In one of my posts last month, I raised the specter of misclassified independent contractors.  If you’d like a refresher about the risks to companies posed by misclassification, take a look here: http://goo.gl/Ptz06.  Trust me – it can get ugly.

Among the perils created by misclassification are the potential back taxes, interest, and penalties imposed upon an employer who has treated employees as contractors.  Especially in these times of declining government revenues, federal and state tax collectors are looking for any and every way to recoup funds to which they believe they are entitled.   And the employment taxes not collected and income taxes not withheld from independent contractors’ paychecks may seem like low-hanging fruit for these agencies’ taking.

But for the Internal Revenue Service, going after the revenues from misclassified contractors has a cost attached to it, and even if the case is won, collecting back taxes, interest, and penalties from already cash-strapped employers is an uncertain proposition.  You can’t get blood from a turnip, and trying to squeeze out another drop from a faltering company may result in another shuddered shop, even more folks out of work, and less overall revenue for the government.

To this end, the IRS recently announced the Voluntary Classification Settlement Program (“VCSP”).  Through the VCSP, companies can, as the Program’s name implies, reclassify heretofore “independent contractors” as employees for employment tax purposes with partial relief from past federal employment taxes.

To be eligible for this safe-harbor, the company must have consistently treated the workers to be reclassified as nonemployees and must have filed all required Forms 1099 for the workers for at least the previous three years.  The company cannot be under an audit by the IRS and cannot be under investigation by the Department of Labor or any state agency with respect to worker classification.

In exchange for the company’s agreement to prospectively treat the subject workers as employees for future tax periods, the company will (i) pay 10 percent of the employment tax liability that may have been due on compensation paid to the worker for the most recent tax year; (ii) not be liable for any interest or penalties on the amount paid; and (iii) not be subject to an employment tax audit with respect to the classification of workers being reclassified under the VCSP.  The company will have to agree to extend the limitations period to three years for the assessment of employment taxes for the first three calendar years after the reclassification.

Under the VCSP, therefore, the Feds get their employment taxes and quarterly withholding payments going forward, and employers dodge at least one potential misclassification hazard.

But is this a great idea?  Perhaps not.

An organization looking to take advantage of the IRS’s seeming largess should do so cautiously.  The VCSP helps with the narrow federal tax issues associated with misclassification, but it does not address, much less alleviate, the host of other problems created by redesignating contractors as employees.

For instance, VCSP participation does not resolve potential liability arising from worker misclassification under federal and state minimum wage and overtime laws, state unemployment compensation and workers’ compensation statutes, or laws pertaining to employee benefits under ERISA.  The wage and hour and ERISA issues could be particularly troublesome for employers, since reclassified workers could seek to recover back wages or benefits through private action even after the company seeks refuge in the VCSP.  An enterprising plaintiffs’ attorney would undoubtedly use the company’s participation in the VCSP as a concession of wrongdoing.

Although likely well intentioned on the part of the IRS (ahem…), the VCSP may create more problems than it’s worth.  Employers are advised to look carefully at the risks of enrolling in the VCSP and consult with tax, benefits, and employment counsel before diving in.