If you’re an employer, the Internal Revenue Service wants to reach deeper into your pocket—again. This time, the IRS, in conjunction with the Department of Labor, is pursuing companies that it believes have engaged in “worker misclassification.” That means misclassifying someone as an independent contractor instead of as an employee in order to save money in the form of withholding taxes, employee benefits, and the like.

A recent Department of Labor study indicates that up to 30 percent of employers misclassify at least part of their work force. The federal government estimates that such misclassification costs it approximately $2.7 billion annually, and it hopes that a newly implemented IRS initiative designed to remedy misclassification of workers will reap at least $7 billion in additional federal revenue over the next decade.

Controversies over whether someone is an employee or an independent contractor aren’t new, says Mark Downey, a shareholder at Dallas’ Munsch Hardt Kopf & Harr PC and a board-certified employment law specialist who heads up the firm’s employment practice. “An independent contractor is typically seen to be less expensive for a company in that the company need not do withholding, pay certain payroll taxes, pay Social Security, pay unemployment, among others,” he says. “Companies are also not required to maintain the same records that are required for employees by various local, state, and federal employment laws.” In addition, Downey points out, independent contractors typically don’t qualify for the protections of various laws protecting employees, such as age and disability discrimination statutes.

But it’s not simply a case of employers trying to cut costs by classifying someone as an independent contractor instead of as an employee. For years, Downey says, “there really hasn’t been a clear, bright line test for determining whether a worker qualifies as an independent contractor.” Generally speaking, whether or not a worker should be considered an independent contractor hinges on whether a company has the right to control the manner and means of how that worker performs his services. If an employer simply contracts for a specific task or a finished product, then it’s likely that the worker should be properly classified as an independent contractor. 

But the IRS has an 11-factor test, the U.S. Supreme Court set forth a 12-factor test in the 1992 case of Nationwide Mutual Insurance Co. v. Darden, and different state and federal courts have articulated tests of their own. The result is a good deal of confusion over misclassification—and plenty of it going on. Sharon Fountain, a partner at Dallas’ Thompson & Knight and leader in the firm’s tax practice group, recommends that companies look at who’s being paid as an independent contractor and conduct an internal reality check. “You want to examine how regularly they are performing services for you, how are you paying them, do you have a written agreement with them, and are they working on a project basis or otherwise,” Fountain says.

Although misclassification itself may be nothing new, governmental efforts to curb it are. A tight economy and budget shortfalls have resulted in local, state, and federal governments focusing on additional sources of revenue. In 2009, the IRS and the Department of Labor announced a massive three-year Misclassification Initiative, and the Obama administration has stressed the issue, increasing the Department of Labor’s budget to investigate what it perceives as an area abused by many employers. Other states such as California, Illinois, New York, and Massachusetts have adopted legislation targeting the misclassification of employees—in some cases imposing stiff penalties for “willful” misclassification of independent contractors.

Most recently, the IRS  decided to play “Let’s Make a Deal” with employers, giving them a chance to come in from the cold through a new Voluntary Classification Settlement Program announced last September. The VCSP is available for employers who are currently treating workers as independent contractors (or other nonemployees) and who want to voluntarily change the classification of such workers to employees. As Downey describes it, “The thought is that by giving companies an opportunity to voluntarily comply and to give them a benefit from doing so, more companies are going to comply.”

Amnesty-like Program
So how does the program work? Participating companies typically pay 10 percent of their employment tax liability that would have been due in the most recent tax year to cover missed payroll taxes (for misclassified workers). An employer will also have to file IRS Form 8952, to reclassify workers at least 60 days before the worker is to be treated by the company as an employee. The employer will also need to enter into a closing agreement with the IRS; upon acceptance by the IRS, the employer must make a single payment equal to 1 percent of the misclassified worker’s wages over the past years. The upside for the company is that its previous payroll tax obligations for that employee, including interest and penalties, will be over; moreover, the employer won’t be subject to an IRS employment tax audit regarding any previous year’s classification of these newly re-categorized workers.

Does this amnesty-like program make sense for employers? According to Downey, the VCSP “can be a good deal for companies who are ready to correct a misclassification situation. The drawback is that this program will not extinguish any liabilities other than the IRS liabilities. There are still other federal, state, and local agencies that may still charge penalties, fees, and interest.” Fountain concurs, noting that “employers should first determine if they have other problems, including with their benefit plans, as well as state law issues.” Downey notes that even though the IRS itself doesn’t report a company’s participation in the VCSP to other agencies, “wise employees may tip off other agencies” about the issue upon being reclassified.

The alternative to participating in the VCSP can be expensive for employers who have misclassified workers. With a new mandate and the funding to support investigative and enforcement efforts, the federal government is typically “going back two to three years, depending on how egregious the violations found are,” says Downey, with the offending company being charged back taxes, interest, fees, and other costs for each and every worker found to have been misclassified. Fountain observes that once an employer has decided that it makes sense to take the IRS’ deal, “the earlier you take advantage of it the better.”

Another reason for taking the government up on this offer, says Downey, is the fact that in the event of an audit, the burden of proof will be on the employer to show that the worker is, in fact, an independent contractor.  “Companies can’t simply rely on contracts or generalizations like ‘the whole industry does it this way,’ ” he says.

If the IRS brings an enforcement action, it’s a safe bet that state agency investigations—not to mention private actions alleging wage and hour violations, among others—won’t be far behind. So employers should regularly take the time to assess whether their independent contractors are properly classified under the current law. Although there may be costs up-front, in the long run a voluntary reclassification is likely to be less expensive to deal with than the potentially devastating tax liability that could result from an involuntary investigation.

John Browning is a partner at the law firm of Lewis Brisbois Bisgaard & Smith LLP in Dallas, an award-winning journalist, and the author of The Lawyer’s Guide to Social Networking.