Misclassifying employees as independent contractors is a very common mistake made by employers. Often, errors stem from the complicated and fact-specific legal analysis needed to determine the proper classification of a worker.

The consequences may be fearsome. An employer that has incorrectly classified its workers faces the potential for back taxes, interest, and penalties, and is also exposed to other, nontax liabilities. Fortunately, the Internal Revenue Service recently announced a new Voluntary Worker Classification Settlement Program (VCSP), which allows an employer, voluntarily and in advance of any audit, to reclassify workers as employees for federal employment-tax purposes at a modest payroll tax cost to the employer. But there are serious implications that extend well beyond tax issues that employers need to consider before deciding to reach out to the IRS. (Editor’s note: For an extensive look at employers’ current challenges in classifying independent contractors, see the upcoming December issue of CFO.)

Companies first need to evaluate whether they are eligible for the VCSP. To be eligible, an employer must have consistently treated the workers as nonemployees and have filed all required 1099 forms for the workers for the previous three years. In addition, the employer cannot be currently under audit by the IRS, the Department of Labor, or a state agency concerning classification of the workers. Keep in mind that eligibility can be influenced if an entity in an affiliated group is under audit.

Note also that the IRS retains discretion as to whether to accept an employer’s application for the VCSP. Thus it is possible that an employer that has misclassified workers could be denied the benefits of the VCSP, leaving it in the unenviable position of an increased employment-tax audit risk as a result of coming forward.

An employer accepted into the VCSP will be required to pay only 10% of the employment-tax liability for the reclassified workers for the most recent tax year and will not be liable for interest and penalties. The employer will not be subject to any IRS employment-tax audits for previous years; however, the employer must consent to a six-year statute of limitations (rather than three years) on the assessment of employment taxes for the first three years under the VCSP and agree to prospectively treat the class of reclassified workers as employees for all future tax periods.

While entering into the VCSP would resolve an employer’s federal employment-tax issues, the IRS announcement does not address whether it would hold an employer liable for failure to withhold federal income taxes. Further, the VCSP does not address employment-tax and income-tax withholding liability at the state level, and it is uncertain whether the various states will offer similar programs.

Although the VCSP would provide relief from an IRS employment-tax audit for prior years, the employer isn’t immune from audits at the state level or by the DoL and other federal agencies. Once workers become aware that their employment status has changed, they may use it as a chance to assert a claim under federal or state wage and hour laws.

In fact, the tax classification of a worker is an important factor that is considered in determining whether a worker is an “employee” for purposes of many employment, benefits, and nondiscrimination laws. Workers reclassified as employees may also be entitled to various statutory protections and rights that do not apply to independent contractors, such as the Fair Labor Standards Act, the Americans with Disabilities Act, Title VII of the Civil Rights Act, and the Employee Retirement Income Security Act. Finally, a company that at first has a relatively small number of employees may become subject to certain statutes if its employee pool increases in size as a result of reclassifying workers.

Employers considering applying for the VCSP should assess their potential exposures before contacting the IRS. For companies with workers that have clearly been misclassified (whether intentionally or not), the VCSP may be a very cost-effective way to deal with the federal employment-tax issues after careful consideration of the other potential costs of entering the program. For employers with workers whose employee status is in the gray area, knocking on the IRS door may not be worth the risk of opening a can of worms.

Gary Q. Michel is a partner at law firm Ervin Cohen & Jessup, in Beverly Hills, California, where he chairs the tax-law practice.

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