Having to add to payroll can be a momentous step for budding small businesses, but the tax implications can be burdensome.

By hiring employees, a small business owner is subject to payroll processing fees, extra paperwork with quarterly and annual filings, payment of payroll tax deposits, as well as the added cost of matching Social Security, Medicare and funding the federal unemployment fund (FUTA) as well as the state unemployment fund.

In an effort to ease the paperwork and monetary demands, many owners hire “independent contractors” instead. However, not every outside laborer is properly classified as such. The IRS has a set of rules governing the use of independent contractors and they will occasionally audit a business and reclassify some (or all) of the workers in this category to employees. At that point, the agency might go back three years to levy penalties, interest  and additional payroll taxes. It will share this information with the state taxing agencies who will add their share of payroll tax, penalties and interest. An experience like this could run a small business out of business.

Some business owners even play ball with independent contractors that don’t want to report their income from the activity and won’t issue a 1099. What the business owner may not realize is that when this happens, he is picking up on the tab on the worker’s taxes. He normally doesn’t declare the expense, and he therefore is paying a higher amount of income as well as self-employment tax. Even if he declares the expense, it will likely be disallowed in audit because a  1099 wasn’t issued.

You can save yourself the stress of this situation by complying with the tax laws. The IRS has initiated a program to help small businesses who voluntarily come forward for reclassification.

According to the IRS, “By prospectively reclassifying workers, making a minimal payment and meeting a few other requirements, eligible businesses can achieve greater certainty for themselves, their workers and the government.” The agency also claims more than 1,500 employers have applied to participate in the IRS Voluntary Classification Settlement Program (VCSP) since it was launched in September 2011.

According to the IRS, to be eligible for VCSP, an employer must:

  • Consistently have treated the workers in the past as nonemployees;
  • Have filed all required Forms 1099 for the workers for the previous three years;
  • Not currently be under audit for employment taxes by the IRS;
  • Not currently be under audit by the Department of Labor or a state agency on the classification of these workers. If either the IRS or Labor Department previously audited the employer on the classification of the workers, the employer must have complied with the results of the audit and not currently be contesting the classification in court.

You can apply for the program by filing IRS Form 8952. If you are accepted into the program, you will be required to pay in an amount effectively equaling just over 1% of the wages paid to the reclassified workers for the past year. When you consider the cost of an employee: matching Social Security and Medicare at 7.65%, FUTA tax at 0.8%, plus whatever your state charges you in payroll taxes, this is a considerable savings.

To determine if your workers are properly classified, check out the rules here:  IRS Guidelines to Independent Contractor of Employee

Bonnie Lee is an enrolled agent admitted to practice and representing taxpayers in all 50 states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, Calif., and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Her new e-book Taxpertise for the Creative Mind Murder, Mayem, Romance, Comedy and Tax Tips for Artists of all Kinds is available at all major booksellers. Follow Bonnie Lee on Twitter and on Facebook.