Proper classification of workers as employees or independent contractors is a decade’s old problem. "Section 530" of the Revenue Act of 1978 which was intended to provide temporary relief while Congress studied solutions, is still with us. The work world of 1978 is not the same as that of today. Today, new work arrangements and job descriptions raise new challenges in worker classification. For example, today, a telecommuting, "knowledge" worker is able to work with little supervision and easily able to perform work for multiple employers from their home.
President Obama has brought attention to workplace flexibility. In March 2010, the White House sponsored the Forum for Workplace Flexibility. A report for the forum by the Council of Economic Advisers, Work-Life Balance and the Economics of Workplace Flexibility (PDF), concluded:
"encouraging more firms to consider adopting flexible practices can potentially boost productivity, improve moral, and benefit the U.S. economy. Especially at this time as the U.S. rebuilds after the Great Recession, it is critical for the 21st century U.S. workplace to be organized for the 21st century workforce."
While the work-life balance report did not address tax considerations of the changed workforce and how desired workplace flexibility might challenge existing worker classification rules, other White House initiatives have included worker classification. This article discusses and critiques these worker classification proposals.
In 2009, President Obama established the White House Task Force on the Middle Class, chaired by Vice President Biden (White House press release, January 30, 2009; task force website). The task force's annual report (February 2010 (PDF)) includes an explanation of actions to be taken to protect workers and create middle class jobs. Such actions include a Department of Labor (DOL) initiative to prevent misclassification and a legislative proposal from Treasury (pages v – vi, 21 – 22).
The report explains that proper worker classification prevents workers from deprivation of benefits and legal protections (such as workers' compensation, unemployment insurance and safe workplace) and better ensures proper tax compliance. In addition, "misclassification gives unfair advantages in the marketplace to employers who misclassify their workers" (page 22).
Department of Labor
On June 17, 2010, the Senate Committee on Health, Education, Labor and Pensions (HELP) held a hearing entitled "Leveling the Playing Field: Protecting Workers and Businesses Affected by Misclassification." In testimony at the hearing, DOL Deputy Secretary Seth D. Harris explained the need to improve worker classification to protect workers and compliant employers and to encourage proper classification. He noted that under some laws administered by the DOL, such as the Fair Labor Standards Act (FLSA), there is no penalty imposed on employers who misclassify workers.
In describing the Administration's efforts to improve worker classification, Harris stated:
"The rules governing employers’ decisions about whether to respect employees’ rights under our nation’s employment laws must change, and they must change now. We must restore a level playing field for responsible employers and employees and ensure that workers benefit from the protections Congress intended them to have."
Harris noted that the Administration's 2011 budget called for $25 million to fund a DOL initiative to improve enforcement of worker classification laws. Activities include providing better guidance to service recipients and workers, and information sharing among federal and state government agencies to improve enforcement of labor laws. One new compliance strategy is “Plan/Prevent/Protect.” Under consideration as part of this strategy is to require employers to "perform a written analysis of the worker’s status applying the “economic realities” test" (applicable under the FLSA) and making that analysis available to any worker or DOL investigator who might ask for it. DOL believes that the added transparency created by such a requirement would reduce misclassification.
The DOL testimony also noted the department's support of S. 3254
(111th Congress), the Employee Misclassification Prevention Act. This proposal would add penalties for employer violation of FLSA and require employers to notify workers in writing whether they have been classified as an employee or a contractor.
Administration's Tax Proposal
The Administration's list of revenue proposals for FY 2011 (the "Greenbook" (PDF)) includes a tax gap measure to "increase certainty with respect to worker classification" (pages 107 – 109). Key elements of this proposal are explained next.
- Treasury and Internal Revenue Service (IRS) would be allowed to issue guidance on how to classify workers under the common law standards. Today they are prohibited by "Section 530" from doing so. The guidance would interpret the "common law in a neutral manner recognizing that many workers are, in fact, not employees." Guidance would be specific to industries and types of jobs. Initial guidance would address industries and jobs in which the greatest number of compliance problems have been found.
- Information on reclassified workers could be shared with the DOL.
- The IRS would be allowed to require service recipients with misclassified workers to reclassify them prospectively. The penalty regime would be modified to allow for lower penalties for service recipients who reclassify workers prior to IRS contact. Penalties would only be reduced if all required Forms 1099 had been filed.
- Contractors would receive information from service recipients who would be required to let the worker know how they are classified and the associated implications for tax, workers' compensation and wage and hour laws.
- Contractors who are paid at least $600 in a calendar year by a service recipient can ask that payor to withhold federal taxes at a specified percentage of the gross payments. The contractor would select the percentage. This proposal is described as easing compliance burdens on contractors.
No doubt, worker classification is a problem area, as Congress and others have noted for decades. The lack of clear and consistent rules lead to confusion, added costs for workers and service recipients, and a portion of the tax gap. Some of the problems would be addressed by the Administration's proposal, but not all. Described below are some additional points to consider in improving worker classification rules:
- Inconsistent rules: The rules for determining whether a worker is an employee or contractor are inconsistent for different purposes. For example, as noted earlier, under the FLSA, the “economic realities” test is used rather than the common law factors approach used for tax laws. State labor and tax rules may involve yet a different approach or modification to the federal tax rules. Also, "Section 530" relief applies to employers with respect to employment taxes, but not for income taxes or workers. Rules that classify workers as employees or contractors consistently for purposes of all federal and state laws would make the tax and labor laws more fair and simple.
- Subjectivity: Subjectivity is inherent in classifying workers. The common law classification approach requires determining whether the employer has the right to control the worker's results and means of accomplishing them. In applying any formulation of the 20 common law factors (Revenue Ruling 87 – 41), it is not unusual to find that not all the factors lead to one classification. It can then be challenging to determine how to weigh the factors to reach a conclusion and people might reasonably reach inapposite conclusions.
- The use of safe harbors or rebuttable presumptions might improve the classification process. For example, classification rules could provide a rebuttable presumption that workers paid some multiple of minimum wage (such as 150%) or trained by the service recipient, are employees.
- Appropriate parties for compliance responsibilities: The Administration's proposal includes allowing workers to ask service recipients to withhold taxes from their gross payments at a rate the worker sets. Thus, a service recipient could easily have multiple withholding rates to handle if they have several contractors working for them. While the Administration notes that this approach reduces the compliance burden for the worker, it increases burden for the service recipient. An appropriate alternative would be for the IRS to help contractors by providing a simpler estimated tax payment system for them, such as automatic monthly bank account withdrawals.
- Fix misclassification incentives: A desire to gain more favorable tax treatment may encourage service recipients and workers to resolve a subjective classification analysis in a certain way. For example, contractors can deduct expenses incurred in generating their business income. In contrast, unreimbursed employee business expenses are miscellaneous itemized deductions for which most employees get no deduction. Allowance of a deduction for certain expenses incurred in generating wage income might minimize an incentive to be a contractor. In contrast, application of unemployment compensation laws favors employees over contractors. A solution to better equalize the treatment would be to enable both workers and contractors to pay into an unemployment insurance fund.
The Joint Committee on Taxation has published an analysis of the Administration's FY2011 revenue proposals that includes comments on the worker classification proposal. [Description of Revenue Provisions Contained in The President's Fiscal Year 2011 Budget Proposal, JCS-2-10, August 16, 2010, page 427 - 446.]
The worker classification problem is longstanding and well-studied. Yet, it gets little attention in active tax legislation. Its placement in the Administration's revenue proposals helps remind everyone that the classification issue is still with us. There are many reasons that justify finally fixing this problem area, including fairness to workers and businesses, reducing the tax gap and simplifying the law. One more reason to address classification is the lurking possibility of a value-added tax (VAT) to help reduce the deficit and debt. Under a VAT, payments to contractors are not taxable, while wages are taxable. Without effective worker classification rules, a VAT would have one more challenge in its administration.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.