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Are Your Contractors Really Employees?

The Federal government continues to move workers from "independent contractor" to "employee" status. If you are using independent contractors, be aware of the, the regulations, the common law factors used by the IRS to determine worker status and your options.

by John M. Lohman, CPA
DGN Tax Manager

The Federal government through the Department of Labor (DOL) and the Internal Revenue Service (IRS) continues its ongoing programs to move workers from “independent contractor” status to employee status.  U.S. Labor Secretary Thomas Perez has said that cracking down on the misuse of independent contractors is among his top priorities.
If your business is audited by the DOL or the IRS and it is determined that you have misclassified employees as independent contractors, the costs can be devastating.  Years of unpaid payroll taxes are assessed and if you have formal employee benefit plans, years of company contributions can be deemed non-deductible. 
If your contractors are really employees, what are your options for rectifying the situation while minimizing the costs?  If you have workers who are legitimate independent contractors, what can you do in advance to improve your chances of coming through an employee classification audit unscathed?
The federal government has two initiatives/provisions in play regarding this issue: 
1.     IRC §§530 provides a safe harbor for some businesses using independent contractors. 
2.      The Voluntary Classification Settlement Program (VCSP) provides an employer the opportunity to move misclassified contractors to employee status while significantly reducing the costs for prior years unpaid payroll taxes.  
Let’s look at these in more detail.
Internal Revenue Code (IRC) §530
If you meet the qualifications under §530, then the IRS and DOL cannot reclassify your contractors as employees, even if it is determined they are misclassified as contractors.  To meet the requirements of §530 you must satisfy all of the following. 
1.     You must have reasonable basis for treating the worker as an independent contractor. 
2.     You must have filed all required documents that are consistent with independent contractor status. 
3.      Each group of workers must be treated consistently.  
Beware, qualifying under §530 for federal purposes does not mean the states you operate in are bound by the provisions of the federal law.  Every effort should still be made to document why the workers qualify for independent contractor status under the 20 common law tests.
Voluntary Compliance Settlement Program 
The VCSP applies to those businesses that currently treat a group of workers as independent contractors and that wish to treat them as employees going forward.  To qualify for the VCSP reduced employment tax liability an employer must: 
1.     Not be currently under an employment-status audit by the DOL or an employment tax audit by the IRS.  If IRS audits in the past touched on this issue, you must have been compliant with the audit results.
2.     Have consistently treated the non-employees as independent contractors and must have filed all required Forms 1099 for them the three previous years. 
3.      Agree to treat the class of workers as employees for future tax periods.
4.      Pay 10% of the employment tax liability that would have been due on compensation paid to the workers for the most recent tax year as determined under the reduced rates of IRC§3509, (equates to a bit over 1% of the compensation paid the previous year).  No interest or penalties are applicable.
5.      File Form 8952 identifying the contractors it wants to convert to employee status at least 60 days prior to the date the employer wants to begin treating the specified workers as employees.
6.      Sign a closing agreement with the IRS and pay the amount due in full.  Installment agreements are not available for this tax liability. 
If you are an employer who has misclassified contractors, the VCSP is the safest way to convert them to employees while dramatically reducing potential costs.
Valid Independent Contractors
What can you do to minimize the risk that the IRS reclassifies your legitimate independent contractors as employees?
While not dependable as audit protection, it is still advisable to qualify each contractor under as many of the 20 factors as possible. Even if your contractors qualify for the §530 safe harbor, it is still important that steps be taken to show that the workers meet the traditional common law criteria applicable to independent contractors.  Have a signed contract for each worker which addresses as many of the 20 common law factors as possible supporting independent contractor status.  
If you are uncertain about the proper status of workers you currently employ, or are considering adding, please feel free to contact Dennis, Gartland & Niergarth.  We  would be happy to help you determine the proper classification, and can also assist with finding ways to insulate your current or new contractors from reclassification.

John M. Lohman, CPA, Tax Manager