By Russell J. Stein
Classifying a worker as an employee or an independent contractor is one of the first questions a company faces when establishing, retaining or increasing its workforce. The classification affects how the worker is taxed as well as the worker’s rights under various benefit plans, unemployment insurance policies, workers’ compensation rules, and employment and labor laws, with each area of the law frequently applying different methods to determine whether a worker is an employee or independent contractor.
For federal payroll tax purposes, incorrectly classifying a worker as an independent contractor can lead to significant taxes, interest and penalties, all of which increase the longer the problem exists. However, since September 2011 the IRS has offered an amnesty program to allow employers under certain circumstances to voluntarily reclassify independent contractors as employees, thereby avoiding significant taxes and penalties.
The approach the IRS applies for payroll tax purposes looks to whether a worker is under the control of the employer. The IRS will generally classify a worker as an employee if the employer has the right to control and direct the worker. In making this determination, the IRS generally utilizes a 20-factor test to determine whether an employer is deemed to have control over the worker. This determination is very fact intensive and takes into account the specific characteristics of each particular industry. State taxation departments utilize similar analyses, although some states, New Hampshire included, assume a worker is an employee unless shown otherwise.
If the IRS determines that workers classified as independent contractors should have been treated as employees, a company can be liable for paying back taxes for each year the worker was misclassified, a late payment penalty of 10%, a late filing penalty of 25%, and interest on the taxes and penalties. Certain companies may be able to take advantage of an IRS amnesty program to minimize some of these taxes, interest and penalties.
Since 2011 the IRS has made available a Voluntary Classification Settlement Program (VCSP) whereby eligible employers can obtain substantial relief from federal payroll taxes attributable to misclassified workers if they are accepted into the program and prospectively treat such workers as employees. If your organization is currently treating workers as independent contractors when it should be treating them as employees, enrolling in the VCSP can minimize the company’s exposure to potential taxes and penalties.
To be eligible for the VCSP, an employer must:
1. consistently have treated the workers in the past as nonemployees,
2. have filed all required IRS Forms 1099 for the workers for the previous three years,
3. not currently be under an employment tax audit by the IRS, and
4. not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers.
To participate in the program, employers must apply to the IRS at least 60 days before they want to begin treating the workers as employees. Once accepted into the program, an employer has to pay a tax based on each misclassified worker’s compensation paid only for the most recent tax year in which the employee was misclassified. This could represent a tremendous tax savings if a company has misclassified workers for a number of years. Additionally, the program waives any penalties and interest attributable to unpaid employment taxes resulting from the misclassification. The IRS has not indicated how long this amnesty program may be available.
Prior to enrolling in the amnesty program, careful consideration should be given to any potential state taxes and penalties. Most states do not have any amnesty program, and companies may still be subject to past state taxes, penalties and interests attributable to misclassification of workers for state purposes even if they are accepted into the IRS amnesty program. Some states, particularly California, have in recent years enacted more stringent penalties relating to the misclassification of workers. Accordingly, it is best to obtain a full analysis of a company’s potential exposure in determining the appropriate action to take to alleviate such exposure. Neither Massachusetts nor New Hampshire currently has any amnesty program relating to misclassified employees in effect. Massachusetts Governor Charlie Baker’s 2016 budget includes a provision for a business tax amnesty program; although at this time it is uncertain whether employment taxes will be covered in any such program.
New Hampshire employers should also take note that there are currently proposals under consideration to change the test used to determine whether a worker is an employee or independent consultant. We will keep you apprised of any changes in these laws.
If you are unsure whether your workers are properly classified as independent contractors (a determination that can be more difficult to make than many companies think) or you would like additional information on this and other available tax amnesty programs, please contact Sheehan Phinney attorneys Russell Stein, Peter Beach or Jim Reidy.
* * *
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice.
ADVERTISEMENT – This electronic publication is labeled advertisement in compliance with Federal Law and may be considered advertising under the ethical rules of certain jurisdictions.