Employee vs. Independent Contractor: Classification Challenges and the IRS


Companies often choose to classify a worker as an “independent contractor” instead of an “employee”, for many reasons which may include reducing liability exposure, tax consequences, and other obligations such as workers compensation insurance and medical benefits. A contract between the worker and company stating that the worker is an independent contractor will not shield the company from scrutiny by the IRS which could result in penalties and a hefty tax bill. Similarly, an employer-employee relationship can still be found even if the worker does not receive things such as vacation time or insurance benefits from the company like a typical employee.

How Do I Know Whether a Worker is an Employee or an Independent Contractor?
The IRS has issued publications that outline several factors determinative of whether a worker should be classified as an employee or an independent contractor; in other words, whether or not the company is on the hook for employment taxes. The worker’s independence compared to the degree of control by the company over how the worker performs services is the central focus of the factors for properly classifying a worker. It is important that the company views the entire relationship with the worker and understands that some factors will not apply to every kind of business. A helpful webinar on the classification of workers, produced by the IRS, is available at the following link: http://www.irsvideos.gov/ProperWorkerClassification/

Voluntary Classification Settlement Program
The Voluntary Classification Settlement Program (VCSP) was established by the IRS as an opportunity for employers to reclassify its workers as employees without facing full liability for past tax periods when the worker was improperly classified as an independent contractor. To participate in the program the employer must meet certain eligibility criteria, submit a formal application to participate, and enter into an agreement with the IRS.

VCSP Eligibility Requirements:

  • The workers must have been consistently treated as nonemployees (independent contractors);
  • Forms 1099 for each worker must have been filed for the previous three (3) years; and
  • The company is not currently being audited concerning classification of the workers by the Department of Labor or another state agency.

A company that participates in the VCSP must agree to treat the workers as employees for future tax periods. In exchange, the employer will only pay 10% of the employment tax liability for the most recent tax year, which will not be subject to interest or penalties. Additionally, the IRS will not conduct an employment tax audit relating to worker classification for prior tax years. Additional information can be obtained at the following link: http://www.irs.gov/businesses/small/article/0,,id=246013,00.html

The VCSP grants amnesty to those who qualify in an effort to encourage employers to properly classify workers and reduce future misclassification. If you believe that your company may be eligible to participate in the VCSP, you should consult with a tax professional.

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