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Are You Classifying Independent Contractors Correctly? IRS Offers Businesses an Amnesty

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Updated: Wednesday, January 9, 2013 - 10:19
Created: Wednesday, November 16, 2011 - 07:57

If your small business uses both employees and independent contractors you may think there are few differences between them – they do the same work, have similar goals and you pay them both for their contributions. But regardless of whether you see any day-to-day differences, the IRS does.

This article explains the grey area of contractor/employee classification and outlines a new IRS “amnesty” program designed to help business owners correct their worker classification mistakes.

How the IRS Sees It

The fundamental difference between an employer and independent contractor from a tax point of view is that an employer withholds employment taxes from its employees but is not required to do so for independent contractors.

However, the definition of what constitutes an independent contractor versus an employee may not be readily apparent. According to the IRS, “In general, someone who performs services for you is your employee if you can control what will be done and how it will be done.”

For example, if you exert any type of control over when, where and how the actual  work is performed by an independent contractor, you may be getting into murky waters. For more on this and other criteria that come into play when classifying workers check out this SBA guide: Independent Contractor vs. Employees.

The Consequences of Misclassifying Workers

Statistics suggest that up to 30 percentof firms are guilty of misclassifying contractors, which translates to billions in unpaid taxes, and an ever-vigilant IRS is cracking down on this issue. If your business is found to have misclassified workers, you may incur back payroll taxes, interest and stiff penalties, not to mention a significant amount of paperwork.

How to Determine Whether Your Contractor Should Be Considered an Employee

To help businesses make a clear distinction between contractors and employees, the IRS publishes clear guidelinesand will even help you make a worker status determination using Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

New IRS Amnesty Program Helps Small Businesses that Misclassified Contractors

If you’ve read this article and think you may have mistakenly treated employees as independent contractors, the IRS is offering you a chance to make amends.

Announced in September 2011, the New Voluntary Worker Classification Settlement Program (VCSP) is an optional program that gives employers the opportunity to correct their worker misclassification mistakes and move contractors onto payroll – without waiting for the IRS to conduct an audit.This “amnesty” is part of a larger IRS “Fresh Start” initiative to help taxpayers and businesses address their tax responsibilities. However, as with all tax-related business decisions, be prepared to assess the potential impact on your wider business strategy. Consider the following:

1.  How the Program Helps Small Businesses

If you are a small business owner, VCSP is an attractive and cost-effective way to resolve any worker classification issues and eliminate the possibility of a tax audit. Under the program, eligible employers can obtain relief from federal payroll taxes they may have owed the IRS on that misclassified contractor. In exchange for treating these workers as employees for future tax periods, employers must pay 10 percentof any past-due employment tax liabilities for one preceding year – without interest or penalties. Employers will also be exempt from any IRS audit on payroll taxes going back six years. 

2.  Assess your Exposure

Reclassifying contractors or bringing them onto payroll has the potential to leave small business owners exposed on several fronts. Talk to a tax expert and/or legal counsel before making any decision. Some factors to consider before making the leap include:

  • Although VCSP only applies to federal taxes, voluntary reclassifications may also expose you to potential state tax law violations.
  • You may also run the risk of being pursued, or even sued, by your contractor(s) for benefits and other compensation that you should have provided during the period in which they were misclassified.
  • Can you afford to convert misclassified contractors to headcount employees? Adding employees to payroll will cost your business more in employment taxes. If you are a new employer, you’ll also need to review your employment and labor law obligations.

To learn more about the eligibility requirements of VCSP and how to apply, visit the Voluntary Classification Settlement Program page on IRS.gov.

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