Payroll In Practice: 9.30.2024

Question: A construction contractor treats all workers as nonemployee subcontractors. The contractor subsequently learned of recent changes to the Labor Department’s rules for determining whether a worker is an independent contractor or an employee. An internal review indicated that some subcontractors should have been classified as employees. The contractor heard of an IRS program that can mitigate payroll tax liability. How does this work?

Answer: The IRS program is the Voluntary Classification Settlement Program. It allows eligible taxpayers to voluntarily resolve worker classification issues for future tax periods without having to wait for an IRS audit and limits federal tax liability for past misclassification.

The VCSP provides a fresh start to businesses by providing certainty as to liability and relief in the form of reduced rates for qualifying federal income, Social Security, and Medicare tax obligations.

A business can incur significant liability under various labor and tax laws for misclassification of workers as nonemployees. Under the Fair Labor Standards Act, an employer may be held liable for back wages, including overtime, for the preceding two or three years. The FLSA and some state wage and hour laws may also establish individual liability for managers or executives responsible for the misclassification.

Liability and monetary penalties may arise if workers are improperly excluded from participation in employee benefit plans. Workers may be able to recover the value of benefits they were denied, such as workers’ compensation, unemployment insurance, health insurance, and qualified retirement plans. Employers may be penalized for failure to offer or provide health insurance or may have the qualified status of a retirement plan jeopardized for failure to cover all eligible employees.

Employers may be held liable for federal and state employment taxes that were not withheld, employer taxes that were not paid, interest and penalties on the unpaid taxes, and, if applicable, penalties for failing to file required information returns.

To apply to participate in the VCSP, a business must meet the program’s eligibility requirements and submit Form 8952, Application for Voluntary Classification Settlement Program, to the IRS. The business must also enter into a closing agreement with the IRS.

To be eligible, a taxpayer must:

1. Want to voluntarily reclassify certain workers as employees for federal employment tax purposes for future periods.
2. Be presently treating the workers as nonemployees.
3. Have filed all required Forms 1099 for each affected worker for the three preceding calendar years ending before the date Form 8952 is filed or the time that the worker worked for the taxpayer, whichever is shorter.
4. Have consistently treated the workers as nonemployees.
5. Have no current dispute with the IRS as to whether the workers are nonemployees or employees for federal employment tax purposes.
6. Not be under employment tax examination by the IRS (including any members of an affiliated group).
7. Not be under examination by the Labor Department or any state agency concerning workers’ proper classification.
8. Not have been examined previously by the IRS or the DOL concerning the proper classification of workers or, if previously examined, the business has complied with the results of the prior examination and is not currently contesting the classification in court.

Form 8952 may be filed at any time but should be filed at least 120 days before the date the taxpayer wants to begin treating the workers as employees. The settlement amount is computed on Form 8952, but the payment is submitted with the signed settlement agreement after the IRS has accepted the settlement.

The settlement amount computation is based on the total compensation paid to affected workers in the most recently completed calendar year. If the taxpayer did not pay independent contractors in the year prior to filing Form 8952, total compensation is the amount paid to affected employees from the beginning of the current calendar year to the date Form 8952 is signed.

The settlement amount is computed using IRC Section 3509(a) rates. To use these special rates, the employer must have filed any required information returns, such as Form 1099-NEC, and cannot recover any resulting tax payments from the employees. Tax computed on the total compensation includes the full computed employer share and 20% of the employee share of Social Security and Medicare tax plus 1.5% of compensation for income tax.

The settlement amount is 10% of the tax computed at the special rates. This is a significant savings over amounts computed on Form 945-X under a Classified Settlement Program adjustment. Taxpayers use Lines 18 to 24 of Form 8952 to calculate the settlement amount.

Form 8952 requires certain supporting documents, including a statement listing the names and Social Security numbers of affected workers. If applicable, Form 2848, Power of Attorney and Declaration of Representative, should also be attached.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

Author Information
Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.