The Internal Revenue Service and the states are arguing over a key reg – and companies could get caught in the crossfire.

The IRS offers companies so few olive branches that it seems like a waste to pass up any of those chances.

Not this time: IRS’ latest program to provide amnesty to businesses that misclassified employees as independent contractors (ICs) is one gift a company must carefully examine before accepting it – or it could cause more IC issues.

Amnesty’s not universal

The Voluntary Worker Classification Settlement Program (VCSP) sounds like a sweet deal for companies: If they’ve made employee/IC mistakes, they can properly reclassify the workers and pay as little as 1% of federal employment taxes due for the misclassified years.

Especially with IRS’ narrow line between employees and ICs, the VCSP is being touted by the feds as the deal of the century for confused businesses.

But there’s a critical factor to note with IRS’ program: It only gives your company amnesty on the federal level.

You may be able to reclassify an IC as an employee and pay only a drop in the bucket of federal taxes, but there’s no reduction in the back state taxes your company would still owe.

In fact, participating in the VCSP could actually lead to state tax audits.

States likely to pounce

If a worker receives a year-end W-2 for federal wages, but is still issued a 1099 at the state level, it’ll likely catch the attention of state DOL auditors.

The VCSP is still an option if your company has struggled with employee classification decisions, but you’ll first want to look at your state’s IC regs.

IRS considers behavior and financial control, as well as the relationship your company has with the IC, but many states use much more stringent tests to make the classification call.

Heavy-hitters like California and New York are notoriously difficult on IC decisions, so any reclassifications for workers in those states are at the highest risk of employment tax audits.

They’re not the only ones: If you have workers in AR, CT, CO, FL, IN, MI, NH or WI, you’ll also need to be well-prepared for any follow-up state DOL audits that may follow.