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CONSIDERATIONS IN RECLASSIFYING WORKERS

Beware of Hidden Consequences

In the 2013 Taxpayers Defense Conference, I talked about the IRS’s Voluntary Classification Settlement Program (VCSP). This is a program that allows companies to “voluntarily” reclassify their mischaracterized independent contractors as employees. Under the program, the company agrees to treat the workers as W-2 employees going forward, in exchange for lower penalties and a waiver on retroactive assessments. By participating in the program, the employer does not admit any wrongdoing but gains closure as to potential delinquency assessments and obtains certainty going forward. For details, see my outline for Session 6 of the 2013 Taxpayers Defense Conference.

From the program’s inception in 2012 through April 2014, more than 25,000 workers from 1,303 entities have been reclassified as employees and are now subject to wage withholding. The good news is that these 1,303 entities face no audits for past years, thus avoiding the massive tax and penalty assessments that often arise when the IRS makes wholesale reclassifications of workers. And while the participating companies face increased costs of doing business (since employees by their nature are more expense than independent contractors), they have the comfort of knowing they will not be blindsided by massive assessments going forward.

The bad news is that the consequences of converting workers to W-2 employees extend beyond merely the IRS. For example, resolving worker classification issues with the IRS doesn't absolve a company of problems that might arise on the state level or with other federal agencies, such as the Department of Labor (DOL). Consider that by using W-2 employees, the company now becomes responsible, at a minimum, for:

  • State income tax withholding,
  • State unemployment tax liabilities and potential unemployment benefit claims,
  • Workers’ compensation insurance and potential claims,
  • Minimum wage laws, overtime pay considerations and potential claims for back pay,
  • Claims regarding working conditions,
  • Potential union issues,
  • Pension and profit sharing considerations, and
  • The payment of a host of potential benefits, not the least of which is Obamacare issues.

Beyond that, the company may exchange one potential federal tax liability for another. Once a company adopts the use of W-2 employees on a larger scale, the company is responsible for ensuring that its payroll tax deposit schedule is met. The deposit schedule can change from month to month, depending upon the size of the payroll. And even if the company makes full payment of its payroll taxes, the penalties can be substantial if the deposits are made just one day late. Likewise, the filing of employment tax returns, Forms 940 and 941, carry substantial penalties even if the tax is paid. And in the worst case scenario—if the employment taxes are not paid in full—company owners and “responsible officers” can be held personally liable for the trust fund portion of the taxes that are not paid. See: Code §6672. 

This is why companies have a substantial incentive to classify workers as contractors. As such, they don’t have to withhold employment taxes or pay unemployment insurance and workers’ compensation premiums, or deal with unions and benefits. Independent contractors are also subject to fewer regulations, such as minimum wage laws. And with the safe-harbor rules applicable to independent contractors, a company may avoid retroactive assessments even if the IRS rules that the workers are in fact employees. For a more detailed discussion of this, see chapter 6 of my book, Taxpayers’ Defense Manual.

You wonder why companies move jobs offshore, and politicians wring their hands trying to concoct solutions to that problem. Keep in mind a very basic axiom of economics: what you tax, you get less of. When you burden companies with the level of taxation and regulation that’s heaped upon W-2 employees, is it any wonder why companies work so hard to cut payroll?

The burden is especially hard for small companies. I’ve had dozens of small business owners tell me over the years, “I will never have another employee as long as I live.” The burden is often just too great. Why put yourself through the torture?

As to the question of whether to join the VCSP or not, companies must be careful to evaluate not just the potential IRS exposure, but the exposure to the host of other federal and state agencies that might join in a feeding frenzy after the IRS matter is resolved. At present, there is no cross-agency, comprehensive program that will resolve all potential government claims. This is certainly a disincentive for applying for the VCSP.

There is no question that the IRS shares data with state tax agencies and other federal agencies, such as the DOL. The DOL has been active for years in dealing with worker complaints (never mind IRS audits) about employers misclassifying workers as contractors, thus depriving workers of overtime pay, insurance benefits, minimum wages, etc. In a statement issued last month, DOL Administrator David Weil said that the alleged misclassification is “a problem found in an increasing number of workplaces and in many states.” As such, the DOL has become aggressive in attacking the contractor status of many workers, apart from tax considerations.

Even worse, the IRS and the DOL use different rules to determine which workers are independent contractors verses employees. The IRS test focuses on who controls the workplace and the manner in which the work is performed. If the worker does, he is likely a contractor. If the company has control of the workplace and worker, the worker is likely an employee. But the DOL uses an “economic realities” test which is more vague. As a result, you can get two different answers given the exact same facts and circumstances. This adds further disincentive to companies to step forward. 

The question of who is an employee has to be resolved with a clear and simple test that is fixed by law, not one subject to arbitrary agency rules and judicial vicissitude. But as unimaginable as it may seem, in the nearly 4 million words of the tax code, there is no comprehensive definition of the term “employee.” Thus, the matter has been an issue for litigation and ongoing abuse (both by companies and the IRS) for decades.

For decades, we’ve been pressing Congress to establish such a law, and many versions have been proposed but nothing has passed. In the meantime, Congress has upped the ante for businesses using independent contractors. A provision in the Trade Preference Extension Act, signed into law in June, increases the maximum penalties for failing to file accurate Forms 1099, which are used to report payments to independent contractors. Under the new law, the penalty under code §6721 goes from $100 to $250, and the cap doubles from $1.5 million to $3 million. This change is applicable to forms filed with the IRS after December 31, 2015. 

 

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