CONSTRUCTION WORKER MISCLASSIFICATION: STAY ON THE IRS' GOOD SIDE

There may be nothing sure but death and taxes, but that hasn’t stopped some people from pursuing that great American pastime: avoiding taxes.

One of the most common ways businesses use to skip out on paying taxes is to misclassify employees as independent contractors, which happens to be illegal. Worker misclassification is also known as payroll fraud.

Sometimes it’s unintentional, but that won’t keep you from getting handed a penalty, so read on to find out how to stay out of trouble.

INDEPENDENT CONTRACTORS: A DEFINITION

Most resources say an independent contractor provides goods or services to another individual or business, often under terms of contract dictating the desired work outcome, but the contractor retains control over how the goods or services are provided.

In other words, independent contractors are their own bosses, not subject to an employer’s control except as agreed by contract. Generally, an independent contractor does a specific job or project for someone called a customer or client, and the IC will have multiple clients.

THE EYE OF SAURON: THE DEPARTMENT OF LABOR

Recently, the Department of Labor has been focusing on employee classification. The Administration of the DOL’s Wage and Hour Division (WHD) acknowledges that an increasing number of employers are intentionally misclassifying employees as "1099 workers" or independent contractors (ICs) to avoid paying:

Payroll taxes

Unemployment tax

Workers compensation insurance

The DOL wants it known that companies that do this are at significant risk of owing:

Penalties, including jail time

Back taxes

Back wages

To strengthen employee classification law, Congress has been working on a couple of bills since 2010, but you know how that goes.

WHY DO COMPANIES MISCLASSIFY?

Sometimes, it’s unintentional. The definitions given by the various government agencies aren’t always clear. However, a majority of the misclassification is willful and intentional. Companies do it because it can cut labor costs by up to 40% and allow them to:

Submit lower construction bids than law-abiding competitors

Avoid paying federal or state tax employment taxes on the worker’s behalf

Avoid the obligation to provide worker’s compensation, unemployment insurance, or other full-time benefits

Avoids the need to verify workers are U.S. citizens or are covered by a work visa

The biggest reason is to avoid paying social security and Medicare.

HOW MUCH MISCLASSIFICATION OCCURS?

Accurate data is not easy to come by. Employers who do this aren’t going to report themselves, after all, and there is no government agency able to conduct comprehensive research. State audits only get performed on 2% of employers. Much of the misclassification occurs in the underground economy.

The Department of Labor commissioned a report in 2000 that reported up to 30% of audited firms had employees that were misclassified as independent contractors.

More bad news: misclassification is especially high in construction. In 2007, the Fiscal Policy Institute found that New York City had about 25% of construction employees that were misclassified as independent contractors.

An audit in Ohio showed there were 25,000 to 459,000 misclassified employees in 2012, just for one state. New York State reported 704,000.

Recovery efforts have been launched in many states. State labor laws are being placed on the books, and task forces are bringing in money from penalties and back taxes. Massachusetts recovered over $15.6 million in 2013 through efforts of this type. New York discovered over $333 million in unreported wages and assess $12 million in unemployment taxes.

THE CONSEQUENCES OF EMPLOYEE MISCLASSIFICATION

Misclassification hurts everyone.

It keeps the government from collecting enough taxes to pay for administration of many programs at all levels: federal, state, and local. It steals the rights and benefits of individual workers. And it creates an unfair advantage for responsible construction contractors (and other businesses).

The General Accounting Office (GAO) estimated that in 2006, the federal government lost $2.72 billion. Nearly 60% of that was due to misclassified individuals who failed to pay tax because they believed their employer was paying it for them.

The rest of the loss is due to the failure of employers and workers to pay social security and Medicare, as well as unemployment taxes.

Misclassification hurts workers. Being classified as an independent contractor means a worker:

Has no workplace protections, including the right to unionize

Has an increased tax burden

Receives no overtime pay

Is not eligible for unemployment insurance and disability compensation

Has no protection from the prohibition against employee discrimination based on age, race, gender, or disability.

Receives no employer benefits.

Misclassification hurts you and other construction companies like yours, too. As we said earlier, a company that doesn’t pay taxes and benefits and ignores construction labor lawshas an unfair advantage. It can bid much lower than a responsible company and perform work that is below standards, which impacts the entire industry.

WHAT SHOULD THE CONSTRUCTION INDUSTRY DO?

Construction companies should look into all of their independent contractor relationships for misclassification.

Much of it is common sense, but several agencies have put out guidelines to help.

From the Wage and Hourly Division of the Department of Labor:

The WHD recommends a multi-pronged approach that considers the employer’s influence over the workers based on behavioral and financial control. The more control the employer has over the work performed and if the worker does not make a profit, the more likely the worker is an employee.

The Internal Revenue Code does not define what an employee is but the IRS has a test it uses for worker classification based on three categories:

Behavioral: does the company control or have the right to control the worker as well as how the worker does the job?

Financial: What aspects of the worker’s job are controlled by the payer? If the worker is reimbursed for expenses and given the tools or supplies for the job, he or she is likely an employee

Type of relationship: Is the worker covered by a pension plan and insurance? Does the worker receive vacation pay? Will the relationship continue and is the employer’s work a key aspect of the worker’s activities? The worker is likely an employee.

The Department of Labor uses an “economic reality” test including this definition:

“An employee, as distinguished from a person who is engaged in a business of his or her own, is one who, as a matter of economic reality, follows the usual path of an employee and is dependent on the business which he or she serves.”

You can always submit IRS Form SS-8 Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding and let the IRS make the call. However, it can take six months or more.

More clarification may come from an unlikely source. Exotic dancers filed class action lawsuits that resulted in multi-million dollar settlements for employees who have historically been misclassified as independent contractors. It may establish a precedent for other commonly misclassified workers.

Their employers must now classify them as either employees or as shareholders.

Misclassifying an employee as an independent contractor is illegal. The Department of Labor and the states are cracking down on the practice. It would be wise to double-check your worker arrangements. 

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