Roll of the DiceThe Internal Revenue Service announced on 9/21/2011 that businesses that have improperly labelled their employees as independent contractors will be allowed to reclassify workers and make only a small payment to cover past payroll taxes.

The IRS is calling this program the Voluntary Worker Classification Settlement Program (the “Reclassification Program”). Under the IRS Reclassification Program, companies will only owe approximately 1% of wages paid to reclassified workers in the past year, with no interest or penalties due. Incorrectly classifying individuals as independent contractors allow companies to avoid withholding or paying employee workers compensation, unemployment insurance, and federal taxes.

To be eligible, a business must:

  • Have consistently treated the workers as non-employees; 
  • Have filed required 1099 tax forms for the past three years; and 
  • Not be under a worker classification audit by federal or state agencies.

What the Right Hand Giveth … 

The IRS’s Reclassification Program, in theory, will be beneficial to many businesses. But as Yogi Berra famously noted, “In theory there is no difference between theory and practice. In practice there is.”

First, theory and benefits: The distinction between who is an independent contractor versus an employee is not always clear-cut. For example, in making this determination, the IRS uses a twenty factor common law test for determing if an individual is an employee or independent contractor (PDF). Thus, employers may simply and mistakenly reach one conclusion that is later second-guessed by the IRS.  

Additionally, conflicting results as whether an individual is an employee or independent contractor may be reached under different agencies and statutes, which may further complicate reaching the “right” decision. In this regard, in enforcing the Fair Labor Standards Act’s wage and hour provisions the Department of Labor distinguishes the two categories based on whether an individual provides services to the company in the course of an independent occupation and if the business entity controls only the results of the work but not the means by which the work is accomplished (29 U.S.C. 201 et seq.). 

Accordingly, the IRS’s Reclassification Program offers significant incentive and cost-savings for employers who may have misclassified individuals as independent contractors.

As to practice and risks, the Wall Street Journal reported that the IRS and Department of Labor entered into information sharing agreements as part of the DOL’s efforts to continue to crack down on businesses that have misclassified workers. Nine states have also signed onto these agreements, with more expected. Michigan was not identified in either category by the WSJ. 

Thus, the information gained under the IRS’s Classification Program may provide a detailed road map for DOL officials to pursue businesses that improperly label workers as independent contractors rather than as employees. 

The Take-away for Employers

Until the DOL provides further clarification or assurances as to how employers entering into the IRS’s Reclassification Program will be treated, the benefits of the IRS’s Reclassification Program must be weighed against the potential downside of responding to cases brought by the DOL and re-classified employees seeking to recover back wages and benefits they believe they may be entitled to.

Absent any further action by the DOL, if an employer elects to enter into the IRS’s Reclassification Program, it is important to try and negotiate for certain provisions that may limit liability or the fallout in subsequent DOL or individual claims.