Many companies make payments to independent contractors. The IRS, however, prefers to see workers classified as employees. Over the years, such disputes have triggered tax audits and court cases. Now, the IRS has offered amnesty to companies with questionable claims of hiring contractors.

The Issues

When companies pay employees, income taxes are withheld from each paycheck. In addition, employers pay certain payroll taxes, such as contributions to Medicare and Social Security, on behalf of employees. As a result, the IRS receives a steady stream of revenues from employers with employees.

Employers treat independent contractors differently. Generally, companies pay contractors for the work they do, and they do not withhold taxes. Then, it’s up to the contractors to pay the taxes they owe, including self-employment taxes for Medicare and Social Security. Because taxes are not withheld upfront, the IRS may find it challenging to collect all the taxes legitimately owed by independent contractors. In addition, contractors can take business deductions against their income more easily than employees can, so federal revenues may be reduced.

The potential for losing significant amounts of revenues due to worker misclassification has led to frequent IRS audits of employers to determine whether they are properly classifying their workers. In many cases, the IRS has ruled that independent contractors are really employees, so their employers owe taxes, interest, and penalties on the payments they have made to the contractors. Along with the IRS, the federal Department of Labor (DOL) and many state agencies are stepping up audit activity, looking to see which companies are improperly classifying employees as independent contractors. In some cases, government agencies are assessing penalties.

The Offer

The IRS has announced a voluntary classification settlement program for this issue. To settle the matter, companies will pay a certain amount. The calculation is fairly complicated, but it usually turns out that companies will pay about 1% of the wages paid to each worker covered by the settlement in the past year. If a worker was paid $50,000, for instance, the company’s obligation under this program might be about $500.

In order for companies to settle in this manner, they must meet certain conditions:[bulletlist]

  • They must have consistently treated workers as nonemployees.
  • They must have filed all required Form 1099s for those workers in the past three years, reporting taxable earned income.
  • They must not currently be undergoing an IRS audit, or undergoing an audit on this issue by any federal or state agencies.
  • In addition, a taxpayer who was previously audited by the IRS or DOL concerning the classification of the workers will only be eligible if the taxpayer has complied with the results of that audit.[/bulletlist]

Assuming companies qualify, make the required payments, and agree to treat the covered workers as employees in the future, they will owe no interest or penalties related to this issue. In addition, the IRS will not initiate payroll tax audits for any prior years on workers covered by this settlement. Companies agreeing to these terms also agree to extend the statute of limitations on payroll tax issues for an additional three years; this portion of the agreement will cover the three calendar years after the settlement.

Business owners considering this settlement should realize this is not an all-or-nothing proposal. An employer may reclassify certain classes of workers as employees while continuing to treat other classes as contractors.

Example: Company ABC has treated all of its telephone salespeople and its software designers as independent contractors. It decides to reclassify its software designers as employees, under the IRS settlement program, but continues to treat its telephone salespeople as independent contractors. Going forward, ABC agrees to treat all of its software designers as employees.

Making the Decision

According to the courts that have ruled on this issue, the difference between an employee and an independent contractor is a matter of control. The more that a company can tell a worker what to do and how to do it, the more likely that worker deserves to be classified as an employee.
Therefore, business owners who hire contractors and grant them a great deal of leeway in the way they operate may have a solid case for classifying them as independent contractors. On the other hand, companies that exercise control over workers now classified as contractors may decide to take the IRS offer and pay the relatively modest amount to avoid future challenges.

There may be other issues facing companies that agree to this settlement, such as employee benefits and state and local taxes. Business owners who wish to participate in this program must apply on Form 8952 at least 60 days from the date the company wants to begin treating its workers as employees.