At some time, most companies have faced the question of whether a person performing services for the company is an independent contractor or must be treated as an employee. For many years now, the trend by tax authorities has been toward the requirement of employment status.
Both federal and state governments have an interest in obtaining payroll taxes, unifying and accelerating the collection process. As a result, the requirements for independent contractor status have become more strict as the years have passed. In the third quarter of 2011, the Internal Revenue Service announced a program to increase compliance audits focusing on the correct classification of independent contractors/employees.
Employment Status Determination
The determination of employment status is not always easy, and had led to many protracted and expensive contests between companies and the tax authorities, often leading to surprising and undesirable results. While the factors used to make this determination seem relatively straightforward, a slight difference in perspective can make all the difference in the result.
Companies often believe that the additional payroll tax and administrative costs of hiring an employee are unacceptable. The contractor/employee may believe that the payroll tax cost, seen periodically on the pay stub, is too expensive, often forgetting that all contractor net income is subject to self-employment tax. The contractor may also be concerned that employee treatment will lead to the loss of business deductions which will not be reimbursed by the company.
Assuming that the contracting party properly files their tax return and pays the appropriate self-employment tax, the hiring party has the greatest risk in this transaction. If the contracting party/employer is found to be hiring employees and not contractors, the penalties for failure to withhold, late payment and possibly failure to file payroll tax returns will accumulate quickly. A contracting party should avail themselves of Independent Contractor status for their workers only after a thorough study of the facts, documentation of the facts, and assurance that company policies, processes, and management practices conform to and support the argument of independent contractor status for its workers.
Many situations exist in which independent contractor status is a correct treatment. However, there are undoubtedly many other situations in which independent contractors should be treated as employees. In these situations the facts – sometimes unintentionally or unknown to management – do not support contractor status. Failure to correct these situations will ultimately result in great cost to the company, and can easily put the existence of the employing company at risk.
Voluntary Classification Settlement Program Introduced
The Internal Revenue Service very recently announced an amnesty program called the Voluntary Classification Settlement Program (VCSP). This Program allows a company to reclassify those employees formerly treated as contractors, pay ten (10%) per cent of the payroll taxes which would have been paid, and thereby avoid all penalties and interest. In order to qualify, a company must have filed Forms 1099 for the workers in question and must not be under a classification audit by any federal or state agency.
This program is a rare opportunity for a company to come into conformity with the law at a very advantageous cost. For many, the failure to take advantage of this opportunity will almost undoubtedly result in significantly greater costs in the future when a classification audit occurs.
We recommend that all independent contractor situations be reviewed, the facts documented, policies and procedures put into place that support the determination of status. If the contractor status can not be supported, the application for treatment under the VCSP should be undertaken promptly, with the assistance of a professional experienced in these matters.