I recently wrote about the tax gap and how the IRS is changing some important policies to minimize the difference between what businesses and consumers owe in taxes and what they actually pay. As both Federal and State budgets become more strained, the IRS and state tax authorities sharpen their pencils further to extract as much in unpaid taxes possible. The next target: misclassification of employees as independent contractors.
Why all the fuss about misclassification?
When workers are classified as employees, employers must pay certain taxes and withhold certain taxes on behalf of taxing authorities from the workers’ pay. These include:
- Federal income taxes
- State income taxes
- Social Security taxes (both employer-paid and employee withholding)
- Medicare taxes (both employer-paid and employee withholding);
- Federal unemployment taxes
- State unemployment taxes
- State disability insurance taxes
- And more...
In the case of an independent contractor, none of these are due. The hiring company simply pays the agreed upon amount to the independent contractor and they are responsible for paying their own taxes. It is generally believed that employers are more likely to withhold taxes than independent contractors are to voluntarily pay them. So by misclassifying, the government is losing the difference between what the employer should have paid in taxes and withheld from the employee and the amount the independent contractor pays when it is due.
I say “generally believed” because the last comprehensive study undertaken by the IRS to estimate the “misclassification” problem was conducted in 1984. In 2009, the Treasury Inspector General for Tax Administration (“TIGTA”) issued a report asserting that misclassification is an important and growing problem, but failed to provide an actual estimate to how widespread the problem is currently. The Joint Committee on Taxation, however, estimates that between 2010 and 2020 addressing the misclassification problem will generate an additional $6.9 billion in tax revenues.
Why does misclassification happen?
Misclassification can occur for a variety of reasons. Many times it is ignorance of how to properly classify. In some cases, employers may seek to avoid many of the costs and regulations associated with having employees which are not required with independent contractors. Other times the employee and employer work together and split the difference on the savings from intentional misclassification. On the whole though, the employer benefits more than the employee, because the lost benefits of being classified as an employee are seldom made whole with any additional increase in pay.
Enforcement against misclassification
In order to address the problem of misclassification, the FY2011 Federal budget includes $25 million for the hiring of 100 new “enforcement personnel” focused on misclassification. Part of the money will be used for grants to state governments to address the issue. Earlier this year, the IRS began to conduct random audits of 6,000 businesses over the next three years to determine if they comply with five employment tax-related areas including misclassification. The businesses will be chosen at random.
New laws with stiff penalties in the works
In the Senate, the Employee Misclassification Prevention Act was introduced this year by Senator Sherrod Brown from Ohio and it currently has 8 cosponsors. The law amends the Fair Labor Standards Act (“FLSA”) by requiring every company to keep records of non-employees who perform labor or services and inform all new employees and non-employees of their classification and rights. The proposed law would also make it unlawful to “fail to classify accurately an employee or non-employee”. It also includes several punitive provisions, including fines of $1,100 for each violation going up to $5,000 per violation for repeat offenders.
The law also uses the “stick approach” to coerce state governments to assist in dealing with misclassification by amending their respective state’s unemployment compensation law. The laws must establish auditing programs for companies that act in such a way as to undercount the employees that should be covered under state unemployment compensation coverage and establish penalties for companies that misclassify. States that do not amend their laws will not be eligible for federal grants for state unemployment compensation funds. With the current condition of state budgets, it is truly an offer they can’t refuse.
In the House of Representatives a proposed law by the same name was introduced by Representative Lynn Woolsey of California’s 6th district. The bill has 16 cosponsors and is identical to the Senate version.
There are several other bills that address misclassification so it is likely that at least one will become law in the near future. If your business may be misclassifying it would be prudent to address the issue sooner rather than later.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.