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IRS reminds taxpayers of worker misclassification, compliance

With more than 60 percent of federal revenues coming through the employment tax system, according to Janine Cook, branch chief, associate/division counsel, IRS Tax Exempt and Government Entities (TE/GE) Division, Employment Tax Branch, taxpayers were reminded of the importance of proper worker classification, withholding and reporting of employment taxes. Cook, who also discussed pending legislation in Congress to address worker misclassification, spoke during a June 29 teleconference on worker classification sponsored by the American Bar Association (ABA) Joint Committee on Employee Benefits.

Employment tax NRP

In an effort to gather information about employment tax compliance, the IRS began conducting employment tax national research project (NRP) exams in February 2010, said Cook. Under the program, the IRS will conduct 6,000 random audits of taxpayers over the next three years—2010, 2011 and 2012. The IRS willrandomly select taxpayers from the Large and Mid-Size (LMSB) Division, Small Business and Self-Employed (SB/SE) Division and the TE/GE Division. Each year, the IRS will audit 2,000 taxpayers. Agents are trained in each division to handle the audits, said Cook. The information is begin gathered “so the IRS can better tailor its employment tax audit program…to better ensure compliance.”

According to Cook, when the IRS audits worker classification issues, the Service’s first step is to determine whether the employer qualifies for relief under Act Sec. 530 of the Revenue Act of 1978 (P.L. 95-600). If they are entitled to relief under Sec. 530, the IRS stops the audit there and no further steps are taken. However, in the employment tax NRP, agents will be required to take further steps because “it is a tool to determine the level of compliance, where to audit in the future,” said Cook.

Correction issues

Cook also discussed the process for employers that want to correct past worker misclassifications in order to avoid interest payments. According to Cook, employers can correct past filings of Forms 941, Employer’s Quarterly Federal Tax Return, if they discover that they misclassified certain workers as independent contractors instead of employees and want to fix and pay the proper employment taxes on those employees. In such cases, employers must file Form 941X to correct misclassification errors and to make the adjustment interest-free. The form must be filed by the due date for the return for that period.

For example, Cook explained, if an employer discovers on June 29 that it misclassified three workers as independent contractors for the first quarter of 2010, the employer must file the Form 941-X before July 31 (when Forms 941 are due for the second quarter of 2010). This will allow them to pay the corrected amount of employment taxes without incurring interest. Employers must also give Forms W-2 to the misclassified workers, zero out their Forms 1099-MISC, Miscellaneous Income, and allow them to recoup some of the self-employment taxes they paid as independent contractors, said Cook.

Voluntary classification settlement programs

Although the IRS has taken note of a limited interest in creating a voluntary classification settlement program to settle worker classification issues arising during audits of past returns, and “the IRS is looking at” the possibility of such a program, Cook said there is “no formal program outside of an audit.” Cook did note the IRS’s Classification Settlement Program (CSP), which allows employers to prospectively change their treatment of a worker from an independent contractor to an employee in order to reduce their liability.

Proposed legislation

Legislation to address worker misclassification issues has been introduced in Congress. For example, legislation to eliminate Sec. 530 safe harbor has been introduced in Congress. According to Cook, it has the ability to be a significant revenue raiser and, “time permitting,” there is a “good chance it has some legs.” The measure, the Taxpayer Responsibility, Accountability and Consistency Bill (S.B. 2882), was introduced in late 2009 by Sen. John Kerry, D-Mass., and is designed to eliminate the safe harbor provision for worker misclassification provided by Sec. 530. Cook surmised that this provision could “get stuck onto some other legislation.”

In early 2010, legislation was also introduced to amend the Fair Labor Standards Act (FLSA) and Social Security Act for purposes of preventing and penalizing employers from misclassifying workers as independent contractors as opposed to employees.