Introduction
Every year, business owners decide it is time to stop treating workers as independent contractors and begin treating them as employees. Businesses reach this conclusion for many reasons, including advice from accountants or legal counsel, due diligence in a business sale or financing transaction, concerns about state labor laws, or simply a desire to modernize payroll and human resources practices.
Unfortunately, many make one costly mistake—they implement the change immediately (rather than waiting at least 120 days before the date they want to begin treating the class or classes of workers as employees). They contact a payroll provider, begin withholding taxes, issue Forms W-2, and believe the issue has been resolved. Only later do they learn that, rather than benefitting by being proactive, they have lost the opportunity to participate in the IRS Voluntary Classification Settlement Program (VCSP), one of the IRS’s most favorable voluntary settlement programs.
This issue is particularly common in service industries that rely heavily on individual workers who provide services directly to customers. Nail salons provide a good example. Many salons have traditionally compensated nail technicians as independent contractors, often through commission arrangements or other percentage-based compensation structures. Similar questions arise in hair salons, barber shops, medical spas, massage practices, fitness centers, restaurants, cleaning companies, home health agencies, construction businesses, landscaping companies, car services, trucking companies, delivery businesses, and many other industries.
For any business considering reclassifying workers, one of the first questions should not be, “How do we set up payroll?” Instead, it should be “should we evaluate the IRS’s VCSP before making the change?”
The VCSP
The VCSP allows eligible businesses to voluntarily begin treating workers as employees while paying only a small fraction of the potential historical federal employment tax liability. [1] In return, participating businesses receive audit protection from IRS employment tax audits on the classification issue for all prior years.[2]
Generally, a business may qualify if it has consistently treated the workers as independent contractors, timely filed the required Forms 1099 for the previous three years, and is not currently under an IRS employment tax audit or a worker-classification examination by another governmental agency.
Don’t Lose the Opportunity by Acting Too Soon
Worker classification has long been an IRS enforcement priority because it directly affects the collection of payroll taxes. Whether workers are properly classified as employees or independent contractors also has implications under state labor laws, unemployment insurance systems, workers’ compensation statutes, and wage-and-hour rules. Accordingly, worker classification should be viewed as a broader business compliance issue rather than simply a payroll tax issue subject to IRS audit.
Worker classification is determined under common-law principles based on the facts and circumstances of the relationship — not simply by a written agreement or the issuance of Forms 1099.[3]
The most important planning point is timing. Before running the first payroll, issuing Forms W-2, or announcing the transition, businesses should evaluate whether the VCSP is viable. If it is, the Form 8952 (Application for Voluntary Classification Program)[4] must be filed at least 120 days before the desired effective date of reclassification.
- Businesses that reclassify workers as employees before evaluating the VCSP will not qualify for the program.
How Much Does It Cost?
Assume a business such as a nail salon paid technicians $1,500,000 during the most recent tax year. If those workers were later determined to be employees, the employment tax exposure could be substantial, especially after interest and penalties are added.
Under the VCSP, however, the payment may be only 10% of the employment tax calculated under the program’s reduced-rate formula[5]. Using a simplified example, if the applicable employment taxes were $160,200[6], the VCSP payment would be approximately $16,020, while providing valuable relief from prior-year employment tax exposure.
- For many businesses, the greatest value of the VCSP is not simply the reduced payment. It is the ability to eliminate uncertainty regarding historical federal employment tax exposure.
Planning the Transition
Businesses should also think about how the change will be communicated to workers. Although some workers may initially focus on payroll withholding, employers should explain the broader benefits of employee status, including employer-paid Social Security and Medicare taxes, workers’ compensation coverage, unemployment insurance protections, simplified tax reporting, and documented earnings.
The Transition Involves More than Payroll
Reclassifying workers as employees is only the beginning of an employer’s compliance obligations. Businesses should consider whether they have adequate payroll and human resources systems in place. Depending on the circumstances, that may involve engaging a payroll provider, expanding the role of an outside accountant, or utilizing a Professional Employer Organization (PEO).
Payroll providers and PEOs can assist with payroll administration and many compliance-related functions. However, they generally rely on the employer’s worker-classification decisions. They do not determine whether workers are properly classified, nor do they eliminate potential exposure arising from prior years.
Conclusion
Before making the first payroll change, every business should ask one question: “Should we evaluate the VCSP first?”
- For eligible businesses, the answer may significantly reduce historical employment tax exposure while allowing a smooth transition to a compliant employee workforce. The key lesson is simple: evaluate the VCSP before implementing the change—not afterward.
For questions about Worker Classification and the IRS Voluntary Classification Settlement Program, please contact H.T. Astrov or one of the other professionals at Zaino Hall & Farrin LLC.
[1] For reference, see Announcement 2012-45, I.R.B. 2012-51 (December 17, 2012), available at https://www.irs.gov/irb/2012-51_IRB#ANN-2012-45
[2] The VCSP is designed for businesses that voluntarily address worker-classification issues before an examination and should not be confused with Section 530 relief or the IRS Classification Settlement Program (CSP). Section 530 of the Revenue Act of 1978 may provide a defense if a business is examined and satisfies the statutory requirements. See Worker Reclassification- Section 530 relief as well as IRM 4.23.5 (Technical Guidelines for Employment Tax Issues). By contrast, the IRS Classification Settlement Program (CSP) (IRM 4.23.6) generally applies after an IRS examination has begun. Further, businesses should remember that the VCSP applies only to federal employment taxes. It does not resolve potential issues under state tax, labor, unemployment, or workers’ compensation laws.
[3] See IRS website for Independent Contractor (self-employed) or employee (last updated 19-May-2026). Even if a business concludes that its workers are properly classified as independent contractors, it should periodically review the relationship to ensure that day-to-day practices continue to support that classification. A properly drafted Independent Contractor Agreement is important, but it is only one part of the analysis. See IRC § 3121(d)(2) (common-law employee for FICA); Treas. Reg. § 31.3121(d)-1(c).
[4] See also Instructions for Form 8952.
[5] The cost of participating in the VCSP is generally equal to 10% of the employment tax liability for the most recent tax year that would have been due under the reduced rates provided by IRC §3509. The payment is substantially less than the potential liability that could result from an IRS employment tax examination, particularly if the IRS audits the businesses’ worker classification for more than one year.
[6] Businesses participating in the VCSP will not be liable for interest and penalties on the VCSP payment. In contrast, if the IRS determines that the workers should have been classified as employees and that the business owes in employment tax, the business would typically be subject to interest and penalties on that amount owed.