Businesses should heed the expansion of the Internal Revenue Service voluntary classification program (VCS) as yet another warning to clean up their worker classification practices and defenses for all workers performing services for the business in any non-employee capacity.
When businesses treat workers as nonemployees, yet they render services in such a way that they likely qualify as a common law employees, the businesses run the risk of overlooking or underestimating the costs and liabilities of employing those workers.
The U.S. Department of Labor’s Wage and Hour Division has an ever-lengthening record of businesses subjected to expensive backpay and penalty awards because the businesses failed to pay minimum wage or overtime to workers determined to qualify as common law employees entitled to minimum wage and overtime under the Fair Labor Standards Act.
Originally announced on Sept. 22, 2011, the VCS program as modified by Announcement 2012-45 continues to offer businesses a carrot to reclassify as employees workers who had been misclassified for payroll tax purposes as independent contractors, leased employees or other nonemployee workers. That carrot came with a stick: the IRS’ promise to zealously impose penalties and interest against employers caught misclassifying workers. And the IRS is only one of many agencies on the alert for worker misclassification exposures — worker misclassification also affects wage and hour, safety, immigration, worker’s compensation, employee benefits, negligence and a host of other obligations. Private plaintiffs are also pursuing businesses for misclassification.
All of these exposures carry potentially costly compensation, interest and civil and in some cases even criminal penalties for the businesses and their leaders. Consequently, businesses should act prudently and promptly to address all of these risks and manage their misclassification exposures. Because most businesses uniformly classify workers as either employees or nonemployees for most purposes, business leaders must understand the full scope of their businesses’ misclassification exposures.
VCS Program offers limited relief
Worker misclassification affects a broad range of tax and non-tax legal obligations and risks well beyond income tax withholding, payroll and other employment tax liability and reporting and disclosure. A worker classification challenge or necessity determination should prompt a business to address the worker reclassification and attendant risks in other areas.
Typically, in addition to treating a worker as a nonemployee for tax purposes, a business also will treat the worker as a nonemployee for immigration law eligibility to work, wage and hour, employment discrimination, employee benefits, fringe benefits, workers’ compensation, workplace safety, tort liability and insurance and other purposes.
Healthcare reform increases risks
Businesses can look forward to these risks rising when the “pay or play” employer-shared responsibility, health plan non-discrimination, default enrollment and other new rules take effect under the Patient Protection & Affordable Care Act (ACA). Given these new ACA requirements and the government’s need to get as many workers covered as employees to make them work, the IRS and other agencies are expanding staffing and stepping up enforcement against businesses that misclassify workers. Businesses must understand how workers are counted and classified for purposes of ACA and other federal health plan mandates.
ACA and other federal health plan rules decide what rules apply to which businesses or health plans based on such factors as the number of employees a business is considered to employ, their hours worked and their seasonal or other status. The ACA and other rules vary in the relevant number of employees that trigger applicability of the rule and how businesses must count workers to decide when a particular rule applies. Consequently, trying to predict the employer shared responsibility payment, if any, under Internal Revenue Code (Code) Section 4980H or trying to model the cost of any other federal health benefit mandates requires each business know who counts and how to classify workers for each of these rules. Most of these rules start with a “common law” definition of employee then apply rules to add or ignore various workers. Because most federal health plan rules also take into account ”commonly controlled” and “affiliated” businesses’ employees, businesses also may need to know their information.
For instance, when a business along with all commonly controlled or affiliated employers employs a combined workforce of 50 or more “full-time” and “full-time equivalent employees” but does not offer “affordable,” “minimum essential coverage” to every full-time employee and his dependents under a legally compliant health plan, the business generally should expect to pay a shared responsibility payment for each month that any “full-time” employee receives a tax subsidy or credit for enrolling in one of ACA’s healthcare exchanges.
If the business intends to continue to offer health coverage, it similarly will need to accurately understand which workers count as its employees for purposes of determining who gets coverage and the consequences to the business for those workers that qualify as full-time, common law employees not offered coverage.
In either case, ACA uses the common law employee test as the basis for classification, and the already significant legal and financial consequences for misclassifying workers will rise considerably when ACA gets fully implemented.
Consider relief in the full context
As part of a broad effort, the IRS is offering certain qualifying businesses an opportunity to resolve payroll liabilities arising from past worker misclassifications. The VCS Program settlement opportunity emerged in 2011.Touted by the IRS as providing “greater certainty for employers, workers and the government,” the VCS Program offers eligible businesses the option to pay just more than 1% of the wages paid to the reclassified workers for the past year. The businesses also must meet other criteria. The IRS promises not to conduct a payroll tax audit or assess interest or penalties against the business for unpaid payroll taxes for the previously misclassified workers.
Participation was low, partly because not all businesses with misclassified workers qualified to use the program. The original criteria to enter the VCS Program required that a business:
Be treating the workers as nonemployees;
Consistently have treated the workers as nonemployees;
Have filed all required Forms 1099 for amounts paid to the workers;
Not currently be under IRS audit;
Not be under audit by the Department of Labor or a state agency on the classification of these workers or contesting the classification of the workers in court; and
Agree to extend the statute of limitations on their payroll tax liabilities from three to six years.
After only about 1,000 employers used the VCS Program, the IRS modified it so that employers under IRS audit, other than an employment tax audit, now qualify. The IRS also eliminated the requirement that employers agree to extend their statute of limitations on payroll tax liability.
Many employers may still view use of the VCS Program as too risky because of uncertainties about the proper classification of certain workers in light of the highly specific nature of the determination. Employers may also have concerns about the effect that use of the VCS Program might have on non-tax misclassification exposures for workers who would be reclassified under the VCS Program.
One of the biggest challenges to getting businesses to change their worker classifications is getting the businesses to accept the notion that long-standing worker classification practices in fact might not be defensible. Although existing precedent and regulatory guidance makes clear that certain long-standing worker classification practices of many businesses would not hold up, business leaders understandably often discount the risk because these classifications historically have faced little or no challenge. Even when business leaders recognize that changing enforcement patterns merit reconsideration, they may be reluctant to reclassify the workers.
The common law employment test often relies on a subjective, highly fact-specific analysis of the circumstances of the worker. The business, rather than the IRS or other agency, generally bears the burden of proving the correctness of its classification of a worker. So, a business must ensure that its decisions can withstand scrutiny under all applicable tests and must retain evidence. Businesses also should exercise special care to avoid relying on overly optimistic assessments of the facts and circumstances.
When the factual evidence creates significant questions, an employing business generally should consider reclassifying or restructuring the position. Often, it also may be desirable to incorporate certain contractual, compensation and other safeguards into the worker relationship, both to support the nonemployee characterization and to minimize future challenges and exposures.
Importance of attorney-client privilege for risk management
Because of the broad exposures arising from misclassification, business leaders generally should work to ensure that their risk analysis and decision-making discussion is positioned for protection under attorney-client privilege and attorney work product privilege.
The interwoven nature of the tax and non-tax risks merits particular awareness by business leaders of the need to use care in deciding the outside advisers that will help in the evaluation of the risks and structuring of solutions. While appropriately structured involvement by accountants and other non-legal consultants can be a valuable tool, the blended nature of the misclassification exposures means that the evidentiary privileges that accountants often assert to help shield their tax-related discussions from discovery are likely to provide inadequate protection. For this reason, business leaders are urged to require that any audits and other activities by these non-legal consultants to evaluate or mitigate exposures be conducted whenever possible within attorney-client privilege. Accordingly, while businesses definitely should use appropriate tax advisers, they will want to first engage counsel and coordinate non-attorney advisers’ activities within the protection of attorney-client privilege