A hot-button issue for the Internal Revenue Service is the misclassification of employees as independent contractors for employment tax purposes.
Classifying a worker as an independent contractor instead of an employee can save a hiring firm a lot of money because it doesn’t have to pay half the worker’s Social Security and Medicare taxes out of its own pocket (as it does for employees), or withhold any tax from the worker’s pay.
All the hiring firm needs to do is file a Form 1099-MISC with the IRS each year reporting how much the contractor was paid (if paid more than $600).
The IRS believes that many employers have classified workers as independent contractors when they should have been employees. This could be intentional, but very often it’s not. In many cases it can be very hard to tell if a worker is an employee or independent contractor.
The IRS relies on a complex and confusing "right of control" test. Under this test, a worker is an employee if the hiring firm has the right to control the worker — both as to final results and the details of how the work is done.
Various factors are considered in determining if such a right of control exists, including whether the worker is given instructions, provided with training, can be fired at any time, has tools and equipment, and runs a risk of loss.
This week the IRS appears to have recognized that worker classification has become a legal morass. It has decided to give hiring firms the opportunity to wipe the slate clean and avoid having to pay back taxes and penalties if they are audited by the IRS and the agency determines they have misclassified employees as independent contractors.
The IRS has launched a new voluntary compliance program that allows employers to prospectively reclassify as employees workers previously treated as independent contractors.
Such voluntary compliance comes with generous settlement terms and audit relief for previous years. The new program is intended to allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit.
To be eligible, an applicant must:
- consistently have treated the workers in the past as nonemployees;
- have filed all required Forms 1099 for the workers for the previous three years; and
- not currently be under audit by the IRS, the Department of Labor, or a state agency concerning the classification of these workers.
It makes no difference if the employer really believed the workers involved were independent contractors or had some reasonable basis for treating them as such. Even employers who have flagrantly misclassified workers as independent contractors can qualify for the program.
Employers accepted into the program will pay an amount effectively equaling just over 1 percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years.
However, participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations rather than the usual three years that generally applies to payroll taxes.
This is a good deal if a firm knows, or strongly suspects, it has misclassified workers as independent contractors. Such firms may be sitting on a ticking time bomb that will go off in the event of an IRS audit.
Voluntarily reclassifying misclassified workers as employees under the new IRS program will defuse this time bomb at a very low cost.
Interested employers can apply for the program by filing Form 8952: Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees. Full details, including FAQs, are available on the Employment Tax pages of IRS.gov, and in Announcement 2011-64.
However, most real estate firms need not worry about this issue when it comes to classifying real estate agents and brokers as independent contractors. This is because real estate agents are ordinarily classified as statutory independent contractors (also called statutory nonemployees) for federal tax purposes.
This means agents are automatically considered independent contractors by the IRS. To qualify, a real estate agent must by duly licensed and meet two threshold requirements:
- the agent’s pay must be based on sales commissions, not on the number of hours worked; and
- there must be a written contract with the hiring firm providing that the agent will not be treated as an employee for federal tax purposes.
Other types of workers do not benefit from this special rule.
Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.