Why is worker misclassification a problem?

09/04/2014 9:40 AM

11/12/2014 8:33 PM

Treating workers as independent contractors isn’t a business decision that company owners have the right to make without considering federal laws.

The Internal Revenue Service and the U.S. Department of Labor have the final word. Each agency has a list of rules and tests – sanctioned by the courts – to figure out whether someone is an employee or an independent contractor. The tests center on control, both financial and behavioral. Does the boss dictate when and how the worker gets the job done? Is the compensation enough to allow the worker to operate as if he’s self-employed with overhead of his own?

The federal government sets these limits for good reasons. Since the Industrial Revolution, America’s leaders have expected industry to clean up its own messes. If a worker gets hurt on the job, it’s the company’s duty to cover hospital bills. If the company falters and needs to lay off or furlough workers, it must tap unemployment insurance to protect the worker from further hardship. Those safety nets prevent the rest of society from footing the bill.

There’s another purpose: The company acts as a tax collector of sorts. Before employees pick up their paychecks each week, the company siphons off the pieces of it that Uncle Sam demands in taxes.

The practice works. The IRS says it collects 99 percent of what it’s owed from employees on the payrolls of companies.

Workers treated as contractors, on the other hand, often elude tax collection. The IRS estimates that those workers who file taxes for income they must declare themselves under-report their wages by 56 percent. This includes workers receiving 1099 forms. Those operating cash-intensive businesses are even less compliant, reporting as little as 19 percent of their income to the federal government.

Though the government has ways to ensure that 1099s filed with the IRS by company owners reappear in tax filings by workers, its efforts are often thin. According to a 2009 Government Accountability Office report on misclassification of workers, less than 3 percent of the companies the IRS marked as having the potential to have misclassified because of a red flag during the 1099 matching process were audited.

The IRS tries to spend its limited resources on the greatest return possible, so low-wage earners and the small employers that hire them get little attention. The construction industry is mostly small employers with workers earning less than $25,000 a year, according to the U.S. Census Bureau.

How commonly have employers missed the mark in determining whether workers are truly independent? Consider this: The IRS has a voluntary process in which workers and employers can solicit its opinion as to whether workers fit the bill for employee status. Only 3 percent of the time, according to the 2009 GAO report, did the IRS agree that the worker was an independent contractor.

Seventy-two percent of the time, the IRS determined the worker should be an employee.

For a full list of the factors the IRS and the Department of Labor use to judge whether a worker is an employee or an independent contractor, visit www.irs.gov and search for “independent contractor.”

In the meantime, consider this scenario.

At one low-income housing project in North Carolina, two-thirds of the workers hired to pour concrete, paint, shingle roofs and hang drywall were treated as independent contractors. Here’s what would have needed to happen with these 100 workers to pass the federal tests:

– Each worker could come and go as he pleased, setting his own hours and schedule.

– Each worker owned and used his own tools and supplies and had enough of a line of credit with vendors to buy the necessary materials, such as HVAC equipment and siding.

– Each worker tackled the work as he saw fit, not heeding direction and correction from superiors.

– Each worker secured enough compensation to allow him to earn a living and cover the overhead that a self-employed person must handle.

All 100 of these workers earned from $7.25 to $20 an hour.

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