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Jim Buttonow
IRS expands eligibility for worker reclassification program

Worker status is a hot-button issue at the IRS. While you prepare 2012 returns, consider this program to limit your clients’ exposure in an employment tax audit.

January 28, 2013
By Jim Buttonow, CPA/CITP

On Dec. 18, the IRS announced a revision to its voluntary classification settlement program (VCSP) that provides partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat workers as employees. This program provides an opportunity for clients to address past noncompliance and for practitioners to limit their exposure.

Original VCSP

On Sept. 21, 2011, the IRS announced a VCSP to enable employers to prospectively treat workers as employees (Announcement 2011-64 and Delegation Order 4-50). This program was an attempt by the IRS to address a prevalent problem in tax compliance: employers treating workers incorrectly as independent contractors instead of employees, which reduces employment costs and the corresponding payment of employment taxes. The VCSP encouraged voluntary compliance by:

  • Removing the complex administrative procedures required to retroactively correct worker status;
  • Allowing the employer to pay 10% of the employment tax liability that may have been due on the compensation paid to the workers for the most recent tax year, determined under the reduced rates of Sec. 3509(a). In most situations, the VCSP payment would be about 1% of the reclassified compensation for the most recent year;
  • Removing penalties and interest on the liability; and
  • Providing the employer amnesty from an employment tax audit on prior years in relation to the reclassified workers.

The 2011 VCSP requires that taxpayers apply for the program using Form 8952, Application for Voluntary Classification Settlement Program. To qualify, taxpayers are required to:

  • File all required Forms 1099 for the previous three tax years before the application;
  • Not be under any type of IRS audit or examination by the U.S. Department of Labor or by a state government agency for worker classification issues; and
  • Agree to extend the assessment statute of limitation for employment taxes for three years for the first, second, and third calendar years after the VCSP closing agreement is completed.

The IRS reported last summer at the 2012 IRS Tax Forum that it received only 623 applications for the VCSP. After gathering feedback on the program, the IRS in December made modifications to the VCSP in Announcement 2012-45. It also announced the VCSP Temporary Eligibility Expansion, which will allow taxpayers that have not filed all their Forms 1099 for the previous three tax years to participate in the VCSP under less-generous terms of relief.

Modifications to VCSP

In the Announcement 2012-45, the IRS modified the VCSP to:

  • Permit a taxpayer under IRS audit, other than an employment tax audit, to be eligible to participate in the VCSP;
  • Clarify the current eligibility requirement that a taxpayer that is a member of an affiliated group (within the meaning of Sec. 1504(a)) is not eligible to participate in the VCSP if any member of the affiliated group is under employment tax audit;
  • Clarify that a taxpayer is not eligible to participate in the VCSP if the taxpayer is contesting in court the classification of the class or classes of workers from a previous audit by the IRS or the Department of Labor; and
  • Eliminate the requirement that a taxpayer agree to extend the period of limitation on assessment of employment taxes as part of the VCSP closing agreement with the IRS.

However, to be eligible for relief under the program, a taxpayer is still required to have consistently treated the workers as nonemployees and must have filed all required Forms 1099, consistent with the nonemployee treatment, for the previous three years with respect to the workers to be reclassified.

VCSP Temporary Eligibility Expansion

To make the VCSP available to more taxpayers, the IRS also announced the VCSP Temporary Eligibility Expansion (the temporary VCSP) in Announcement 2012-46. Taxpayers that are otherwise eligible for the original VCSP (after the modifications in Announcement 2012-45), but have not filed all required Forms 1099 for misclassified workers for the previous three years, are eligible for the temporary VCSP. However, the temporary VCSP is only available to taxpayers that file their application to participate in the program on or before June 30, 2013, and it comes with costs for taxpayers.

The payment for the temporary VCSP is higher than the payment under the original VCSP. Under the temporary VCSP, employers would pay 25% of the employment tax liability that may have been due on the compensation paid to the workers for the most recent tax year, determined using the reduced rates of Sec. 3509(b). In contrast to the original VCSP, which uses Sec. 3509(a) rates, the temporary VCSP uses slightly higher Sec. 3509(b) rates.

For example, for 2011 and 2012 tax years, the Sec. 3509(a) reduced rates were 10.28%, while Sec. 3509(b) rates were 12.91%. Under both programs, the reduced rates are in sharp contrast to the full potential employment tax liability that employers could owe for FICA and backup withholding: 41.3% (Internal Revenue Manual §4.23.8.13.1).

Applicants must self-assess a reduced Form 1099 nonfiling penalty. This penalty is between $50 and $100 per unfiled Form 1099, depending on the number of total unfiled forms, according to the IRS worksheet provided under the temporary VCSP. The maximum penalty is $10,000. The reduced penalty under this program is also in contrast to typical IRS procedures. In IRS examinations, the standard penalty for unfiled information statements is up to $100 per form, with a maximum penalty of up to $1.5 million ($500,000 for small businesses). If the IRS determines that the employer intentionally failed to file the information statements, the penalty increases to $250 per unfiled form, with no maximum.­

To participate in the temporary VCSP, taxpayers must meet the eligibility requirements; apply using Form 8952 and following the instructions under Announcement 2012-46; and enter into a closing agreement with the IRS. As noted above, taxpayers must file their application to participate in the temporary VCSP on or before June 30, 2013.

How to help your clients

The IRS is completing a three-year study on employment tax noncompliance and will continue to focus on proper worker classification and employment tax audits. Participating in the temporary VCSP will cost clients more than participating in the original VCSP, but for many taxpayers, it will provide the opportunity to address a substantial area of past noncompliance at much less cost than an employment tax audit. Here’s how practitioners can help clients.

First, investigate a client’s exposure to worker reclassification. Review the client’s payments, including vendor files, checks issued, cash payments, and Form 1099 recipients. Determine whether the client has filed Forms 1099 on these workers in prior years. If the client has unfiled Forms 1099 for prior years, the temporary VCSP might offer the client an opportunity to reduce Form 1099 penalties and enable full compliance going forward.

Next, consider the VCSP. The IRS has provided worksheets to quantify the client’s liability for both the original VCSP and the temporary VCSP. The tax computation for the original VCSP is on Form 8952. The worksheet for the temporary VCSP is in Announcement 2012-46. If an application is filed for the temporary VCSP, closely follow the application instructions found in Part V of Announcement 2012-46.

The temporary VCSP might allow access to the VCSP for clients that didn’t initially qualify for the program, based on Form 1099 noncompliance. Opting into either version of the program could limit a client’s exposure in an employment tax audit. Many practitioners are concerned that the IRS will share VCSP application information with other state and federal agencies. The IRS explicitly states that it will not share the information with states or the Department of Labor. The IRS also states that submitting a VCSP application will not trigger an IRS audit.

With the temporary VCSP, the IRS is offering an unusual and temporary opportunity to taxpayers. When practitioners are closing their clients’ 2012 books and preparing information statements and tax returns, they should take advantage of this program to limit clients’ audit exposure and correct any worker misclassification issues. The IRS is likely to continue focusing its enforcement resources on proper worker classification. Practitioners can help clients start the new year in compliance and avoid this potentially costly issue.

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Jim Buttonow, CPA/CITP, is the co-founder of New River Innovation, creator of Beyond415. He has more than 25 years of experience in IRS practice and procedures.