Uh-oh! The IRS audited your business and concluded that you misclassified some workers as independent contractors. The IRS says they are employees.
You are worried—rightfully worried.
If you got this wrong, the IRS will assess years of back employment taxes, plus penalties and interest. The dollar amounts can be huge.
This is the second in a three-part series on various remedies available to small-business owners who misclassified their workers as independent contractors rather than employees. In the upcoming June issue, we will discuss the IRS Voluntary Classification Program, another relief program—but available only before your mistake gets discovered in an audit.
In the first article in this series, Owe Taxes for Misclassified Workers? Section 530 to the Rescue!, we discussed the Section 530 safe harbor that can apply in some cases where workers have been misclassified. But let’s say you don’t meet all the requirements for Section 530 relief.
Okay, no Section 530 relief? Here’s a second shot: the IRS’s Classification Settlement Program (CSP). It can provide relief for your employment tax woes.
But first a . . .
Quick Review of Section 530
- 1. To qualify for Section 530 safe harbor relief, you must meet the following three requirements:1 Reporting consistency. You must have timely filed all required federal tax returns (i.e., 1099s) consistent with your treatment of the workers you classified as independent contractors.
- Substantive consistency. You must have treated the independent contractors in question and all similar workers as non-employees.
- Reasonable basis. You must show that you had a reasonable basis for treating your workers as independent contractors.
If your business is audited and you don’t qualify for Section 530 safe harbor relief, the CSP offers a chance to settle your employment tax liability due to worker misclassification, at a considerable discount.2
The CSP
The CSP allows you and the IRS tax examiners to resolve worker classification cases early in the audit process, reducing burdens on you. The procedures also ensure that if you qualify for Section 530 relief, the Section 530 relief procedures will be properly applied.
But there’s a catch. In order to qualify for the CSP, you must satisfy the reporting consistency requirement of the three-part test for Section 530 safe harbor relief, as we laid out above. The big deal here: you must have filed all required 1099s for the independent contractors disputed by the IRS.
Generally, you will qualify for the CSP if you have timely filed all required 1099s for the workers that you have misclassified as independent contractors. If you failed to file the required 1099s, you will not qualify for the CSP.
The IRS examiner is normally required to present a CSP offer to you if you qualify for the program.
You then have the option of either accepting or rejecting the examiner’s offer.3 The CSP pertains only to worker classification issues, and not to any other wage issues.4 And if you are no longer in business, you don’t qualify for the CSP.5
It is important to remember that CSP agreements are closing agreements6 that bind the IRS and you to prospective tax treatment for future tax periods. In other words, if you enter into a CSP agreement for a certain group of workers in any given tax year, you must treat those workers as employees in all future tax returns.
The CSP is an offer from the IRS allowing you to settle your employment tax assessment, typically for an amount less than or equal to a single year’s tax assessment. Thus, the CSP can save you a bundle of money on your failed worker classifications.
Depending on the extent to which you have complied with IRS reporting requirements, and the strength of your arguments for why your workers are really independent contractors rather than employees, CSP agreements will vary in the percentage of employment tax adjustments offered.7
25 Percent CSP Offer
If you meet the reporting consistency requirement (in other words, you timely filed all of your 1099s for the workers in question), you satisfy either the substantive consistency requirement or the reasonable basis requirement, and you have at least a colorable argument that you satisfy the other requirement, then the CSP offer will be an adjustment of 25 percent of the employment tax owed for the most recent tax year under examination.
A “colorable argument” means that your argument for why you meet the requirement has some merit but is not sufficient to fully satisfy the test.
Key point. The CSP savings here are huge (25 percent of one year, or about 8 percent of what could be). Without the CSP, you likely would face back payroll taxes, penalties, and interest on three years.
100 Percent CSP Offer
If you meet the reporting consistency requirement but clearly do not meet the substantive consistency requirement or clearly do not meet the reasonable basis test, the offer will be a full employment tax adjustment for the most recent tax year under examination.8 In other words, you will be required to pay 100 percent of the employment tax due for the year under examination.
Again, this is a huge savings: one year of payroll taxes versus three years of payroll taxes, penalties, and interest.
With both the 25 percent and 100 percent deals, you must agree to classify the workers in question as employees on a going-forward basis, thus ensuring future compliance in the eyes of the IRS.
The following chart summarizes the relief available under various scenarios:9
Finally, if several classes of workers are at issue, you may qualify for more than one CSP offer. For example, you might receive a 25 percent CSP offer for one class of workers and a 100 percent CSP offer for another class. And for yet a third class of workers, you might satisfy all the requirements for the Section 530 safe harbor.
Takeaways
Here are some key insights from this article.
The IRS Classification Settlement Program offers a chance to settle your employment tax debt due to worker misclassification if you do not qualify for Section 530 relief.
- Because the IRS requires reporting consistency in order for you to qualify for the CSP, you absolutely need to timely file your 1099s every year for your independent contractor workers.
- In most cases, the IRS examiner is required to present a CSP offer to you in the course of the audit if you qualify for the CSP.
- You have the option of either accepting or rejecting a CSP offer.
- CSP agreements are closing agreements that are binding for future tax periods.
- CSP agreements typically result in a substantial reduction of assessed employment taxes, especially if you misclassified workers over several years.
- Your worker classifications for federal tax purposes do not have to match your classifications for state law purposes.
- You may qualify for more than one CSP offer if several classes of workers are at issue.
Next month we’ll discuss how you can save even more money by being proactive with the IRS Voluntary Classification Settlement Program.
Client Letter on This Article for Use by Tax Pros. Click Here.