Misclassify a Worker on Your Taxes? IRS Offers Help

How employers classify their employees can hold serious tax implications.

Some employers misclassify workers as independent contractors to avoid paying payroll taxes when they should pay them as employees. But the IRS will catch on and check to see if workers are properly classified.

During income tax audits of businesses the IRS will look at how you treat your workers to determine if you are following the guidelines. And if you are not, the penalties can be very expensive. Now, thanks to a new program, business owners may enjoy an overall reduction of liabilities and a reprieve from IRS penalties.

Recently, The Voluntary Classification Settlement Program (VCSP) was set up to provide taxpayers with an opportunity to reclassify workers as employees for future tax periods for employment tax purposes. Employers will enjoy some relief from federal employment taxes if they come into compliance.

According to the IRS, “To participate in this new voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS.”

So if you’re under an income tax audit – not an employment tax audit – the auditor may be scrutinizing your outside services or subcontractor expense categories and questioning whether your 1099 recipients should really be classified as employees. This is your opportunity to enter the VCSP program.

It’s important to know how the IRS defines an independent contractor versus an employee. Generally, anyone who offers the same service that your firm offers should be considered an employee. So if you have a pet store and you have clerks who run the cash registers and help customers, they should be classified as employees. It’s all about behavioral control and financial control. Even if your workers agree to be treated as independent contractors and take responsibility for their own taxes, the IRS will reclassify them as employees and penalize you for not following the rules.

If, however, you employ a web designer to put your pet store on the map and that’s all this designer does for you, he or she can likely be treated as an independent contractor. In fact, if he has a string of other clients, a business license, insurance, an office, and a contract with you, there is no question that you are dealing with an independent contractor.

But let’s say you own a day spa and you hire a masseuse to work on call. The masseuse has his/her own business and a set of clients, a business license, insurance and you agree to payment of a percentage of completed massages. Sounds like an independent contractor, right? The answer is no. The masseuse offers the same service that your business offers, so he or she should be treated as an employee.

If you are eligible for The Voluntary Classification Settlement Program, you will be required to pay 10% of the employment tax liability that would have been due on current year compensation determined at reduced rates listed in the Internal Revenue Service tax code, section 3509(a). In return, the IRS promises not to perform employment tax audits for prior years and you will not be required to pay penalties and interest.

A pretty good deal if you ask me.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.