A client that has paid people on Forms 1099 who look like employees has two federal routes to limit the damage. Section 530 of the Revenue Act of 1978 can erase the employment tax liability for the past and the future if three statutory tests are met. The Voluntary Classification Settlement Program (VCSP) lets a business that cannot meet those tests move workers to employee status going forward for a payment equal to 10 percent of a reduced-rate liability for one year. Choosing between them is mostly a question of what the client's historical records can prove. This article covers both, with a worked comparison. For the common-law test itself, see worker classification for small business clients.
What is section 530 relief?
Section 530 is not part of the Internal Revenue Code, though some publishers print its text after section 3401. The IRS says relief can cover the audited periods and future periods as long as the requirements continue to be met, and that a material change in facts can end it. The business does not have to claim the relief. Examiners must consider it on every worker reclassification audit, and Publication 1976 must be given to the taxpayer whenever it is considered.
Relief protects the employer's liability only. It does not decide that the worker is an independent contractor. A worker can still be found to be an employee, for example through a Form SS-8 determination.
What are the three section 530 tests?
- Reporting consistency. The business timely filed the required information returns, such as Forms 1099, consistent with treating the worker as a nonemployee.
- Substantive consistency. The business, or a predecessor, did not treat the worker, or a substantially similar worker, as an employee after December 31, 1977. The IRS compares the day-to-day duties, and similar job titles alone are not enough.
- Reasonable basis. The business reasonably relied on a safe harbor when it made the decision: a prior IRS audit, judicial precedent or published IRS rulings, or long-standing recognized industry practice. Other reasonable bases are accepted, such as advice from an attorney or accountant, and the IRS says the requirement is construed liberally in the taxpayer's favor. Reliance cannot be justified after the fact.
Two limits matter. The IRS says section 530 does not apply to third-party arrangements for engineers, designers, drafters, computer programmers, systems analysts or other similarly skilled workers. And if the client later reports the same workers on Forms W-2, it loses the relief.
On burden of proof, the business must make a prima facie case that not treating the worker as an employee was reasonable and must cooperate fully with the examiner's reasonable requests. If it does, the burden shifts to the IRS on reporting consistency, substantive consistency and the safe harbors.
What is the VCSP and who qualifies?
The VCSP is for taxpayers currently treating workers, or a class of workers, as independent contractors or other nonemployees who want to treat them as employees going forward. The IRS lists these conditions:
- The taxpayer filed all required Forms 1099 for the workers to be reclassified for the previous three years. The VCSP FAQ states that taxpayers who have not filed required 1099s are not eligible, and that those who filed more than six months after the due date, including extensions, are also ineligible. Filing within six months of the due date is treated as eligible.
- The taxpayer is not currently under an IRS employment tax audit, or under audit by the Department of Labor or a state agency concerning the classification of the workers.
- A taxpayer previously audited on classification is eligible only if it complied with the audit results. A taxpayer contesting classification in court is not eligible.
- An affiliated group member is not eligible if any member of the group is under employment tax audit.
The application on Form 8952 should be filed at least 120 days before the date the taxpayer wants to begin treating the workers as employees. Accepted taxpayers enter a closing agreement and pay the amount due at the same time. In return, the taxpayer is not liable for interest and penalties on the amount, and is not subject to an employment tax audit for the reclassified workers in prior years.
How is the VCSP payment computed?
The payment is 10 percent of the employment tax calculated under the reduced rates of section 3509(a), based on compensation paid in the most recently closed tax year when the application is filed. The IRS FAQ gives these effective rates:
| Component | Up to the wage base | Above the wage base |
|---|---|---|
| Federal income tax withholding | 1.5% | 1.5% |
| Employee Social Security | 1.24% | 0% |
| Employer Social Security | 6.2% | 0% |
| Employee Medicare | 0.29% | 0.29% |
| Employer Medicare | 1.45% | 1.45% |
| Total | 10.68% | 3.24% |
What does the choice look like in numbers?
A client paid six contractors a total of $600,000 in the most recent closed year, each under the Social Security wage base. It filed 1099s on time every year, has no audit, and cannot show a reasonable basis because it never took advice.
- VCSP payment. $600,000 x 10.68% = $64,080 of section 3509(a) tax. The payment is 10% of that: $6,408.
- Exposure if the IRS examines the same year. Because the client filed its 1099s, the section 3509(a) rates apply, and the liability is $64,080 for that single year. Had the client failed to file the 1099s (or W-2s) without reasonable cause, section 3509(b) would raise the withholding rate to 3 percent and the employee Social Security rate to 40 percent of the statutory amount instead of 20 percent. Using the same components, that is 3% + 2.48% + 0.58% + 7.65% = 13.71%, or $82,260 for the year. Section 3509 does not apply if the failure is due to the employer's intentional disregard of the withholding requirement.
The exposure repeats for every open year, while the VCSP payment is based on one year. That asymmetry is why a client with clean 1099 filings and no safe harbor usually looks at the VCSP before an audit starts.
How should the firm decide?
- Test section 530 first. If the client can show all three tests, relief covers past and future periods and the client can keep reporting on Forms 1099.
- Check VCSP eligibility if section 530 fails. The 1099 filing history for three years and the absence of any audit decide it.
- Calendar the 120 days. The application date drives the start of employee treatment.
- Document the reasonable basis contemporaneously. Advice letters, prior audit closing letters and industry practice evidence need dates that predate the classification decision.
- Update payroll before the effective date. New hires on W-4s, withholding tables and deposit schedules, as covered in payroll tax deposits.
For clients already behind on 1099 filing, the 1099 deadlines and penalties post covers the cleanup that decides VCSP eligibility. A related exposure for unpaid withholding is explained in the trust fund recovery penalty.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- IRS, Worker reclassification, Section 530 relief: https://www.irs.gov/government-entities/worker-reclassification-section-530-relief
- IRS, Voluntary Classification Settlement Program: https://www.irs.gov/businesses/small-businesses-self-employed/voluntary-classification-settlement-program
- IRS, Voluntary Classification Settlement Program frequently asked questions: https://www.irs.gov/businesses/small-businesses-self-employed/voluntary-classification-settlement-program-vcsp-frequently-asked-questions
- Cornell Law School Legal Information Institute, 26 U.S.C. 3509: https://www.law.cornell.edu/uscode/text/26/3509
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