My business has been issuing 1099s to workers who are really employees. How should I correct this?

Once you realize that you have misclassified workers you thought were independent contractors, you should take the following actions assuming you are not under audit:
  • Immediately stop what you've been doing wrong and put the workers on the payroll.
  • Best practice: Go back to the first of the year and treat every payment to the workers as payroll. That will require filing federal and state employment tax returns some of which will be delinquent. Consequently, there will be late filing and late payment penalties and inerest.
  • Consider correcting what the misclassifications for other years. In addition to the consequences described above, you will need to issue corrected W-2s (Form W-2C) and your employees may need to file amended income tax returns.
Voluntary Classification Settlement Program (VCSP)

The VCSP provides an opportunity for taxpayers to voluntarily reclassify workers as employees for federal employment tax purposes. The VCSP allows eligible taxpayers to obtain relief similar to that available through the Classification Settlement Program (CSP) for taxpayers under examination.

The VCSP is an optional program that provides taxpayers not under an employment tax examination with an opportunity to voluntarily reclassify their workers as employees for future tax periods with limited federal employment tax liability for past nonemployee treatment. To participate in the program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP, and enter into a closing agreement with the IRS.

Eligibility Requirements

To participate in the VCSP, taxpayers must meet certain eligibility requirements and certify on Form 8952 that they meet these requirements.

Specifically, to be eligible for the VCSP, a taxpayer must:
  • Want to voluntarily reclassify certain workers as employees for federal income tax withholding, Federal Insurance Contributions Act (FICA), and Federal Unemployment Tax Act (FUTA) taxes (collectively referred to as federal employment taxes) for future tax periods;
  • Be presently treating the workers as non-employees;
  • Have filed all required Forms 1099 for each of the workers to be reclassified for the 3 preceding calendar years ending before the date Form 8952 is filed (a taxpayer will meet this requirement if it filed all required Forms 1099 for the workers being reclassified for the period of time that the workers worked for the taxpayer; for example, a taxpayer who has only been in business for 2 years meets this requirement if the taxpayer filed all required Forms 1099 for the workers being reclassified for those 2 years);
  • Have consistently treated the workers as non-employees;
  • Have no current dispute with the IRS as to whether the workers are non-employees or employees for federal employment tax purposes;
  • Not be under employment tax examination by the IRS (if the taxpayer is a member of an affiliated group, this requirement is met only if no member of the affiliated group is under employment tax examination by the IRS);
  • Not be under examination by the Department of Labor or any state agency concerning the proper classification of the class or classes of workers; and
  • Not have been examined previously by the IRS or the Department of Labor concerning the proper classification of the class or classes of workers; orb. If the taxpayer has been examined previously by the IRS or the Department of Labor concerning the proper classification of the class or classes of workers, the taxpayer must have complied with the results of the prior examination and not be currently contesting the classification in court.
Cost to Employer

A taxpayer who participates in the VCSP agrees to prospectively treat the class or classes of workers identified in the application as employees for future tax periods. In exchange, the taxpayer pays 10 percent of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year if those workers were classified as employees for such year, determined under the reduced rates of section 3509(a); is not liable for any interest and penalties on the liability; and is not subject to an employment tax audit with respect to the worker classification of the class or classes of workers for prior years.