Earlier this year we reported that there was a battle brewing over the employment status of financial advisors. It can be hard to know how to classify your firm’s registered reps: Are they employees or independent contractors? Make the wrong choice and it could cost your firm big.

Now the IRS is offering to allow employers who have been misclassifying employees to come clean with the IRS without facing any severe penalties. Under the Voluntary Worker Classification Settlement Program, all the firms will have to do is properly classify their employees and pay a minimal fee equal to just over 1% of last year’s wages.

After that, the IRS won’t hit you with interest or penalties and won’t challenge your worker classifications for prior years. It can be a very good deal for firms that believe they have been misclassifying reps.

But squaring up with the IRS is only one part of the equation. Firms could run into trouble with the states if they reclassify their reps under the program. The states have wildly divergent employee classification laws, some of which closely mirror the federal standard and others which differ significantly. Make the switch with the federal government and states may piggyback off the change. And don’t expect the state to take it easy on you just because the federal government did.

The states may hit you hard with back taxes, interest, and penalties for failing to withhold multiple payroll taxes—e.g., state unemployment and disability taxes—and they most often won’t abate the interest or penalties. That can add up to thousands of dollars per employee or more, depending on state law and how long your firm has been out of compliance.

You won’t be finished once you pay past tax debts stemming from the misclassification. After settling with the IRS and states, you’ll next be faced with the decision how to proceed with your new employees. Can your business model support the instantaneous reclassification?

One big issue that could force you to reconsider your business model after a mass employee recharacterization is your exposure to your employee’s acts. Your liability for acts of your employees is often far greater than your liability for acts of independent contractors.

You’ll also have a massive new compliance burden. You’ll have to begin withholding income tax from your new employees’ paychecks, pay your share of the employee’s employment taxes, purchase workers’ compensation coverage, and a take on a host of new duties.

Despite the tremendous expense and hassle of reclassifying reps and other personnel, your firm doesn’t have other good options for dealing with the issue. If you previously misclassified workers you stand a good chance of being caught by the federal government or the states. 

If you have employee classification issues, now is the time to take advantage of the program. The relatively low cost of dealing with the issue under the IRS’ Voluntary Worker Classification Settlement Program may vanish at any time since the IRS hasn’t yet issued a deadline for participation.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’sSummit Business Media partner, AdvisorFX, for a free trial.

You may also be interested in signing up for a free trial with another Summit Business Media partner, Tax Facts Online.

See also The Law Professor’s blog at AdvisorFYI.