Industry Insights

The age-old issue of whether certain employers have “employees” or “independent contractors” rages on. There are distinctly different tax issues related to workers classified as employees versus independent contractors. This dilemma is more prevalent—and often confusing—in certain industries, such as construction and real estate.

There are several significant differences between employees and independent contractors, including:

• Employees receive wages subject to income tax, payroll taxes including federal and state unemployment, Social Security, Medicare and possibly other state taxes.
• Employees are taxed on the full gross amount of their wages.
• Employees only pay half the taxes for Social Security and Medicare; the employer pays the other half.
• Employers pay 100 percent of federal and state unemployment taxes for employees.
• Independent contractors are taxed only on their net profits, after business expenses.
• Independent contractors must pay all tax for Social Security and Medicare.
• Different tax reporting forms, such as Form W-2, Form W-9 and Form 1099-MISC, also apply, depending on the classification.

In general, the IRS considers three characteristics to determine if a worker is an employee or an independent contractor:

1. Behavioral Control:  Is there a right to direct or control how the worker does the work?
2. Financial Control:  Is there a right to direct financial aspects of the worker’s job, such as significant investments, expenses or opportunities for profit or loss?
3. Relationship of the Parties:  How do the businesses and workers perceive their relationship? Are there employee benefits or written contracts?

Employers that misclassify employees as independent contractors may face harsh consequences—including more than simply paying an employment tax liability to the IRS. There also is a significant amount of information sharing between the IRS, U.S. Department of Labor and various other state agencies; therefore, an IRS audit resulting in the reclassification of workers as employees can trigger inquiries by state agencies with worker classification standards often more strict than those of the IRS.

Considering the severity of the issue, any business using independent contractors should be aware of the potential risks and likelihood of defending the position if challenged by the IRS.

While the situation may sound dire, there is great news:  In an effort to assist companies that have historically been unclear as to proper worker classification, the IRS launched a new Voluntary Classification Settlement Program (VCSP) allowing employers to prospectively reclassify workers who may have been erroneously treated as independent contractors.

According to IRS Announcement 2011-64, the VCSP allows eligible taxpayers to voluntarily reclassify workers for federal employment tax purposes and obtain relief similar to that obtained in the current Classification Settlement Program (CSP). 

Under the VCSP, participating taxpayers agree to prospectively treat the class of workers as employees for future tax periods.

In exchange, the taxpayer will:

• Pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Internal Revenue Code Section 3509
• Not be liable for interest or penalties on the liability
• Not be subject to an employment tax audit with respect to the worker classification of the workers for prior years
• Agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees

While certain eligibility requirements apply and an application is required, the VCSP will enable many employers to resolve past worker classification issues at a low cost and with confidence that compliance will be satisfied.

More information regarding the VCSP is available on the IRS website, and more information regarding classifying independent contractors versus employees is available in IRS Publication 1779. In addition, Form SS-8 is available from the IRS to assist employers in determining their workers’ status.

For more information regarding this topic, contact your BKD advisor.