The lure of saving money on employment taxes and health insurance, along with other financial incentives, has led some employers to classify workers as independent contractors, rather than employees. The Internal Revenue Service (IRS), however, imposes significant penalties for misclassifying workers and avoiding tax payments.

In fact, the IRS and the United States Department of Labor (DOL) recently signed a Memorandum of Understanding designed to increase the number of employment tax audits on businesses, thereby boosting compliance and generating revenues. Under this agreement, DOL will provide information obtained from its Wage and Hour Division investigations regarding employers that misclassify workers as independent contractors.

In conjunction with this crackdown, however, the IRS has launched an initiative that allows businesses to become compliant with worker classification requirements at significantly reduced penalty rates. Known as the Voluntary Classification Settlement Program, this initiative also allows eligible employers to comply with employment tax laws—provided their violations have not yet been detected by the IRS.

Whether an employer can properly classify a worker as an independent contractor is a fact-intensive analysis that turns on the degree of control the employer exercises over how workers perform their jobs, whether workers are free to set their own hours, whether they are allowed to work for others and additional factors. For a more detailed explanation of the worker classification criteria used by the IRS and certain other government agencies, please read "He's an Independent Contractor...Or Is He?"

Employer Eligibility and Benefits

To be eligible for the new IRS program, an employer must have consistently treated a group of workers as non-employees in the past and filed the appropriate 1099 forms for those workers during the past three years. The program also requires that there be no current dispute between the employer and the IRS or the applicable state agency regarding the classification of its workers. Going forward, the program requires that employers agree to treat as employees any workers whom they previously misclassified as independent contractors.

The potential benefits of participating in the Voluntary Classification Settlement Program are great. In exchange for reclassifying workers as employees, an employer will pay only 10% of the employment tax liability that has accrued on compensation paid to each worker during the past year. Furthermore, employers will not be required to pay interest or penalties on that liability and will not be subject to an employment tax audit regarding worker classification issues. According to IRS calculations, liability for employers that participate in the program would only total approximately 1% of the compensation paid to misclassified workers for the most recent calendar year.

On the other hand, the risks can be great if an employer chooses not to enter the program and an IRS audit subsequently determines that one or more of its workers should have been treated as employees. In fact, the IRS can force non-compliant employers to pay the appropriate employment taxes in full for several years and impose significant interest and monetary penalties.

Companies that would like to participate in the program should submit an application to the IRS at least 60 days from the date on which they want to begin treating misclassified workers as employees. Once accepted into the program, employers must agree to extend the statute of limitations on assessments of employment taxes from three years to six years, enter into a closing agreement with the IRS regarding the total taxes due, and make full payment of any amounts due under the agreement when the closing agreement is signed. Employers should bear in mind that participation in the program may not relieve them of liability to other state or federal agencies (such as the Illinois Department of Employment Security) regarding the misclassification of workers.

Employers also should be aware that the Illinois Department of Revenue (IDR) has not announced a similar voluntary disclosure program. However, if the past is any indication, IDR will follow suit and allow a similar discount for state fines. That said, before signing up for the new federal program, employers should consult with counsel to confirm that IDR is proceeding in conformity with the IRS.