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Misclassification of Independent Contractors Called Unfair, Costly

Misclassification of Independent Contractors Called Unfair, Costly

By Bill Leonard

Workers who are incorrectly classified by employers as independent contractors are costing federal, state and local government billions of dollars in tax revenue each year. At the same time, the misclassifications deprive U.S. workers of benefits such as unemployment insurance, workers’ compensation and fair wages, according to testimony during a May 8, 2007, joint hearing of the House Ways and Means subcommittees on Select Revenue Measures and Income Security and Family Support in Washington, D.C.

"Misclassification may happen because of uncertainties with definitions, but it likely happens at least as frequently because some employers are looking to cut costs,” said Rep. Jim McDermott, D-Wash., chairman of the Income Security and Family Support subcommittee. “When unscrupulous employers commit this type of fraud, it hurts more than workers. Responsible business people who play by the rules are placed at an unfair competitive disadvantage.”

McDermott said that incorrect classifications of workers is not a new problem, but he added that it appears to be becoming more common because of the competitive pressures of globalization and the rising costs of health and retirement benefits.

Sigurd R. Nilsen, director of education, workforce and income security for the U.S. Government Accountability Office (GAO), provided testimony based on a 2006 GAO report that concluded that improved outreach programs from the U.S. Department of Labor (DOL) could help improve the classification of workers. According to the GAO research, independent contractors in the U.S. workforce grew from 6.7 percent in 1995 to 7.4 percent in 2005. At the end of 2005, an estimated 10.3 million independent contractors were working in the United States.

Nilsen told the subcommittee members that the last employee misclassification estimate conducted by the IRS was in 1984. In that estimate, IRS officials concluded that employers had misclassified 3.4 million workers as independent contractors. The IRS found that because of the misclassifications the federal government lost $1.6 billion in tax revenues or $2.72 billion when adjusted for inflation.

Since 1984, the number of independent contractors in the United States has grown dramatically, which has increased the probability for worker misclassifications, Nilsen said. However, many businesses are confused by the many laws and regulations that define which workers should be classified as independent contractors.

“Notably, the tests used to determine whether a worker is an independent contractor or an employee are complex, subjective, and differ from law to law,” Nilsen said in his written testimony. “The DOL detects and addresses misclassification of employees as independent contractors by investigating complaints but does not always forward the misclassification cases to other federal and state agencies.”

Nilsen added that several “economic incentives” exist for businesses to misclassify their employees as contractors and that employers run a small risk of being penalized if caught. Nilsen told the subcommittee that GAO was not recommending any new changes and was standing by the agency’s recommendations in the 2006 report. The DOL largely agreed with those recommendations, Nilsen said, which included providing additional contact information to facilitate reporting of possible misclassification complaints and evaluating the extent to which misclassification investigations were referred to other agencies by the DOL.

While no legislation has been introduced to change the definitions or rules for classifying independent contractors, McDermott said that members of the two subcommittees will explore ways to clarify the regulations and standards.

“When workers are wrongly classified as independent contractors, they lose access to vital benefits, employers who play by the rules are unfairly disadvantaged, and state and federal programs are starved of resources,” he said. “We need a fair standard that is fairly enforced. Employers and the IRS need an easily understood set of rules in order to classify workers.”

Bill Leonard is senior writer for HR News.

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