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IRS Wants to Know: Are You Playing Games with Your Employees?

IRS Wants to Know: Are You Playing Games with Your Employees?

The Treasury Inspector General of For Tax Administration recently issued a report entitled Employers Do Not Always Follow Internal Revenue Service Determination Rulings that indicated the employers just do not get it when it comes to treating workers correctly for tax purposes.  This report sheds more light on non-compliance and will result in more audits of small businesses who have miss-classified workers as independent contractors.  So employers beware!

Employers illegally treating employees as independent contractors can come clean through a program called the Voluntary Classification Settlement Program (VCSP).  To explore in more detail the merits of this VCSP program and how it works, readers should look at Risky Business: Playing Fast and Loose with Worker Classification.  Basically, this program allows employers to voluntarily correct erroneously classified workers from independent contractors to employees in exchange for paying less taxes and penalties than if audited by the IRS.  Recently, the IRS provided some needed clarifications of this standard VCSP program under IRS Announcement 2012-46:

  • An employer can now be eligible for this program even if being audited by the IRS, except for a payroll tax audit.
  • An employer that is part of an affiliated group can not use the VCSP program where an employment tax audit involves one of its group members.
  • An employer that is in court contesting classification of workers from a previous audit by the IRS or Department of Labor is not eligible for the VCSP program.
  • An employer no longer has to agree to extend the limitation period on employment tax assessments as part of the closing agreement.  Under the original VCSP program, employers had to extend the statute of limitation for three years for the three taxable years after the date of the closing agreement.  This is no longer required under the standard VCSP program.

Additional Information and Insights:

For those interested in gaining greater insight into this problem and a lot more, please give a listen to my guest appearance on Money For Lunch.  We discuss not only the VCSP program but also explore the allowable “piercing of the corporate veil” by the IRS to impose individual personal tax liability on shareholders and officers for corporate tax obligations under Section 6672 of the Internal Revenue Code.  We also discuss related criminal tax implications.  So please click on the triangle to hear our discussion:

Money for Lunch

Bottom Line:

Employers should objectively and carefully review their employment policies.  If they are playing fast and loose with their classification of employees it could blow up in their face down the road.  The voluntary payments under this special program could be far less than the cost of an IRS employment tax audit for all open years resulting in the required payment of back taxes, interest and penalties.  With the IRS audit presence in this area, this may end up being a costly and in some cases a fatal gamble for a business and its shareholders or owners.  The sure thing is to use the current or the temporary VCSP to clean up a looming and expensive tax problem.

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Risky Business 1920 Silent Film With Gladys Walton

Risky Business 1920 Silent Film With Gladys Walton

In light of the IRS’s fairly recent Voluntary Worker Classification Settlement Program (VCSP) issued in 2012, employers need to consider the benefits and risks of their current classification of employees as independent contractors. This window of opportunity is only available before the IRS or Department of Labor initiates an examination.

Small companies and businesses of many sizes have classified their workers as independent contractors and not employees to gain the following illegal advantages and savings:

  • Avoid paying payroll taxes including Social Security, Medicare, Unemployment, and Federal tax withholding.
  • Avoid having to pay for medical insurance.
  • Avoid making payments of contributions into employer retirement plans.
  • Obtaining services at a fixed rate, no matter what the time required to complete the assignment.
  • Reducing employee record keeping, clerical and other administrative cost savings.

These tempting advantages have created a tremendous incentive for employers to classify workers as independent contractors when they are truly employees.  The IRS has warned that it is stepping up its policing of this area.  Here are some of the costs and penalties employers face if caught by the IRS:

  • Payroll tax liability, plus significant penalties and interest.
  • Various civil and criminal sanctions brought by the IRS, including fines and imprisonment.
  • Retirement plan disqualification or remediation and penalties.  If these workers were wrongly excluded from coverage under any and all retirement plans, such plans would not meet certain plan qualification tests and could be disqualified.  In the alternative,  the employer would have to go through an IRS plan remediation application and pay various penalties and costs to salvage the plan. For more details on plan remediation see Failing To Update Retirement Plans: Avoid Plan Disqualification & Penalties By Using the VCP Program
  • Personal liability for corporate officers of up to 100% of the amount the employer should have withheld from the employee’s compensation in payroll taxes.  Section 6672 imposes personal liability on officers, shareholders and board of directors as “responsible persons.”  For more details read Personal Liability For Corporate Employment Taxes.
  • Legal fees, the lost time spent litigating this matter and the related out-of-pocket costs of litigation.  In these cases, payments to accountants and other experts are necessary for the attorney to prepare for the case and for such experts to appear in court. Even if the case avoids full-blown litigation, legal fees and out-of-court settlement fees will result.

A battle with the IRS is only part of the employer’s problem.  Additionally, a disgruntled or vengeful worker can make real trouble for the employer by making the following claims against the employer:

  • Medical coverage:  If the employer had medical plans for its other employees, these excluded workers may make claims for lack of coverage.
  • Retirement Benefits:  For all the years in which they were erroneously treated as independent contractors, such workers may demand to have contributions made to the employer’s profit-sharing, 401(k), pension or other retirement plan.  This could be a very large liability if the claim involves multiple employees over multiple years.
  • Other Fringe Benefits: In addition to retirement plans, workers may demand stock options, disability payments, workers’ compensation and any other fringe benefits being offered by the employer to its other employees.
  • Overtime Pay:  These workers would be entitled to overtime pay under the Fair Labor Standards Act if the hours he or she provided to the employer in the past exceeded the standard workweek.
  • Unemployment claims.  For those workers erroneously treated as independent, they may assert a claim to collect unemployment for past employment.
  • Lawsuits:  Lawsuits brought against the worker may trigger legal action against the employer to hold the employer legally responsible.

Where the worker seeks reclassification and complains to the authorities, the IRS or the Department of Labor may then get involved by auditing the employer  on how it classifies all of its independent contractors. A full-blown audit could result in economic disaster or ruin for an employer.

Bottom Line:  Any employer playing fast and loose in this area needs to look at their employment practices very carefully.  For determining whether a worker is truly independent please read my article Employee or Independent Contractor?  Finally, see Employers Playing Tax Games with Workers: IRS Offers Way to Come Clean for the details and qualification requirements for coming within the IRS’s Voluntary Worker Classification Settlement Program (VCSP).

The key here is to get with your tax attorney to review your situation and take advantage of the VCSP before the IRS comes knocking on your door.

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