Statement of Rebecca Smith, Staff Attorney, National Employment Law Project Testimony Before the Subcommittee on Income Security and Family Support of the House Committee on Ways and Means May 08, 2007
Chairmen McDermott
and Neal and members of the Committee: thank you for this opportunity to
testify today on the important subject of independent contractor
misclassification and its impacts on workers and their families, law abiding
employers, and our economy.
My name is Rebecca
Smith, and I coordinate the Justice for Low-wage and Immigrant Worker Project
of the National Employment Law Project (NELP), a thirty-five year old national non-profit
law and policy organization dedicated to research and advocacy on issues of
concern to low wage and jobless workers. We work to promote policies that
advance economic opportunity, increase enforcement of baseline workers’ rights,
and help jobless workers reconnect to the promise of economic progress. NELP has
partnered with community and advocacy groups to promote good models for closing
independent contractor loopholes and increase access to the unemployment
insurance system. For twenty-five years, I have represented low-wage workers on employment issues, including
issues related to the unemployment insurance systems in my home state of Washington and around the country. I worked with over half the states on state level
implementation of the SUTA Dumping Prevention Act of 2004, and I have
previously provided written testimony to this committee on SUTA dumping
implementation and on the FY 2007 US Department of Labor (USDOL) budget for
unemployment insurance.[1]
In my testimony
today, I will describe misclassification of workers as independent contractors
and relate what we know about the extent of misclassification and its impact on
the nation’s tax gap. Then I will discuss the impacts of misclassification on
unemployed workers, in the unemployment insurance (UI) system and beyond. I
will also touch on the implications of misclassification for the “tax gap” in
the UI and other tax systems. Finally, I will propose some key initiatives reducing
the incidence of misclassification and increasing the degree of fairness in the
unemployment insurance system for workers, taxpaying employers and state trust
funds.
A. Background:
Independent Contractor Misclassification
Employers across
the United States have found that tax laws and worker protections can be
avoided by entering into a “contract” relationship with their workers, even
where the worker is providing personal services that are completely integrated
into the employer’s business. Generally, employers accomplish this by giving
their employees an IRS Form 1099 instead of a Form W-2, or by paying them in
cash, off the books. Misclassification may occur at the time of hire, or an
employer may convert a worker to “independent contractor” status at a later
date in the employment relationship. Employers may require workers to sign a
contract stating that they are an independent contractor, or take out their own
business licenses or insurance coverage.
By this simple
arrangement, employers hope to avoid paying unemployment insurance, workers’
compensation, and social security taxes, and to escape the cost of withholding
income taxes, since employers are not obligated to make these payments to, or
on behalf of, independent contractors.
[2]
Misclassifying employers stand to save as much as 30% of their payroll costs
if they count workers as independent contractors. Thus, they can undercut
law-abiding employers because they don’t account for these normal payroll costs.
Workers who have
been misclassified as independent contractors lose out on workplace protections.
When they lose jobs, they face potentially insurmountable obstacles in
correcting their files and determining eligibility for unemployment insurance.
If they are injured on the job, they may be burdened with huge medical bills,
and uncompensated for lost wages. They may never receive Social Security benefits
and may be on their own for retirement savings and Medicare.
In addition, misclassification
of workers as independent contractors contricutes significantly to the nation’s
tax gap. Total losses, from unpaid federal and state income and payroll taxes
show a hefty loss of revenue due to independent contractor misclassification, in
the form of unpaid and uncollectible income taxes, payroll taxes, and
unemployment insurance and workers’ compensation premiums. The GAO estimated
that misclassification of employees as independent contractors reduces federal
income tax revenues up to $4.7 billion.[3]
Coopers & Lybrand (now PriceWaterhouse Coopers) estimated in 1994 that
proper classification of employees would increase tax receipts by $34.7 billion
over the period 1996-2004.[4]
In systems such as
unemployment compensation, nonpayment of taxes can lead to trust fund
deficits. When some employers are not paying their fair share, compliant
employers must make up the difference.
Genuine independent
contractors constitute a small proportion of the American workforce, because by
definition, an “independent contractor” is a person who is in business for him-
or herself. True independent contractors have specialized skill, invest
capital in their business, and perform a service that is not part of the
receiving firm’s overall business.[5]
Most workers in labor-intensive and low-paying jobs are not operating a
business of their own.
Misclassification
has significant negative consequences for workers, employers and state and
federal tax revenues.
B. Misclassification
of workers is pervasive.
Recent studies at
both the national and state levels give some indication of the extent of this
illegal practice. In 2000 the US Department of Labor commissioned a study of
the extent of misclassification in the unemployment insurance system. That
study found that up to 30% of firms misclassify their employees as independent
contractors.[6]
The percentage of employers who had misclassified workers ranged from a low
of 9% in New Jersey to a high of 42% in Connecticut.
The states have
been leading the way in documenting and recovering taxes unfairly denied the
state treasuries due to misclassification. Recent studies document rates of
misclassification from 10-20%, with higher rates of misclassification in the
construction industry.
The state studies
found not only high rates of misclassification, but also that misclassification
is a growing problem. For example, the Massachusetts researchers found a
misclassification rate of 8.2 % in 1995-1997, but that rate grew to 13.4% in
2001-2003.[7]
Table 1 - Recent
Studies of Misclassification, Using UI Data |
|
|
|
|
|
|
|
State |
Percent of
Employers Misclassifying Some of their Workers |
Number of Workers
Misclassified annually |
Years Studied |
Source |
Illinois |
18% |
387,000 |
2001-2003 |
Kelsay et al. (2006)[8] |
Maine |
11% |
573,000 |
1999-2002 |
(Carre and Wilson, 2006)[9] |
Massachusetts |
13% |
126,000 – 248,000 |
2001-2003 |
(Carre and McCormack, 2004)[10] |
New York |
10% |
705,000 |
2002-2005 |
(Donahue, et al., 2007)[11] |
Average |
13% |
|
|
|
Second, while
misclassification rates are especially high in construction, (where as many as
4 in 10 construction workers were found to be misclassified),[12]
this practice has expanded to nearly all major industries, including delivery
services like FedEx, which has been found to be misclassifying its employees in
New Hampshire and California, to building maintenance and janitorial services
companies like Coverall, found in Massachusetts to have misclassified
employees, to agriculture[13],
home health care,[14]
child care[15]
and other industries. The Massachusetts study provides a helpful table
documenting the scope of misclassification across industries.
Massachusetts
Prevalence of Misclassification by Industry 2001-2003.
|
Moderate estimate (All Audits[16]) |
Transportation/utilities
|
28.70% |
Information
|
28.70% |
Construction
|
23.70% |
Professional/business
services |
22.20% |
Other
services, private |
20.00% |
Education/health
services |
18.70% |
Natural
resources |
17.60% |
Financial
activities |
15.70% |
Manufacturing
|
15.30% |
Leisure/hospitality
|
13.70% |
Trade
|
13.40% |
Nonpayment of taxes
is likely underrepresented in these studies. This is because studies can not adequately
capture the so-called “underground economy,” where workers are paid off the books,
sometimes in cash. These workers are de facto misclassified independent
contractors, because the employers do not withhold and report taxes or comply
with other basic workplace rules.
Unreported cash pay
is one facet of this growing problem that is particularly difficult for the IRS
to catch, since employers have no record of pay. The problem is complicated by
company’s failure to report payments they make by means of a 1099 to other
companies. For instance, a construction employer can subcontract labor and pay
the subcontractor $600,000 in the course of a year. That number is added into
the contractor’s business expenses, but the payments to that subcontractor are
not identified in any reporting to the IRS. The subcontractor is then free to
pay workers cash and only report $100,000 of income.
C. Unemployed
workers whose employers have misclassified them lose out on vital safety net
benefits.
As the Committee
knows, a critical purpose of the unemployment insurance (UI) safety net is to
partially replace lost wages of jobless workers. This income replacement
function prevents extreme hardship, maintains essential household spending, and
supports work search and a return to work. According to a 2004 report by the
Congressional Budget Office, UI benefits during 2001 and early 2002 “played a
substantial role in maintaining the family income of recipients who experienced
a long-term spell of unemployment.” The CBO report found that job loss reduced
family income by 40 percent for those receiving UI benefits, as compared to an
average income loss of 60 percent for those not receiving unemployment
benefits.[17]
Large numbers of workers
who should be classified as employees lose out on these vital safety net
benefits when they are separated from their jobs and file for unemployment
compensation. Many may simply forego filing for unemployment compensation
benefits. These workers may wrongly assume that if their employer has told
them they are an “independent contractor,” that the state unemployment agency
will not question that determination. Still others, having signed a confusing
array of papers claiming they are independent contractors, may fear that they
will create problems for themselves if they now claim to be an “employee.”
Finally, workers may fear that applying for benefits and challenging their
employer means they will not be offered a job by that particular employer
again.[18]
C. Jobless
workers face lengthy court battles to establish UI Claims.
Some workers have
overcome these obstacles and filed their claims for unemployment insurance,
only to find themselves embroiled in lengthy legal battles, in which they must
disprove their employer’s claim that they are an independent contractor:
Rhina
Alvarenga was a janitor employed by Coverall, a national cleaning company.
After her initial hire in November 2002, Ms. Alvarenga was presented with a
$10,500 “Franchise” package by her employer. She paid for the package by
taking out a loan from the employer. She was directed to sign a contract with
the company written in English, a language that she does not fully understand.
The contract, including the hours that she would work and amount that she would
earn per week, had already been negotiated by the janitorial company and the
nursing home where she worked. The method that she used to clean was dictated
by the company, and a company employee was her supervisor. Ms. Alvarenga
applied for unemployment insurance benefits in November of 2003, after losing
her job, but the cleaning company argued that she was a “franchisee” and thus
not eligible for unemployment compensation. The Masachusetts Supreme Court
eventually found that Ms. Alvarenga was the employee of the cleaning company,
in December, 2006.[19]
In
New Hampshire, a worker lost his long-term job and applied for unemployment
compensation. He was hired to deliver packages for FedEx national package
delivery service. The service required him to receive a particular kind of
training from a particular company, purchase his own van (of a type specified
by the company) from a particular dealer and install the company’s logo on the
van. He was required to wear a certain uniform, and the company specified his
work days. He could not use his van for any purpose but to deliver packages
for the company. Nonetheless, the company argued that he was an independent
contractor and not eligible for unemployment insurance when he was separated
from his job. Although he eventually won UI benefits, he was without income
from December 2005 through July 2006 while he appealed this denial.[20]
Even where
unemployed workers have the understanding, sophistication and wherewithal to
challenge an employer’s claim that they are independent contractors, they may
go many months or years without UI benefits before their case is resolved.
Even if they prevail at a lower level of appeal, they face the risk of reversal,
and of being obligated to repay UI benefits should they lose the appeal at a
higher level. In addition, filing a claim for unemployment compensation does
not necessarily trigger an audit of the particular employer. In short,
misclassification of workers as independent contractors wreaks havoc on the
wage replacement purpose of the unemployment compensation program.
D.
Misclassification distorts the playing field for business and undermines UI
trust funds.
Employers who misclassify their workers as independent
contractors undercut law-abiding employers who pay their fair share of taxes.
In addition, they cheat average taxpayers.
The 2000 study commissioned by the U.S. Department of Labor
found nearly $200 million in lost UI tax revenue per year through the 1990s due
to misclassification of workers as independent contractors Carrying this number
forward to 2005, estimated losses would be on the order of $343 million per
year. The more recent state studies found much higher losses:
- In New York, the
researchers estimated a loss to the state UI fund of $176 million annually – a
7.4% of total taxes paid in the state.
- In Illinois, the loss
was estimated at $39.2 million, and in Massachusetts, a range of $12.6 to $35
million annually was discovered.[21]
- Total losses from unpaid federal and state income and payroll
taxes show a hefty loss of revenue due to independent contractor
misclassification, in the form of unpaid and uncollectible income taxes,
payroll taxes, and unemployment insurance and workers’ compensation premiums.
- The GAO estimated that
misclassification of employees as independent contractors reduces federal
income tax revenues up to $4.7 billion.[22]
- Coopers & Lybrand
(now PriceWaterhouse Coopers) estimated in 1994 that proper classification of
employees would increase tax receipts by $34.7 billion over the period
1996-2004.[23]
- The New York State analysis found that noncompliance with payroll tax laws means as many as twenty
per cent of workers’ compensation premiums—$500 million to $1 billion—go unpaid
each year.[24]
- The Massachusetts
construction industry found that misclassification of employees resulted in
annual losses of up to $278 million in uncollected taxes and premiums.[25]
- Total tax loss in California due to misclassification is as high as $7 billion.[26]
In order to achieve
its program goals, the UI program must, of course, be adequately financed.
Employers who misclassify make other employers foot the bill for the program.
[27]
Some amount of the loss to funds is recaptured when workers such as those
mentioned above apply for UI and an audit is triggered. More of it shifted to
other employers, whose taxes may increase because the trust fund is not
sufficiently solvent.[28]
E.
Misclassification is inefficiently addressed by current tax law and practice.
Both state and
federal authorities have responsibility for auditing employers to determine
whether they are misclassifying workers as independent contractors. At the
federal level, federal law creates a gaping loophole that allows employers both
to misclassify workers and to escape any future liability for doing so. This
loophole is compounded by a lack of serious, concentrated efforts to detect
misclassification by employers and recover unpaid taxes. At the state level,
greater attention to use of IRS 1099 data and to auditing employers could
improve collections.
1. The tax gap
and the “Safe Harbor” provision of the tax code.
In 1978, Congress
adopted a “safe harbor” provision (Section 530 of the Revenue Act of 1978),
which precludes the IRS from collecting employment taxes against employers who
“reasonably” misclassify their workers as independent contractors.[29]
In addition, the IRS is prevented from reclassifying these workers prospectively
as employees under the safe harbor statute.
When adopted by
Congress, the safe harbor provision was intended to provide “interim relief for
taxpayers who are involved in employment tax status controversies with the
Internal Revenue Service, and who potentially face large assessments, as a
result of the Service’s proposed reclassification of workers, until the
Congress has adequate time to resolve the many complex issues involved in this
area.”[30]
The provision was extended “indefinitely” in 1982, and subsequently amended
again in 1996.[31]
Significantly, since 1978, the federal law has also prohibited the IRS from
issuing any regulations or revenue rulings “clarifying the employment status of
individuals for purposes of employment taxes . . . .”[32]
Section 530 of the
Internal Revenue Code prohibits the IRS from correcting erroneous
classifications of workers as independent contractors for employment tax (but
not income tax) purposes, including prospective corrections, as long as the
employer has a reasonable basis for its treatment of the workers as independent
contractors.[33]
To qualify for the
safe harbor provision, the employer must have consistently filed 1099s with the
IRS identifying their independent contractors and treated all similar workers
the same with regard to their employment status. If these requirements are
met, then the employer will have a “reasonable basis for not treating an
individual as an employee” if the employer’s decision was in “reasonable
reliance” on any one of three factors: Judicial precedent, published rulings,
technical advice with respect to the taxpayer, or a letter ruling to the
taxpayer; a past IRS audit; or, a
“long-standing
recognized practice of a significant segment of the industry in which such
individual was engaged.” (Section(a)(2))
According to the
1996 IRS compliance manual, the “safe haven most commonly argued, and the one
which causes the most controversy between businesses and the Government, is
industry practice.”[34]
The GAO analysis also found that about 40% of the recommended unpaid taxes and
penalties they identified could not be assessed because of the Section 530
restrictions.[35]
Under current law,
there are only limited penalties, reporting requirements and complaint
procedures that regulate employers who hire independent contractors. These
include a minimum $50 penalty. While there is a procedure for individuals to
correct their records with the IRS using form SS-4, that procedure lacks any
private right of action or safeguards against retaliation by employers.
2. The
Department of Labor and State level audits of employers.
Within
the Unemployment Insurance system, the federal Department of Labor does not itself
conduct audits of employers. Instead, the Internal Revenue Service audits
employers for unreported federal taxes, including the FUTA tax, and USDOL
recommends that states audit 2% of employers each year, in order to determine
whether or not they are misclassifying workers as independent contractors.[36]
In 2004, for the eighth year in a row, states audited only 1.7% of their
employers, and focused their audits on small employers.[37] In program year
2006, audits also focused on small employers. Forty-four percent of that year’s
audits resulted in some change in the audited employer’s liability or taxes
due.[38]
States perform
random, non-random and targeted audits. Some states conduct only random
audits, which generally will show a lower rate of misclassification.[39]
Non-random audits are those that are triggered by the filing of a claim for UI
benefits. Targeted audits are those that are focused on particular indicators
of non-compliance with the law, such as delinquent filings, high degree of
employee turnover, type of industry, or prior reporting history. Not
surprisingly, the state studies mentioned above find a much higher degree of
misclassification when state conduct targeted audits, giving the states a
better return on their enforcement dollar.[40]
Nonetheless, USDOL permits
states to conduct all of its required investigations by random, rather than
targeted, audit.[41]
USDOL requires only
1% of the 2% of audited employers to be large employers of 100 or more
employees.[42]
Some states rightly
view misclassification as a serious, compelling problem, and have set aside
their scarce administrative funding to perform additional audits. For example,
New York increased both random and specific audits over the four year period
covered in study 2002-2005, but cited limited staff and resources as a reason
it could not do more.[43]
State administrators with whom we have spoken cite the continued reduction in federal administrative funding
as a reason that these efforts fall short. Cash-strapped state administrations
are increasingly skimping on their audit functions, with the result that
program integrity measures intended to recover unpaid taxes have been hampered.
One
tool that has been made available to the states by the IRS and USDOL is a
cross-match between IRS 1099 forms filed by employers and state wage reports. The
IRS has several data sets showing payments made by companies using 1099 forms,
since employers are required to file 1099 reports with the IRS for workers paid
$600 or more. IRS has made this data available to states.[44]
Two-thirds of the audits resulted in changes in the employer’s reports of
taxes. At least one state that uses the IRS process to target employers, New Jersey, has an even higher success rate, of 70%.
F. Some Key Federal
Policy Reforms
While
misclassification presents a multi-faceted problem, there are several
initiatives that could close the tax gap and protect America’s workers.
1. Close the
Section 530 “safe harbor” loophole that promote misclassification.
- Allow IRS to require
that employers correct their books prospectively.
Although there is a
strong case that could be made to repeal the entire safe harbor scheme, the
specific language that prevents the IRS from reclassifying workers
prospectively as employees is especially ripe for reform.
In its 1989
testimony to Congress, the GAO strongly supported this reform of the federal
law. Specifically, the GAO stated “In view of the equity issues and tax
revenues involved, Congress may want to consider repealing this restriction
against requiring employers to prospectively reclassify employees who have been
misclassified as independent contractors.”[45]
In response to the GAO’s recommendation, the IRS wrote “we support your
recommendation that Congress reconsider Section 530 of the Revenue Act of
1978. Although we continue to seek improvements in our compliance programs,
their effectiveness will be limited by the statutory restrictions of Section
530.”[46]
- Eliminate the
“everybody does it” defense.
Another safe harbor
rule that significantly compounds the problem of misclassification is the
provision that applies to those employers who relied on “long-standing recognized
practice of a significant segment of the industry in which such individual was
engaged.” (Section (a)(2)(C). Not surprisingly, the 1996 IRS compliance manual
states this provision has created the most controversy with employers.
- Increase penalties
for violations.
To address the more
blatant abuses associated with those employers who pay their workers off the
books, new penalties far in excess of the $50 minimum should be established
that apply to employers who fail to file 1099s as recommended by the GAO.[47]
Elimination of the minimum $50 penalty was also recommended by the Advisory
Council on Unemployment Comopensation in 1996.[48]
The funding generated by these new penalties could be designated to help fund
more targeted enforcement on this issue. As the GAO concluded, increased
penalties can help increase the number of 1099s filed by employers. And when
the 1099’s are on file with the IRS, far more income is reported by
misclassified workers.
- Increase notification
and reporting requirements.
In addition, as
recommended by GAO, businesses should be required to notify their workers in
writing of the rights and IRS responsibilities as independent contractors,
including their rights to file for a status determination and, if adopted, the
new complaint procedures proposed above.
Finally, in order
to more accurately discover off the books employment, Employers should be
required to keep records on and to report to the IRS the amount of payments
made to their independent contractors (above the existing $600 threshold),
including corporations and other businesses. For instance, a construction
contractor should be required to file an information return on payments to a
subcontractor, even if that subcontractor is incorporated. In addition to
alerting the IRS about misclassification problems and unreported cash pay, this
proposal, which is also supported by the Bush Administration, would raise
nearly $8 billion over 10 years.[49]
By enacting these
reforms, Congress would remove a clear incentive in the law that specifically
rewards industries and employers that misclassify their workers as independent
contractors.
2. Enlist
Workers’ Help in Locating Misclassifying Employers and Collecting Taxes.
Building on the
current Form SS-8 now provided by the IRS to workers wishing to correct
misclassification, a series of new procedural protections should apply to
workers who seek to have their status determined by the IRS.
- Procedural
protections for workers.
The law should
expressly authorize workers to request employee status determinations and
require an IRS decision on the request while maintaining the worker’s
confidentiality to the maximum extent possible. In addition, the law should
authorize third-parties (including unions and other worker representatives) to
initiate a status determination on behalf of an individual or a group of
workers, similar to the worker representative complaint procedures available
under the OSHA.[50]
The federal law should, as well, include an anti-retaliation provision
protecting workers who request a status determination, backed by serious
penalties imposed on employers who violate the new law.
In order to ensure
that workers are treated equally with taxpayers, workers and their
representatives should have the right to appeal a negative determination by the
IRS, just as taxpayers can appeal a decision in connection with an IRS
examination or audit. Finally, workers should have the right to a court
proceeding under standards that specifically define fraud in the context of
misclassification and provide significant damages to the worker in those cases
where the employer acted illegally.
These changes would
bring workers’ own resources to identification of employers who are
misclassifying. Workers’ participation is important, not only because the tax
system is not the only entry point to discover misclassification, but because
workers’ participation can be a valuable tool for tax authorities. First,
workers are in the best position to either answer or operate as a check on
employer information, as tax authorities apply the IRS 20-factor test, such as
questions about the degree of control that the employer exercises over workers,
who sets hours of work, whether the employer furnishes tools and materials,
whether they work for one employer at a time, or whether the employer can fire
them.[51]
Second, most of the cross-matching currently used by states relies on a paper
trail of 1099 forms and does not capture workers who are paid entirely off the
books. Enlisting these workers’ help via the SS-8 process, with the proper
assurances of protection against retaliation, could go a long way towards
shutting down the underground economy.
3. Increase
Targeted and Coordinated Federal Enforcement.
Repairing Section
530 is, however, a necessary, but not sufficient, solution to the problem of
misclassification. There is more that the federal Department of Labor can do to
assist states in identifying payroll tax cheaters and collecting taxes owed at
the state and federal level. Two good models exist for increased enforcement
activity: USDOL’s approach to claimant fraud and its approach to SUTA dumping.
In recent years,
the Administration’s budget proposals and practices have included a number of
elements to track down and recover overpayments from workers. These include increased
penalties for claimant fraud overpayments and allowing state to use 5% paid
benefits recovered for additional program integrity efforts, earmarking for
claimant fraud detection efforts, and special grants to the states to enable
them to beef up their claimant fraud efforts. USDOL publishes yearly an
estimate of the amount of UI benefits overpaid, carrying forward its sampling
and applying it to the total workforce.[52]
Both Congress and USDOL
should be commended for their approach to SUTA dumping in 2004, for bringing
resources to detection of this particular employer fraud scheme.[53]
Members of this Committee may recall GAO testimony identifying national
accounting firms that at the time were advising their clients that they should
engage in SUTA dumping, one suggesting that the employer “move your employees
on paper into another type of organization to obtain more favorable rates.”[54]
After the SUTA dumping bill was passed, USDOL worked with the states to develop
a SUTA dumping detection tool, and has commissioned a report to evaluate the
states’ success in this area.
USDOL and IRS
should prioritize misclassification in their enforcement efforts, as follows:
- Target audits in
problem industries.
USDOL should
mandate that states investigate the extent of misclassification problems within
a state, and require that all states perform targeted audits in industries most
susceptible to employer misclassification, as well as random audits. This approach
was recommended in detailed studies of the UI system as far back as 1995, but
has not yet been implemented.[55]
The state studies noted above demonstrate its effectiveness.
- Engage in enforcement across
state lines against major violators.
As GAO
identified with respect to SUTA dumping in 2003, and as the cases cited here
demonstrate, major firms engage in major misclassification across state lines.
Yet USDOL currently only requires that states audit 1% of large employers, out
of their 2% total audits. The Department of Labor should engage directly where
corporations that are found in one state to be misclassifying. across state
lines of
- n
Make special grants and pilots projects to encourage state
innovation.
As it has done
with SUTA dumping, USDOL could issue special grants and pilot projects to fund
new technology and new statistical models, in order to help states identify
employers who are misclassifying workers. The 2000 study conducted by
Planmatics and cited here suggested that USDOL investigate new technologies (e.g.
intelligent collection systems, pattern recognition) that can be used to track
“independent contractors” and their employers.[56]
The Planmatics study also recommended that USDOL develop a repository of
information on independent contractor issues, best practices, new initiatives,
and legislative measures, to be updated, publicized, and its contents made
accessible to agencies dealing with independent contractors.[57]
- Regular reporting of data.
USDOL should
develop models to update the national Planmatics study and provide a yearly
estimate of numbers of employers who are misclassifying workers, number of
workers affected, industries involved, and the effect on the tax system, in
order to support state efforts in this area. IRS should engage in a similar effort
with respect to use of the “safe harbor.”
Again, I offer
my thanks to the Committee for inviting me to testify on this issue of vital
importance to America’s workforce. Myself, as well as other staff at NELP,
invite your questions as these policy proposals develop.
[1] Implementation of the SUTA
Dumping Prevention Act of 2004 (June 2005) (with Rick McHugh); U.S. Department of Labor’s
FY 2007 Budget For Unemployment Insurance (May 2006) (with Andrew Stettner).
[2] Workers classified as independent
contractors also lack coverage under labor protective laws such as minimum
wage, overtime, discrimination, and freedom of association laws. U.S. General
Accountability Office, Employment Arrangements: Improved Outreach Could Help
Ensure Proper Worker Classification, GAO-06-656 (July 2006), at 7, 25.
Though these are significant issues, my testimony today will focus on
work-related benefits and the payroll taxes that fund them.
[3] U.S. General Accounting
Office, Tax Administration Information: Returns Can Be Used to Identify
Employers Who Misclassify Employees, GAO\GGD-89-107 (1989).
[4] Projection of the Loss in Federal Tax
Revenues Due to Misclassification of Workers, Coopers & Lybrand (1994).
[5] GAO 06-656, at 43. Examples are a plumber
called in by an office manager to fix a leaky sink in the corporate bathroom,
or a computer technician on a retainer with a shipping and receiving company to
trouble-shoot software glitches.
[6] Lalith de Silva et al., Independent
Contractors: Prevalence and Implications for Unemployment Insurance Programs
i-iv, prepared for U.S. Department of Labor, Employment and Training Division
by Planmatics, Inc. (“Planmatics”)(Feb. 2000), available at
http://wdr.doleta.gov/owsdrr/00-5/00-5.pdf.
[7] Massachusetts, 7.
[8]Michael Kelsay, James Sturgeon, Kelly
Pinkham, “The Economic Costs of Employee Misclassification in the State of Illinois,” 4-5, (Dept of Economics, University of Missouri-Kansas City: December 2006)(“Illinois”),
available at
http://www.lecetchicagoarea.org/pdfs/Illinois_Misclassification_Study.pdf
[9] Francoise Carre and Randall Wilson, “The
Social and Economic Costs of Employee Misclassification in the Maine
Construction Industry,” 2 (Construction Policy Research Center, Labor and
Worklife Program, Harvard Law School and Harvard School of Public Health: April
2006)(“Maine”), available at http://www.mccormack.umb.edu/csp/publications/Maine_misclassification.pdf.
[10] Francoise Carre, J.W. McCormack, “The
Social and Economic Cost of Employee Misclassification in Construction,” 2
(Labor and Worklife Program, Harvard Law School and Harvard School of Public
Health: December 2004)(“Massachusetts”), available at http://www.mccormack.umb.edu/csp/publications/misclassification.pdf
[11] Linda H. Donahue, James Ryan Lamare and
Fred B. Kotler, “The Cost of Worker Misclassification in New York State,” (Cornell University: 2007)(New York”), available at http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=1009&context=reports
[12] See Fiscal Policy Institute, “New York
State Workers Compensation: How Big is the Shortfall?” (January 2007); Illinois; Peter Fisher et al, “Nonstandard Jobs, Substandard Benefits”, Iowa Policy Project
(July 2005); Massachusetts; State of New Jersey, Commission of Investigation,
“Contract Labor: The Making of an Underground Economy” (September 1997).
[13] See, Secretary of Labor v. Lauritzen,
835 F.2d 1529 (7th Cir. 1988).
[14] See, Bonnette v. Cal. Health &
Welfare Agency, 704 F.2d 1465 (9th Cir. 1983).
[15] See, IL Executive Order conferring
bargaining status on child day care workers otherwise labeled independent
contractors, available at
http://www.gov.il.gov/gov/execorder.dfm?eorder=34.
[16] “All audits,” refers to a combination of
both targeted audits and random audits. Targeted audits generally result in a
higher rate of misclassification.
[17] Congressional Budget Office,
Family
Income of Unemployment Insurance Recipients (March 2004).
[18] Illinois, 10-11.
[19] Coverall North America,
Inc., v. DUA,
Supreme
Judicial Court of Massachusetts. No. SJC-09682 (December 12, 2006). The Massachusetts
Court decided Ms. Alvarenga’s case using the “ABC” test, a common test of the
employer-employee relationship used in about half of the states. To be exempted
from the requirement of contributions to the fund, an employer must establish
that an individual providing services is an independent contractor. Under
Massachusetts’ law, the employer bears the burden of proving "that the
services at issue are performed (a) free from control or direction of the
employing enterprise; (b) outside of the usual course of business, or outside
of all the places of business, of the enterprise; and (c) as part of an
independently established trade, occupation, profession, or business of the
worker." Mass. Gen. Law § 151A, 2.
[20] NH Employment Security Appeal Tribunal, Decision
of Appeal Tribunal, Docket No. 06-0463 6016-06.
[21] New York, 10; Illinois, 18; Massachusetts, 2.
[22] U.S. General Accounting
Office, Tax Administration Information: Returns Can Be Used to Identify
Employers Who Misclassify Employees, GAO\GGD-89-107 (1989).
[23] Projection of the Loss in Federal Tax
Revenues Due to Misclassification of Workers, Coopers & Lybrand (1994).
[24]
New York State Workers'
Compensation: How Big Is the Coverage Shortfall?, (New York: Fiscal Policy Institute, Jan. 2007).
[25] Massachusetts, 15-17.
[26] Jerome Horton, California State Assembly
Member, 51st Assembly District, recorded interview within “1099
Misclassification: It’s Time to Play by the Rules,” video stream available
at http://www.mosaicprint.com/client_preview/1099/index.html#.
[27] Employers pay two types of
UI payroll taxes: the federal tax under FUTA is .8% of the first $7,000 of a
worker’s earnings, or $56 per year. State taxes vary according to the health
of the state fund and the individual employer’s experience with layoffs, with
an average tax rate on total wages of .8% in 2006. U.S. Department of Labor,
Employment and Training Administration, Unemployment Insurance Data Summary,
2006.4.
[28]In Illinois, while the researchers found
that the national recession was the major contributing factor to the state’s UI
trust fund deficit, misclassification also contributed to negative outcome in
fund. Illinois, 12.
[29] The safe harbor provision
does not apply to IRS determinations related to income taxes, which are subject
to the traditional 20-factor “common law” test used by IRS to distinguish
employees from independent contractors.
[30] P.L. 95-600, Revenue Act of 1978, Senate
Report No. 95-1263, 95th Cong., 2nd Session, 92 Stat.
2763 (1978).
[31] P. L. 97-248 [Tax Equity and Fiscal
Responsibility Act of 1982], title II, Sec. 269(c)(1), (2), 96 Stat. 552 .
[32] Section 530 of the Revenue Act of 1978,
Section(b).
[33] Statement of Donald C. Lubick, Acting
Assistant Secretary (Tax Policy), Department of the Treasury, Before the
Subcommittee on Taxation and IRS Oversight Committee on Finance, U.S. Senate (June 5, 1997), 4.
[34] Department of Treasury, Internal Revenue
Services, Independent Contractor or Employee? Training Material (October
30, 1996) I-26.
[35] U.S. General Accounting Office,
Tax
Administration: Information Returns Can Be Used to Identify Employers Who
Misclassify Workers, 8 (September 1989).
[36] U.S. Department of Labor, Employment
Security Manual, Unemployment Insurance Program, ¶ 3677.
[37] 2004 UI Performs, 38, available at
http://www.workforcesecurity.doleta.gov/unemploy/pdf/ar_04.pdf.
[38] UI Performs, PY 2006, 37-39, available at
http://www.workforcesecurity.doleta.gov/unemploy/pdf/ar_05.pdf.
[39] In Illinois, for example,
98% of audits are random. Illinois, 4.
[40] Maine, 13.
[41] DOL encourages states to select some
employers in a more targeted fashion, but requires 10% of audits be random.
Employment Security Manual, ¶ 3679.
[42] Employment Security Manual, ¶ 3681.
[43] New York, 15.
[44] U.S. Department of Labor,
Office of Inspector General, Use of Form 1099 Data to Identify Misclassified
Workers, (September 2005). Despite these success rates, as of the time
that the Office of Inspector General reviewed this system in 2005, only nine
states were using the data. OIG anticipated that an additional sixteen states
would make use of the data in the following year. States reported difficulties
with their own IT processes, procedural difficulties in communicating with the
IRS and meeting its safeguards, as well as “other priorities” as reasons that
they were not using the IRS data sets.[44]
Because the IRS data sets are so large, states were required to load it on
their mainframe computers. They also faced IT challenges in converting the
tapes to documents that could be useful to auditors in the field. While OIG
was satisfied that ETA, having convened a telephone conference call and
presented this issue at its National UI Tax Conference, was meeting its obligations,
there are many other activities, in provision of IT resources, training, and
grants to states to help them prioritize use of this data, that can uncover
additional tax cheating.
The OIG projected that sixteen more states would
use the data in 2006.
[45] Tax Administration: Information Returns
Can Be Used to Identify Employers Who Misclassify Workers, 10.
[46] Id.
[47] Statement of Natwar M. Gandhi, Before the
Subcommittee on Taxation and Finance, Committee on Small Business, House of
Representatives, “Tax Administration: Issues Involving Worker Classification”
(August 2, 1995, at page 7.).
[48] Advisory Council on Unemployment
Compensation, Collected Findings and Recommendations: 1994-1996, Recommendation
1995-15
[49] U.S.
Dep’t of the Treasury, General Explanations of the Administration’s Fiscal Year
2008 Revenue Proposals 63 (Feb. 2007), available at
http://www.treas.gov/offices/tax-policy/library/bluebk07.pdf.
[50] 29 U.S.C. Section 657(f)(1).
[51] The test is reprinted in GAO,
Tax
Administration: Information Returns Can Be Used to Identify Employers Who
Misclassify Workers, GAO GGD-89-107 (1989), available at
http://archive.gao.gov/d26t7/139838.pdf
[52] See, e.g., U.S. Department
of Labor’s FY 2007 Budget For Unemployment Insurance (May 2006) (with Andrew Stettner); NELP,
The Whole Truth: Employer Fraud and Error in the UI System
(2003) .
[53] SUTA dumping entails the transfer of employees from a company’s
direct payroll into the account of a new or existing shell corporation or to a
corporation with a lower tax rate, which lists itself as the nominal “employer”
of workers, and thus lowers the initial employers’ tax rates. Work remains to
be done on the use of Professional Employee Organizations (PEOs) in SUTA
dumping.
[54] GAO, Unemployment Insurance: Survey of
State Administrators and Contacts with Companies Promoting Tax Avoidance
Policies, Testimony before the Subcommittee on Oversight and Subcommittee of
Human Resources, Committee on Ways and Means, U.S. House of Representatives,
GAO-03-819T (June 19, 2003).
[55] “From this perspective, profiles of
noncompliant firms can improve significantly the collection of UI taxes in two
ways. First, UI agencies may be able to detect and collect a large
proportion of the taxes that continue to go unreported. Second, employers
may be induced to voluntarily report the correct amount of taxable wages to
avoid the more certain detection of tax evasion that results from using the
profile." at pages 2-3. Paul L. Burgess, Arthur E. Blakemore,
Stuart A. Low, "Improving Employer Compliance with Unemployment Insurance
Tax Reporting Requirements," Advisory Council on Unemployment Compensation
Background Papers, Vol. II, July 1995.
[56] Planmatics, 94.
[57] Planmatics, 95.
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