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Employee vs Independent Contractor IRS Checklist

employee vs. independent contractor irs checklist

As part of an effort to close the tax gap and generate revenue, audits of employers on employment issues are increasing. Of particular interest is whether workers have been properly classified as employees or independent contractors. “There absolutely has been an increase in audit activity in this area,” says Evan White, a partner at White Harris LLP. “In a tough economic time where governments, both state and federal, are trying to increase revenues, this is one way they are looking to do so.”

Coming Clean with the IRS
Sometimes, regulators will do these audits with companies’ active participation. Since 2011, nearly 1,000 employers have participated in the IRS’s Voluntary Classification Settlement Program (VCSP), which allows companies that meet certain criteria to voluntarily reclassify independent contractors as employees for future tax periods. In return, they have to pay only a fraction of their payroll tax liability for prior periods. “This is an area that is a money maker for the IRS because misclassification occurs frequently,” says Clarence Kehoe, a partner at Anchin, Block & Anchin.

Still, some practitioners believe that just a thousand employers between late 2011 and now has been an underwhelming response, likely due to the non-tax issues that can arise when companies admit workers have been misclassified. Employers that decide to participate have to consider the risks before collaborating with the taxman.

IRS Gives a Welcoming Hand to Employers Willing to Come Forward
The IRS recently loosened its eligibility requirements to open the program to even more employers. Now, employers that are under audit – so long as they are not under an employment tax audit as well – are eligible to participate. Kehoe notes that the VCSP “is a great way to get clean.”

To participate, employers must file a Form 8952 with the IRS at least 60 days before they intend to begin treating the workers in question as employees. If the IRS accepts the application, employers will generally pay an amount equal to just over 1 percent of the wages paid to the reclassified workers in the prior year. No interest or penalties will be assessed on the amounts paid and no audit on payroll taxes will result with respect to those particular workers. For those employers that also failed to file Form 1099 for those individuals, a slightly higher amount, including some penalties, will be due. They will also be expected to still put those previously due 1099s together, although the IRS is waiving the requirement until June 30.

Overall, the hassle to employers to fix past mistakes is minimal. “The process is pretty straight forward. In my experience, it has taken a couple of months between filing of the form and acceptance by the IRS,” Kehoe says.

However, White observes, “there is a general concern with respect to the VCSP as to the potential collateral damage to participation. In other words, if you participate in the program and admit you have a misclassification issue, will the Department of Labor and state agencies jump on the same bandwagon for these other issues?”

What You Need to Consider Before Cooperating with the IRS
What are the other potential issues? There are a lot.

  • Wage and hour requirements under the Federal Labor Standards Act. The FLSA establishes the rules regarding minimum wage and overtime pay, among other things. Only certain employees are exempt from overtime. “If employers are held liable for not properly paying overtime, they could be subject not just to the payment of back wages but also liquidated damages, attorneys fees, and costs,” warns Cathleen Scott, a labor and employment attorney at Cathleen Scott & Associates P.A.
  • Unemployment insurance. Unemployment insurance premiums must be paid for employees. “If a worker is classified as an independent contractor and then files an unemployment claim, this could raise issues for a company,” warns Christine Reinhard, a partner at Schmoyer Reinhard LLP. “A state unemployment agency could determine the worker was, in its opinion, an employee and assess unpaid unemployment taxes on past compensation paid to the worker.”
  • Workers’ compensation and the Immigration Reform and Control Act. Workers’ compensation insurance and requirements under the Immigration Reform and Control Act are “two other areas to consider where workers have been misclassified as independent contractors,” advises Reinhard. A failure to provide workers compensation insurance coverage and maintain a Form I-9 could result in liability.
  • Civil rights protections. Reinhard notes that “not only are issues related to unemployment, federal tax, and wage and hour claims on the table, but so are discrimination claims. Independent contractors generally are not covered by anti-discrimination statutes while employees are.”
  • Benefits. This could be a gray area when employees leave a company but return as independent contractors. “Exercise caution to avoid question as to whether they had a true separation from service for both retirement plan and nonqualified deferred compensation distribution purposes,” says Cristina Jennings, senior counsel at Schmoyer Reinhard LLP. Another matter to consider is the Affordable Care Act, which could tempt companies to misclassify workers in an attempt to fall under the 50-employee threshold for being required to provide all full-time workers with health insurance or pay a penalty. “This point potentially creates significant additional scrutiny on the issue of worker classification that already has such a heightened level of governmental interest,” Jennings says.

While the VCSP may look like a great way to address a misclassification issue for federal employment tax purposes, employers should proceed with caution. The IRS, DOL, and some state agencies have entered into an information-sharing agreement. If employers admit to a misclassification via VCSP participation, they should be prepared to also address other issues with other agencies.

Kandice Bridges is a freelance writer specializing in issues related to business, legal, tax, retirement, executive compensation, and women in executive leadership. She can be found at