Help with worker classification issues

Q: When I started my small business a few years ago, I paid my workers appropriately as independent contractors because I was using them on a project basis without a lot of supervision. As my business has grown, though, I’ve evolved to the point where I use them continuously under my supervision and they really should now be classified as employees. Is there any way that I can switch their classification without exposing myself to heavy IRS penalties and back taxes?

A: It’s not unusual for employers to find themselves in this situation. Fortunately, the Internal Revenue Service recently released a new program that can provide the relief you are looking for. This new IRS program is called the Voluntary Classification Settlement Program (VCSP) and is meant to encourage employers to come in compliance with respect to their worker classifications.

The program allows employers to voluntarily correct misclassification issues going forward for workers who had previously been wrongly classified as nonemployees or independent contractors. While providing protection from the possibility of an employment tax audit for prior years, it offers substantially reduced costs for reclassifying workers.  

A business owner who participates in the VCSP agrees to treat the class or classes of workers as employees for future tax periods for employment tax purposes. The employer will pay 10% of the employment tax liability that may have been due on the compensation paid to the workers, calculated at the reduced rates for the most recent year with no liability for any interest or penalties. For example, an employer who misclassified workers and paid them $100,000 in 2010 for wages below the Social Security wage base would owe only $1,068 in employment taxes, rather than $10,680, plus interest and penalties, for that year. 

Organizations considering this program should keep in mind that the IRS is in the midst of a three-year program that significantly increases the number of worker classification audits.
There are more details to the program than I can describe here. But this may be a good time to “clear the air” with the IRS with respect to employee classifications with minimal cost and exposure. Deciding who can legitimately work as a contractor and who must be given employee status has become a difficult matter for small business owners. So, consult with your CPA or tax attorney to get advice on how best to take advantage of this opportunity.