It’s up to a company to decide whether to treat its workers as employees or independent contractors. The decision has wide-ranging tax consequences for the company.  For workers who are independent contractors, the company saves on payroll taxes (the employer share of FICA and unemployment tax), benefits (such as payments for health insurance and retirement plan contributions), and insurance (including workers’ compensation).

Expanded voluntary settlement program

You may recall that in September 2011, the IRS introduced a new program, called the Voluntary Classification Settlement Program (VCSP), to enable employees to reclassify their independent contractors as employees with reduced penalties and interest (only 10% of the employment tax liability otherwise due on compensation for the most recent tax year if workers had been classified as employees). The idea for the program was to encourage employers to reclassify workers by easing tax penalties.

Interested companies that had filed all required Forms 1099-MISC for their independent contractors could apply for participation in the VCSP. They had to agree to extend the statute of limitations (the period in which the IRS can start an audit) for three years after starting participation. Companies currently under any type of audit were barred from the program. (Q-and-As on the VCSP can be found here.)

Now the IRS has temporarily (until June 30, 2013) revised and liberalized the VCSP. Participation is allowed even if the company is under an income tax audit; it is only barred if under an employment tax audit. The company is not required to extend the statute of limitations.

Companies that failed to file required Form 1099-MISCs for their independent contractors can now apply to the program. However, they will be required to pay 25% (rather than 10%) of the employment tax liability that would have been due on compensation for the most recent tax year if workers had been classified as employees. They also owe a penalty, although reduced, for unfiled 1099s for the three previous tax years and will have to file such forms electronically for the previous three years for workers being reclassified.

Legislation proposed

Currently, the VCSP is not necessarily the best option for a company. As long as the employer has issued required Form 1099-MISC to its independent contractors and had a reasonable basis for this classification, it could rely on Section 530 of the Revenue Act of 1978 to minimize or even avoid back employment taxes. This relief provision could be raised if and when the IRS challenged worker classification.

A bill in Congress, entitled the Independent Contractor Tax Fairness and Simplification Act of 2012 (H.R. 6653) would repeal Section 530 relief. Of course, the likelihood of passage before Congress adjourns is slim to none. But the idea could be renewed in the new Congress, so stay tuned.

Bottom line

If your company has been treating workers as independent contractors, talk your tax advisor to make sure you are properly classifying these workers. You can’t arbitrarily pin an independent contractor label on a worker who is really an employee because of the level of control exerted by the company over the worker.

If you have concerns about worker classification, discuss the VCSP and whether it makes sense to voluntarily reclassify some or all workers and pay the taxes before the IRS challenges your classification and embroils you in an audit.