The IRS Classification Settlement Program (CSP) is designed to allow businesses to settle a tax debt owed due misclassifying employees as independent contractors. Along with safe harbor relief under Section 530, the CSP can be an effective tool for businesses involved in payroll tax disputes.
The Costs of Misclassifying Employees
Many businesses would like to treat their workers as employees, but the status of the employment relationship is not determined solely based on the employer’s classification of the worker. Rather, the facts and circumstances of the employment arrangement will determine whether the worker is an employee of independent contractor. In particular, courts will look at the behavior control, financial control, and relationship of the parties when classifying a worker.
Employers who have classified workers as independent contractors for years, only to the IRS classify the workers as employees, can face back taxes, penalties, and interest for multiple tax years. The vagueness of the worker classification test, along with the enormous potential penalties, made worker classification cases hotly contested, and the IRS expended considerable resources on these cases.
Section 530 Safe Harbor Relief
To make things easier on employers, Section 530 of the Revenue Act of 1978 allowed employers to treat employees as independent contractors if certain tests are met. The employer must show that:
- It never treated the individual, or other workers in substantially similar positions, as an employee for federal employment tax purposes,
- All federal tax returns were filed consistent with treating the individual as an independent contractor, and
- A reasonable basis existed for classifying the individual as an independent contractor
The reasonable basis requirement can be met if the employer relied on judicial precedents or other administrative rulings, a prior audit, industry custom, or reliance on an accountant or attorney.
If the safe harbor tests are met, and employer can the workers as “non-employees” for employment tax purposes.
The IRS Classification Settlement Program
For employers that do not meet all of the safe harbor tests, the CSP offers a chance to settle the tax debt for employment taxes owed due to worker misclassification. If an employer failed to meet either the first or third prong of the safe harbor relief test, they may be eligible for the CSP.
In this case, the tax examiner will offer the settle the back taxes, typically for an amount equal to one year’s tax assessment. This can result in a substantial reduction of tax debt if the employer misclassified workers over a period of several years.
For more information on independent contractor status, read our article here.