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Friday, June 15, 2012

Mixed News on Misclassification of Workers

Federal and state tax authorities say they lose many millions of dollars in revenue due to the misclassification of workers. On January 1st a new California law went into effect that proscribes severe penalties that can be applied to employers who “willfully misclassify” employees as independent contractors.

At the federal level, the IRS has recently struck up an information sharing arrangement with the U.S. Department of Labor that could result in the detection of many more non-compliant businesses on the issue of misclassification. However, there is some relief: a voluntary settlement program that the IRS offers which can reduce the impact for employers who have failed to achieve compliance in prior years. In the following article, Armanino Senior Tax Manager Virginia Choy discusses the new law, the IRS/DOL arrangement and their consequences.

Compliance, legal, human resources and tax experts are buzzing about Senate Bill 459, a new California law now in effect that imposes severe penalties on employers who willfully misclassify individual employees as independent contractors. Some tax blogs have intimated the law was aimed at the construction and other labor intensive industries that have a reputation; deserved or not; for misclassification. But the law goes far beyond these industries.

SB 459 makes it unlawful for any person or employer to engage in willful misclassification of an individual as an independent contractor. It also prohibits charging a fee or any deductions from pay to individuals who have been misclassified as independent contractors (even if those acts would have violated the law under normal circumstances).

Penalties for non-compliance are severe. For instance, if your business is out of compliance with SB 459, you are subject to civil penalties of between $5,000 and $15,000 per violation. If an employer is found to have engaged in a pattern or practice of violations, the civil penalty is increased to $10,000 to $25,000 per violation. The law authorizes the state’s Labor and Workforce Development Agency, specifically the Labor Commissioner or a court, to assess the penalties.

If that wasn’t enough, there’s also a reputational penalty exposure. The law states that any business that is found to have willfully engaged in misclassification must “display prominently” for one year on their websites a notice to employees and the general public announcing, among other things, that the employer “has committed a serious violation of law by engaging in willful misclassification of employees.” The notice must be signed by a corporate officer.

As for the federal government, the IRS has long been concerned about misclassification and it recently signed a memorandum of understanding with the U.S. Department of Labor to share information that the two agencies believe will uncover many auditable discrepancies in this area. The IRS claims it has lost billions in unpaid payroll taxes.

There is great incentive to misclassify employees. An independent contractor does not require any benefits other than perhaps workspace and materials for daily use. An independent contractor can be dismissed at will with no consequences to either party. But the IRS looks at factors such as whether the employer controls the details of the work; how the worker is paid; whether the worker is truly a separate business considering the economic realities of the relationship and the allocation of business risk and so forth.

Until now, policing these standards has been difficult, but the IRS and DOL agreement is likely to make it easier for the tax authorities to prosecute violators. The good news is that the IRS has also created an amnesty program for employers who have misclassified workers in the past and who would like to create a clean slate with the tax authorities. Through this program — called the Voluntary Classification Settlement Program (VCSP) — employers can avoid many of the consequences of incorrect filings in their past and create a fresh and fully compliant start for their future filings.

The benefits of the program are substantial. For example, employers who qualify and come forward are required to pay only 10 percent of the employment tax liability that may be due for the most recent tax year on compensation paid to incorrectly classified workers. In addition, the IRS will not audit the participating employer with respect to classification of workers in any prior year which might still be open or subject to audit.

In exchange, employers must agree to adopt accurate classification of workers for all future tax periods. Employers must also extend the statute of limitations on assessment of employment taxes an additional three years for the first, second and third calendar years that the employer is under the VCSP program.

Qualifications to obtain VCSP relief are fairly straight forward. To qualify, employers must:

  • have consistently treated the workers as independent contractors or as non-employees in the past.
  • have filed all of the required 1099 Forms for these workers during the previous three years.
  • not currently be undergoing an audit by the IRS.
  • not currently be undergoing an audit focused on classification of workers by the DOL, or any state agency.

Interested employers can apply for the program by filing Federal Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees. See Form 8952 at http://www.irs.gov/pub/irs-pdf/f8952.pdf  and instructions at http://www.irs.gov/pub/irs-pdf/i8952.pdf.

Accurate worker status is relevant for many reasons. It determines the applicability of payroll taxes, worker’s compensation insurance, retirement plans and company fringe benefits. Worker status is also important in collective bargaining and when assigning responsibility under civil rights laws.

Now is the time for you to take a second look at your existing relationship with your independent contractors to determine whether a potential financial exposure exists. We strongly urge you to consult an employment labor counsel to assist you in determining the appropriate classification of your workers.


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