Misclassifying workers as independent contractors instead of employees can lead to significant IRS penalties, back taxes, and legal consequences. To help businesses correct worker classification issues while minimizing financial liabilities, the IRS offers the Voluntary Classification Settlement Program (VCSP).
This article explores how the VCSP works, its benefits, eligibility requirements, and the steps businesses need to take to participate.
1. What Is the Voluntary Classification Settlement Program (VCSP)?
The VCSP is an IRS program that allows businesses to voluntarily reclassify independent contractors as employees for future tax periods. In exchange, the IRS significantly reduces back taxes, penalties, and interest that the business would otherwise owe.
This program is designed to encourage compliance while providing relief to businesses that may have misclassified workers unintentionally.
2. Why Worker Classification Matters
Correctly classifying workers is crucial because it affects:
Tax withholding (employers must withhold payroll taxes for employees but not for independent contractors).
Benefits eligibility (employees may qualify for health insurance, retirement plans, and unemployment benefits, while independent contractors do not).
Legal liability (misclassification can result in audits, lawsuits, and penalties).
Misclassification is a common issue in industries like construction, gig economy services, healthcare, and IT contracting.
3. Benefits of Participating in the VCSP
By applying for the VCSP, businesses receive significant relief from potential tax liabilities:
✅ Reduced Payroll Tax Liability – Pay only 10% of the employment tax liability that would have been owed for the previous tax year.
✅ No Interest or Penalties – The IRS waives interest and penalties on the underpaid payroll taxes.
✅ No IRS Audit or Investigation – Businesses under VCSP are not subject to worker classification audits for prior years.
📌 Example: If a business misclassified a worker for three years and owed $30,000 in payroll taxes, under the VCSP, they may only owe $3,000 with no penalties or interest.
4. Who Is Eligible for the VCSP?
Businesses can apply for the VCSP if they meet the following criteria:
Consistently misclassified workers as independent contractors (and issued Form 1099-NEC instead of W-2s).
Not currently under audit by the IRS, the Department of Labor (DOL), or a state agency for worker classification.
Filed Form 1099-NEC for the misclassified workers for at least one of the last three years.
🚫 Who is NOT eligible?
Businesses currently under an IRS audit for employment tax issues.
Those under DOL or state agency investigations regarding worker classification.
5. How to Apply for the VCSP
To participate in the VCSP, businesses must:
Step 1: Complete IRS Form 8952
The application form is Form 8952 (Application for Voluntary Classification Settlement Program).
Submit at least 60 days before the business wants to reclassify workers.
Step 2: Wait for IRS Approval
The IRS reviews the application and may request additional information.
Once approved, the business enters into a closing agreement with the IRS.
Step 3: Pay the Reduced Tax Liability
The employer must pay 10% of the past-due employment taxes for the most recent tax year.
Step 4: Begin Treating Workers as Employees
Moving forward, the business must classify and treat affected workers as employees, issuing W-2s instead of 1099s and withholding payroll taxes.
📌 Important Note: If a business fails to comply after entering the VCSP, the IRS may take enforcement actions in the future.
6. Potential Risks and Considerations
While the VCSP offers significant relief, businesses should be aware of potential challenges:
⚠️ Future Payroll Costs – Employers must begin withholding payroll taxes and providing employee benefits, increasing labor costs.
⚠️ State Tax and Labor Law Issues – The VCSP does not protect businesses from state tax agencies or labor departments, which may still investigate worker misclassification.
⚠️ Impact on Independent Contractors – Reclassified workers may need to adjust their tax filings and may lose certain self-employment tax deductions.
7. Alternative Compliance Options
If a business is not eligible for the VCSP or prefers a different approach, they can:
Proactively correct worker classification moving forward without entering the VCSP.
Consult a tax professional or employment attorney to assess risks and compliance strategies.
Negotiate a settlement with the IRS if an audit occurs.
Final Thoughts
The Voluntary Classification Settlement Program (VCSP) provides a valuable opportunity for businesses to correct worker classification issues while minimizing penalties. However, it requires a long-term commitment to proper payroll tax compliance.
Before applying, businesses should carefully assess their financial situation and consult with a tax professional to determine the best course of action.