In December 2007, the Internal Revenue Service ("IRS") fined the Federal Express Company ("Fedex") $319 million in penalties and back-taxes for misclassifying its drivers as independent contractors. Although the IRS rescinded this assessment two years later, Fedex ultimately footed the bill for years of fighting with the IRS and the significant cost of defending numerous private lawsuits, including a multi-district litigation encompassing forty-two consolidated class actions. Fedex's plight highlights the increasing risk to businesses that retain the services of independent contractors. However, some relief is in sight for these companies thanks to a new IRS program, the Voluntary Classification Settlement Program ("VCSP"), which reduces the prospective liability of employers who misclassified their employees as independent contractors.

What is the VCSP?

Businesses that misclassify employees face tax liability for failing to withhold income taxes and failing to contribute to social security and federal unemployment taxes. Companies that fail an IRS audit may owe the IRS back taxes, fines and interest for up to three years of misclassification.

The VCSP offers participants the opportunity to reclassify these workers for employment tax purposes. Program participants pay just ten (10) percent of owed employment taxes without interest or penalties for the most recent year of misclassification. The IRS also agrees not to conduct a worker classification audit on program participants for the reclassified workers' prior work years.

In exchange, VCSP participants agree to treat the reclassified workers as employees for future tax periods. In addition, participating companies agree to extend the period of limitations on assessment of employment taxes for the first three years following the workers' reclassification. VCSP participants are not required to reclassify all workers. However, companies that reclassify certain workers must treat all workers in the same class as employees for tax purposes.

Which companies are eligible for the VCSP?

Employers are eligible for this program if they have consistently treated workers as nonemployees and have filed out all required Forms 1099 for the workers for the previous three years. Additionally, the employer cannot currently be under audit by the IRS, or under audit concerning the classification of the workers by the U.S. Department of Labor (or a similar state agency). Companies that have already been audited by the IRS or U.S. Department of Labor are only eligible for this program if they have complied with the results of that audit.

Application Process

Companies wishing to participate in this program must apply using Form 8952, available at: www.irs.gov/formspubs/article/0,,id=242970,00.html. This form should be submitted at least sixty (60) days prior to the date the employer wants to begin reclassifying its workers. The applicant may also provide the name of an authorized representative with a valid Power of Attorney (Form 2848).

The IRS will then review the application and contact the company or its authorized representative once eligibility is determined. To be accepted into the program, accepted applicants must fill out a closing agreement with the IRS and simultaneously make full payment of the amount owed under the agreement.

Should my company enroll in VCSP?

To determine if an independent contractor is properly classified, the IRS uses the "right to control" test, which focuses on the degree of "behavioral control" and "financial control" the company retains over the worker and the nature of the relationship between the company and the worker. A business exercises behavioral control if it directs the way in which the worker completes his or her assignments or tasks. Financial control is the degree of control the worker exercises over the business relationship between the company and the worker. The IRS also looks to the relationship between the employer and contractor, such as whether the contractor receives employment benefits (i.e., health insurance or paid leave) and whether the employer and worker have signed an agreement memorializing the worker's status as an independent contractor. Companies should review the status of all workers classified as independent contractors and consult with counsel to determine if enrollment in the VCSP is appropriate.

Employers should be aware that participation in the program only reduces liability for employment tax purposes, and will not affect liability in a subsequent U.S. Department of Labor audit or private lawsuit. Furthermore, just because a worker is considered an independent contractor by the IRS for federal tax purposes, does not mean the worker is an independent contractor under applicable state law (e.g., for unemployment insurance eligibility purposes).

For more information on the VCSP, please refer to the IRS website at www.irs.gov/businesses/small/article/0,,id=246014,00.html.