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Feds and States Turn Up the Heat On Employee Misclassification

Like other enterprises with labor needs that shift from job to job and season to season, construction companies have long relied on subcontractors to get jobs done in a timely fashion without crippling overhead costs. But that long-established way of doing business is looking increasingly uncertain as the federal government and the states — driven partly by pressure from organized labor and partly by a desire to increase tax revenues — have put ever-increasing pressure on employers to justify their classification of independent contractors as nonemployees.

The most recent evidence of the trend is a pair of similar bills introduced in the House and Senate in April of this year. The Employee Misclassification Prevention Act would impose civil penalties of up to $5,000 per employee on employers who improperly classify workers as independent contractors. Among other provisions, it would also require the states to conduct audits to identify employers who are misclassifying employees; direct the Department of Labor to undertake targeted audits of employers in certain industries; revise the Fair Labor Standards Act to require employers to notify workers of their status as employees or independent contractors; and allow the Labor Department and the IRS to share information on cases of worker misclassification.

Uncollected taxes. From the taxman’s point of view, the fewer independent contractors out there, the better. Because such workers are responsible for keeping track of their own earnings and figuring out any income tax owed — as opposed to a conventional employer-employee relationship, in which that burden falls to the employer — there are more players for the government to keep track of. There’s also more opportunity for independent contractors to evade taxes that they legitimately owe.

According to Labor Department numbers, up to 30 percent of all businesses routinely misclassify employees as independent contractors. And the nonpartisan Government Accountability Office estimates that underpayment of Social Security taxes, unemployment insurance, and income taxes cost the government $2.72 billion in 2006 alone.

Who’s a contractor and who’s not? Deciding whether a worker is a legitimate independent contractor or a misclassified employee can be a tricky call. Government agencies typically try to determine an individual’s employment status by applying some sort of test. The two best-known are the so-called ABC Test used by many state unemployment agencies and the more elaborate 20 Factor Test used by the IRS.

The ABC test considers three criteria, all of which must be met for an individual to be recognized as an independent contractor. First, he or she must be free from control or direction by the entity for which the work is performed. Second, the service performed must be outside the usual course of business of that entity — or it must take place outside the entity’s usual places of business. Finally, the individual must be customarily engaged in an independently established trade, occupation, profession, or business.

The IRS 20 Factor Test is more open-ended. The agency considers a list of 20 criteria — such as whether the worker receives training from the company for which the work is performed, has set hours of work, or furnishes his or her own tools and materials — in light of whether they are more likely to make the worker an independent contractor or an employee. (A worker who must work set hours, for example, would be more likely to be an employee, while a worker who is able to designate his or her own hours of work would be more likely to be an independent contractor.) By its nature, the test is highly subjective. No single element is decisive in itself; the IRS makes its decision about a worker’s status based on the proportion of “more likely” to “less likely” responses. While 20 of one or the other response might provide a clear answer, a fairly even split renders any individual worker’s classification arguable, to say the least.

“Safe harbor” at risk. Employers in industries that make frequent use of contract workers have long enjoyed the benefit of the doubt in cases where a worker’s status is less than clear-cut. Section 530 of the Revenue Act of 1978 created a “safe harbor” for businesses that classify workers as independent workers for employment tax purposes. In general, the safe-harbor provision applies if the business has a “reasonable basis” for treating a category of workers as independent contractors, files federal tax returns consistent with that classification, and treats all employees holding similar positions in the same way. Where the safe-harbor provision applies, the IRS is prohibited from using the 20-Factor Test to reclassify workers.

A second pair of worker-classification bills before Congress, however, would do away with that protection. Under the Taxpayer Responsibility, Accountability, and Consistency Act of 2009, the safe-harbor provision would be repealed. And this bill, like the Employee Misclassification Prevention Act, would subject employers who misclassify workers to stiff penalties.

According to NAHB economist Rob Dietz, the Taxpayer Responsibility Act “would require a company to make its case to the IRS before it could classify someone as an independent contractor. Depending on administrative costs and how quickly the IRS is able to make that determination, that could just shut down some businesses, particularly smaller ones.”

The states push ahead. Regardless of what happens at the federal level — neither pair of bills seems guaranteed to pass — several states are moving ahead with their own initiatives. Among them are the following:

A bill filed in the Oklahoma legislature earlier this year would allow that state’s tax commissioner, worker’s comp board, and employment security commission to share information and coordinate investigative and enforcement efforts against businesses that misclassify workers.

In New Hampshire, the interagency Task Force for Misclassification of New Hampshire Workers has created a tip-off website where visitors can report businesses suspected of improperly classifying employees as independent contractors.

Iowa has followed up on the report of a state task force on independent-contractor misclassification by hiring nine full-time employees and budgeting $771,000 to crack down on businesses that classify workers incorrectly.

Massachusetts Governor Deval Patrick has issued an executive order creating a task force to identify illegal misclassification of workers. Its stated goal is to “foster compliance with the law by educating business owners and employees about applicable requirements; conduct joint, targeted investigations and enforcement actions against violators; protect the health, safety and benefit rights of workers, and restore competitive equality for law-abiding businesses.”

In 2007, New Jersey enacted the Construction Industry Independent Contractor Act, which imposes a civil fine of $5,000 for each worker found to have been misclassified as an independent contractor.

Also in 2007, Illinois enacted the “Employee Classification Act,” which imposes fines of $1,500 per day for each misclassified worker.

Cash cow. Contractors in states that have not yet taken any action on the issue shouldn’t let the still-uncertain status of the federal bills lull them into thinking they can afford to be casual about worker classification. The 2011 federal budget, released early this year, suggests that the Obama administration sees worker misclassification as both a regulatory priority and a potential cash cow. It allocates $25 million to the Department of Labor and the Treasury to “eliminate incentives in law for employers to misclassify their employees; enhances the ability of both agencies to penalize employers who misclassify; and restores protections to employees who have been denied them because of their improper classification.”

An unspecified portion of that $25 million will be used to hire an additional 100 enforcement personnel at the federal level and to make grants to individual states. And if all goes according to plan, taxpayers stand to make a tidy return on that investment: The measure is expected to increase treasury receipts by more than $7 billion over a 10-year span.