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October 19, 2011


Whether companies are
properly treating workers as independent contractors rather than as employees
is a frequent area of dispute in a variety of contexts — federal employment
tax, state workers compensation and unemployment tax, wage and hour and other
labor laws (both state and federal) and employee fringe benefits.  This is an area that has given rise to
frequent, and often very expensive, litigation. 

With respect to worker classification, an Internal
Revenue Service (IRS) investigation may be the most-feared action because a
determination of misclassification may well result in assessment of FICA,
Medicare, FUTA and income tax withholding taxes for a three-year period โ€“ a
liability that can be so large for a company whose work force consists largely
of independent contractors that it may well put the company out of
business.  In an unexpected move, the IRS
recently launched a new Voluntary Classification Settlement Program (VCSP),
under which employers can prospectively change the status of misclassifed
independent contractors to employees, with dramatically reduced tax liability
for past misclassification.

To be eligible for the
VCSP, an employer must satisfy the following requirements:

            (1)        In the
past it must have consistently treated all workers in the same class as

            (2)        It must
have filed all required Forms 1099 for these workers for the past three years;

            (3)        It must
not currently be under audit by the IRS, the Department of Labor (DOL) or any
state agency concerning worker classification; and

            (4)        It must change worker classification in
the future for workers in this class to employee status.

A company that was
previously audited by the IRS or the DOL about worker classification may participate
only if it has complied with the audit results.

If the employer
qualifies for participation in the VCSP, it will have the following benefits:

  1. In
    lieu of being liable for taxes, penalties and interest for the prior three
    years, it will be required to pay only an amount equal to 10% of its
    employment tax liability for the immediately preceding tax year (with that
    rate itself determined at greatly reduced rates afforded by Internal
    Revenue Code ยง3509).
  2. It
    will not be subject to employment tax audit for any prior year.

companies that are concerned about their possible exposure for classifying
workers as independent contractors rather than as employees, this may look at
first blush like an unequivocally good deal. Unfortunately, it is not so simple. The potential downsides of participating in the VCSP include the

  1.  As
    part of participation in the VCSP, the company must agree for the next three
    years to extend the normal three-year statute of limitations for audit
    adjustments to six years.  This extension
    apparently applies to all employment tax liabilities, not merely those
    attributable to worker misclassification.
  2. The
    VCSP applies only to federal employment tax liabilities; it does nothing to
    shelter the company from corresponding workers compensation and state
    employment tax liabilities for having misclassified employees.
  3. The
    VCSP does not protect the company from claims by the misclassified workers, the
    DOL or state agencies that the company had violated wage and hour laws
    applicable to employees.  These misclassified
    workers may also have claims against the company for not having allowed them to
    participate in retirement and other benefit plans available to employees.  These claims can be significant, and participation
    in the VCSP may be viewed as an admission by the company that it had improperly
    classified the workers.
  4. The
    IRS and the DOL recently instituted a program for enhanced sharing of
    information about worker classification, and several states (including
    Maryland) have entered into information sharing arrangements with the DOL.  It is unclear whether information provided to
    the IRS in the VCSP may be disclosed to the DOL and the states under these, or
    other, information sharing programs.

determining whether to participate in the VCSP, a company needs to carefully weigh
the pros and cons set out above, and all other relevant factors.  The relief from liability afforded by the
VCSP may provide companies with a way of escaping from a constantly troubling
situation, freeing them from worrying about a potential IRS audit that could jeopardize
the business.  But by doing so, the
company might possibly, as noted above, be increasing its exposure to claims by
the DOL, state authorities and employees that could also have serious consequences. 

The contents of this Alert are for informational purposes only, and do not constitute legal advice. If you have any questions about this Alert, please contact a member of the Shulman Rogers Employment and Labor Law Group  or the Shulman Rogers attorney with whom you regularly work.