. You should document the conclusions reached, which will then facilitate rapid rebuttal of allegations that are likely to be arising with increased regularity. Since compliance by other companies is this area is often weak, plaintiffs and government auditors will have plenty of other easy targets to move onto once your documentation is presented.
Perhaps Too Good to be True?
At the surface, the VCSP is a great deal, particularly for those numerous small businesses that have no realistic way of justifying their current worker classifications and therefore would face significant back taxes, interest, and penalties. But, one must wonder why the IRS is offering this great deal. We should put aside for purposes of this paragraph the risk of class action lawsuits, which do not directly benefit the government and which are a lesser risk for a small business. However, the government could also benefit from the following possibilities, none of which are mutually exclusive:
- The federal government realizes that proving workers are employees is easier said than done. The fact-intensive analysis involving smaller pots of money that necessarily are involved with small businesses means that voluntary compliance (vs. audits) are really more cost effective, even if it does mean that huge back taxes, penalties, and interest need to be waived.
- The value of an annuity of future payroll taxes is worth more than the huge back taxes, penalties, and interest that will be waived.
- The program is a possible trap. Although some reporters have interpreted the announcement of IRS and DOL information sharing to mean that the DOL is participating in the program, the IRS announcement does not say this. One interpretation is that the federal government will benefit from the IRS forgiveness by collecting DOL penalties.
- Certain federal programs supported by the current Administration are only applicable with larger employee counts. For example, a company with 50 or more employees would be subject to providing health insurance in 2014 under the Patient Protection and Affordable Care Act (aka ObamaCare).
- The federal government is interested in helping the states, many of whom are asking for additional federal assistance and practically all of whom will benefit from higher payroll tax compliance. Additional payroll compliance will allow states to pay for unemployment, ObamaCare, or any of the other numerous federal/state combined programs.
- The additional employment reporting will create better statistics about job growth, just in time for the upcoming 2012 elections.
But even with these risks, if the initial independent contractor classification is frivolous (as it often is for truly small businesses), paying 10% of taxes for only one of three open tax years is simply too good to pass up. Perhaps your business faces increased exposure because (i) a former worker has made a claim for unemployment benefits, workman’s compensation, or wrongful discharge, or (ii) a competitor has learned about your practices (because one of your former workers has gone to work there) and might turn you in under the IRS whistleblower program. Businesses facing meaningful risks in this area should participate in the program.
But, for those businesses that have a viable argument that the independent contractor status is legitimate, we expect that VCSP participation may not be such a great deal. To determine into which of these two groups your business belongs, you will need to wade through the lengthy analysis listed above in “When is a Worker an Independent Contractor?” In short, VCSP participation, which might otherwise seem like a great deal, requires care and legal analysis.