Worker Misclassification Under Congressional Scrutiny

A Congressional research report titled "Tax Gap: Misclassification of Employees as Independent Contractors," focused on the tax gap created by misclassifying workers as independent contractors rather than employees and the problems associated with enforcing proper classifications.

Businesses must withhold tax and pay Social Security, Medicare and unemployment tax on wages paid to employees. On the other hand, they don't withhold or pay taxes on payments to independent contractors. An IRS study found that workers misclassified as independent contractors for whom employers did not report compensation on Form 1099-MISC reported only 29% of their compensation on their tax returns and, as a result, created a significant tax gap. The IRS study also found that 15% of employers misclassified 3.4 million workers as independent contractors, causing an estimated total tax loss of $2.7 billion, in inflation-adjusted 2006 dollars.

Congress is making an effort to reduce misclassification through yet to be passed legislation:

Taxpayer Responsibility, Accountability and Consistency Act - would repeal Section 530 and replace it with new rules that would make it more difficult for employers to avoid employment tax liability if they misclassified a worker as an independent contractor. The new rules would generally require employers to have a "reasonable basis" for classifying a worker as an independent contractor.

Misclassification Prevention Act - which was introduced this spring as H.R. 5107 and S. 3254, would take a different approach to reducing misclassification. It would amend the Fair Labor Standards Act of 1938 (FLSA) to require every person to (1) keep records of non-employees (contractors) who perform labor or services (except substitute work), including through an entity such as a trust, estate, partnership, association, company, or corporation, for remuneration; and (2) provide certain notice to each new employee and new non-employee, including their classification as an employee or non-employee and information concerning their legal rights.

The report concludes that improved classification would not only cut the federal tax gap but also reduce state and local tax gaps; possibly reduce the cost of publicly-provided assistance programs such as Medicaid (on the theory that independent contractors aren't provided with employee benefits and are more likely to rely on government programs); and provide reclassified workers with fringe benefits and protections under federal law.

Watch for further developments.