When the IRS determines that hiring firms have misclassified employees as ICs, the Classification Settlement Program (or CSP) gives the firms the chance to pay reduced assessments in return for agreeing to classify the workers involved as employees in the future. The program is intended to encourage hiring firms to resolve worker classification cases as quickly as possible, saving themselves and the IRS time and money.
1. When the CSP Is Used
The CSP comes into play only if the IRS determines that you don’t qualify for Safe Harbor protection and that the workers involved don’t qualify as ICs under the common law test. In this event, the examiner will determine if you qualify for a CSP offer and make one if you do.
To qualify, you must have filed the required 1099 forms for the workers involved. However, your failure to file a small number of 1099 forms will not disqualify you from the CSP.
EXAMPLE: The Acme Factory Outlet Store treated 150 workers as ICs. Acme filed all required 1099 forms for the workers except for three who were missed by the processing department. Acme’s failure to file such a small number of 1099 forms does not disqualify it from the CSP.
2. CSP Offers
There are two different types of CSP offers. Which one you receive depends on whether the examiner believes you may have satisfied the requirements for Safe Harbor protection.
a. One full year of assessments
If the examiner concludes that you clearly don’t qualify for Safe Harbor protection because you didn’t consistently treat the workers involved as ICs or you clearly lacked a reasonable basis for the IC classification, your CSP offer will require you to pay the full IRS employment tax assessment for the workers involved for the year under audit. However, no IRS penalties will be imposed. You must also agree to begin treating the workers involved as employees.
EXAMPLE: The Acme Masonry Company hired two bricklayers in 2000. The two workers performed identical duties, but Acme treated one as an IC and the other as an employee—that is, it filed a 1099 for one and a W-2 for the other. The IRS audited the company. Acme is entitled to a CSP offer because it filed a 1099 for the worker it treated as an IC. However, it is absolutely clear that Acme is not entitled to Safe Harbor protection because it did not treat the similarly situated workers consistently. As a result, the CSP offer will be for one year’s full employment tax assessments.
b. 25% of one year’s assessments
The CSP offer will require you to pay only 25% of one year’s employment tax assessments if you’ve filed the required 1099 forms and if the IRS auditor concludes you might have a good argument that you’re entitled to Safe Harbor protection. These will be cases where you have a problem establishing that you treated all your workers holding substantially similar positions as ICs, where it’s not completely clear that you had a reasonable basis for classifying them that way, or both.
EXAMPLE: The IRS audits the owner of the Larkspur Dock and questions the status of several IC workers. The owner filed all required 1099 forms for the workers and consistently treated them all as ICs. The owner claims he had a reasonable basis for treating the workers as ICs because an accountant told him they qualified as such. The IRS auditor questions the accountant. It turns out the accountant gave the advice orally and can no longer remember what facts were provided. The owner has a potential reasonable basis, but has not clearly established such a basis because the advice was not in writing and the accountant can’t remember why he gave it. Under these circumstances, the auditor proposes a CSP offer with a 25% assessment.
3. CSP Procedures
If you accept the CSP offer, the auditor will provide you with a standard closing agreement to sign. You will be required to begin treating the workers involved as employees on the first day of the calendar quarter following the date you sign the agreement. For example, if you sign the agreement on February 1, you’d have to begin employee treatment on April 1. Such treatment must extend not only to those workers who worked for you during the year under audit, but to all workers you hire subsequently to perform equivalent duties, regardless of their job titles.
You are free to reject a CSP offer if you wish. If you reject the offer initially, you can change your mind and accept it during the entire examination process.
Rejecting a CSP offer is not supposed to affect the outcome of the audit. However, the audit will be expanded to include all your open tax years instead of just one year.
To Accept or Not Accept a CSP Offer
Hiring firms that are given CSP offers by the IRS often accept them. But this doesn’t mean you should. If you conclude that you erred in classifying the workers involved as ICs, then the CSP offer may be a good deal. However, if you believe that you have a strong case for Safe Harbor protection or that the workers involved are ICs under the common law test, you may be better off rejecting the CSP offer and fighting the IRS. This may be particularly true if you provide generous pension or stock ownership benefits to your employees. An admission to the IRS that the workers involved are really employees may lead the workers to sue you for employee benefits.
Accepting a CSP offer could cost you in another way as well. Once you accept the offer, you will have to treat the workers as employees for all future years. Even if the workers don’t sue you for back benefits, you will feel the pinch in the increased employment tax, workers’ compensation premiums and unemployment insurance expenses. Indeed, these added expenses could cost you more than an appeal would have.
So, if you’ve got a leg to stand on, stand on it. Despite the cost of the appeal, you may end up saving money in the long run.