New IRS Worker Classification Settlement Program

One of the hottest current audit areas for the IRS is the employee/independent contractor issue. An employer who has misclassified workers as independent contractors faces potential liability for employee income tax withholding, employer and employee FICA taxes, federal unemployment tax (FUTA), as well as interest and penalties thereon.

Over the years, Congress has provided some relief to employers who misclassify workers. For example, under IRC §3509, the amount of liability for income tax withholding and the employee portion of FICA is greatly reduced if the error was simply misclassification. Further, under IRC §6205(a)(1), if an employer pays income tax withholding and FICA tax deficiencies after an audit but before the Service Center issues a bill for these items, no interest is due on these amounts. Rev. Rul. 75-464, 1975-2 C.B. 474. In §530 of the Revenue Act of 1978, Congress created safe harbors for employers to continue to treat certain workers as independent contractors who would, under common law tests, be considered employees. Such safe harbors include (1) that the employer previously underwent an IRS audit where the worker classification issue was not raised or was resolved favorably to the taxpayer, or (2) that a substantial segment of the relevant industry also treats such workers as independent contractors.

Under pressure from Congress, the IRS has now adopted its own program to expedite resolution of worker classification audit disputes. The new "Classification Settlement Program" (CSP) is an optional settlement program which IRS agents can offer to employers under audit.

Under CSP, an IRS agent who concludes that workers were improperly treated as independent contractors both under the common law test and the safe harbors of §530 of the Revenue Act of 1978 will, if the employer has filed Forms 1099, be able to offer a closing agreement which seeks only one year of tax deficiency if the employer agrees to treat the workers as employees prospectively. This tax deficiency is computed with the reductions of IRC §3509 relief. An agent who concludes that the employer has an arguable, but still erroneous, position for entitlement to §530 relief may offer the employer a closing agreement seeking only 25% of one year's tax deficiency (again, taking into account IRC §3509 relief), if the employer agrees to treat the workers as employees prospectively.

The CSP is a great improvement over the prior system of contesting these disputes before the IRS Appeals level or in the courts. Before adoption of the CSP, if the employer continued to treat the workers as independent contractors while contesting the issue for one or more earlier years at IRS Appeals or in court, the employer exposed itself to even greater liability if it lost the dispute. CSP settlements must be entered into prior to March 5, 1998.

While the CSP, §530 and IRC §3509 provide significant relief from possible payroll tax liability, before agreeing to classify workers as employees, consideration must be given to possible liability for state employment taxes, as well as for health benefits and past and future pension plan contributions for such individuals. By agreeing to treat individuals as employees, the taxpayer might be subjecting itself to claims by those individuals that they should be treated as employees from the date they originally began work for the taxpayer.

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