Background

In general, employee misclassification occurs when an employer  improperly classifies a worker as an independent contractor instead of an  employee. As we reported in 2006, the tests used to determine whether a  worker is an independent contractor or an employee are complex and  differ from law to law. While laws vary in their definitions of the  conditions that make a worker an employee, in general, a person is  considered an employee if he or she is subject to another’s right to control  the manner and means of performing the work. In contrast, independent  contractors are individuals who obtain customers on their own to provide  services (and who may have other employees working for them) and who  are not subject to control over the manner by which they perform their  services.
Many independent contractors are classified properly, and the  independent contractor relationship can offer advantages to both  businesses and workers. Businesses may choose to hire independent  contractors for reasons such as being able to easily expand or contract  their workforces to accommodate workload fluctuations or fill temporary  absences. Workers may choose to become independent contractors to  have greater control over their work schedules or when they pay taxes,  rather than have employers withhold taxes from their paychecks.
However, employers have financial incentives to misclassify employees as  independent contractors. While employers are generally responsible for  matching the Social Security and Medicare tax payments their employees  make and paying all federal unemployment taxes and a portion of or all  state unemployment taxes, independent contractors are generally  responsible for paying their own Social Security and Medicare tax  liabilities and do not pay unemployment taxes because they are not  eligible to receive unemployment insurance benefits. In addition,  businesses generally are not required to withhold the income, Social  Security, or Medicare taxes from payments made to independent  contractors that they are required to withhold for their employees.  Independent contractors may also be responsible for making their own  workers’ compensation payments, depending on their state program. The  differences, in general terms, between the tax responsibilities of  employees and independent contractors are summarized in table 1.
While businesses may be confused about how to properly classify  workers, some employers may misclassify employees to circumvent laws  that restrict employers’ hiring, retention, and other labor practices, and to  avoid providing numerous rights and privileges provided to employees by  federal workforce protection laws. These laws include    FLSA, which establishes minimum wage, overtime, and child labor  the Americans with Disabilities Act of 1990 and the Age Discrimination in  Employment Act of 1967, which protect employees from discrimination  based on disability or age;  the Family and Medical Leave Act of 1993, which provides various  protections for employees who need time off from their jobs because of  medical problems or the birth or adoption of a child; and  the National Labor Relations Act, which guarantees the right of employees  to organize and bargain collectively.
Employers may also choose to misclassify their employees in order to  avoid having to obtain proof that workers are U.S. citizens or obtain work  visas for them. In addition, independent contractors generally do not  qualify to participate in health and pension plans that employers may offer  to employees. Finally, when employers misclassify employees, they may  be able to undercut competitors because their costs are reduced.
While some workers may agree to be misclassified as independent  contractors in order to be paid in cash, avoid withholding of taxes, or  prevent having to provide proof of their immigration status, other workers  may not realize that they have been misclassified. In addition, they may  not realize that as independent contractors, they are not protected under  many laws designed to protect employees, and that they have obligations  for which employees are not responsible, such as payment of their own  taxes over the course of the year.
Responsibility for enforcing laws that afford employee protections and  administering programs that can be affected by employee misclassification  issues is dispersed among a number of federal and state agencies, as  shown in table 2.
Misclassification itself is not a violation of any federal labor law, but it can  result in violations of federal and state laws. For example, DOL’s Wage and  Hour Division (WHD) may cite employers that have misclassified their  employees as independent contractors for violations of FLSA relating to  recordkeeping (not keeping required records for these employees),  nonpayment of the federal minimum wage, and nonpayment of overtime. It  also assesses back wages owed to workers in cases where  misclassification leads to nonpayment of overtime or minimum wage. IRS  can also assess taxes and penalties on employers that it finds have  misclassified employees.
However, some workers who would otherwise be considered employees  are deemed not to be employees for tax purposes. With increased IRS  enforcement of the employment tax laws beginning in the late 1960s,  controversies developed over whether employers had correctly classified  certain workers as independent contractors rather than as employees. In  some instances when IRS prevailed in reclassifying workers as employees,  the employers became liable for portions of employees’ Social Security  and income tax liabilities (that the employers had failed to withhold and  remit), although the employees might have fully paid their liabilities for  self-employment and income taxes.
In response to this problem, Congress enacted section 530 of the Revenue  Act of 1978. That provision generally allows employers to treat workers as  not being employees for employment tax purposes regardless of the  workers’ actual status if the employers meet three tests. The employers  must have filed all federal tax returns in a manner consistent with not  treating the workers as employees, consistently treated similarly situated  workers as independent contractors, and had a reasonable basis for  treating the workers as independent contractors. Under section 530, a  reasonable basis exists if the employer reasonably relied on (1) past IRS  examination practice with respect to the employer, (2) published rulings  or judicial precedent, (3) long-standing recognized practices in the  industry of which the employer is a member, or (4) any other reasonable  basis for treating a worker as an independent contractor. Section 530 also  prohibits IRS from issuing regulations or Revenue Rulings with respect to  the classification of any individual for the purposes of employment taxes.  Congress intended that this moratorium to be temporary until more  workable rules were established, but the moratorium continues to this  day. The provision was extended indefinitely by the Tax Equity and Fiscal  Responsibility Act of 1982.
Federal agencies use different tests to determine whether a worker is an  independent contractor or an employee. IRS uses the concepts of  behavioral control and financial control and the relationship between the  employer and the worker to determine whether a worker is an employee,  while WHD uses six factors identified by the United States Supreme Court  to determine employee status during investigations of FLSA violations.  The complexity and variety of worker classification tests may also  complicate agencies’ enforcement efforts. In addition, states use varying  definitions of employee. For example, according to a report commissioned  by DOL, at least 4 states follow IRS’s test, and at least 10 states use their  own definitions. The remaining states use various definitions that rely at  least in part on whether the employer has the right to control the worker.
Decisions regarding employee status are sometimes determined through  the courts. For example, in a recent decision, the United States Court of  Appeals for the District of Columbia Circuit ruled that drivers for FedEx’s  small package delivery unit are independent contractors, and not  employees, and therefore do not have the right to bargain collectively.  FedEx had sought review of the determination by the National Labor  Relations Board that the FedEx drivers were employees and that FedEx  had committed an unfair labor practice by refusing to bargain with the  union certified as the collective bargaining representative of its  Wilmington, Massachusetts drivers. In ruling that the drivers are  independent contractors, the court noted that because FedEx Ground  drivers can operate multiple routes, hire extra drivers, and sell their routes  without company permission, they were not like employees of traditional  trucking companies.
Legislation aimed at preventing employee misclassification has been  introduced in previous sessions of Congress. At least four bills relating to  employee misclassification were introduced in the 110th Congress. Two of  the bills, both titled the Employee Misclassification Prevention Act (H.R.  6111 and S. 3648), were introduced in the House of Representatives and  the Senate, respectively, to amend FLSA to require employers to keep  records of independent contractors and to provide a special penalty for  misclassification. Two other bills were aimed, in part, at amending the  Internal Revenue Code to aid in proper classification. The Independent  Contractor Proper Classification Act of 2007 (S. 2044) was introduced in  the Senate to provide procedures for the proper classification of  employees and independent contractors, including amending the tax code  and requiring DOL and IRS to exchange information regarding cases  involving employee misclassification. In the House of Representatives, the  Taxpayer Responsibility, Accountability, and Consistency Act of 2008  (H.R. 5804) sought to amend the Internal Revenue Code to modify the  rules relating to the treatment of individuals as independent contractors or  employees, including requiring IRS to inform DOL of cases involving  employee misclassification. However, these bills were not enacted into  law.

	The Current Extent of Misclassification Is Unknown, but Misclassification Can Be a Significant Problem with Adverse Consequences

Although the national extent of employee misclassification is unknown,  earlier national studies and more recent, though not comprehensive,  studies suggest that employee misclassification could be a significant  problem with adverse consequences.
In its last comprehensive estimate of misclassification, for tax year 1984,  IRS estimated that nationally about 15 percent of employers misclassified  a total of 3.4 million employees as independent contractors, resulting in an  estimated revenue loss of $1.6 billion (in 1984 dollars). Nearly 60 percent  of the revenue loss was attributable to the misclassified individuals failing  to report and pay income taxes on compensation they received as  misclassified independent contractors. The remaining revenue loss  stemmed from the failure of (1) employers and misclassified independent  contractors to pay taxes for Social Security and Medicare and   (2) employers to pay federal unemployment taxes.
For 84 percent of the workers misclassified as independent contractors in  tax year 1984, employers reported the workers’ compensation to IRS and  the workers, as required, on the IRS Form 1099-MISC information return.  These workers subsequently reported most of their compensation (77  percent) on their tax returns. In contrast, workers misclassified as  independent contractors for whom employers did not report  compensation on Form 1099-MISC reported only 29 percent of their  compensation on their tax returns.
Although IRS has not updated the information from its 1984 report, it plans  to review the national extent of employee misclassification as part of a  broader study of employment tax compliance. However, IRS officials  anticipate that the results of this study will not be available until 2013, at  the earliest. As part of its National Research Program, IRS plans to  examine a randomly selected sample of employers’ tax returns for tax  years 2008 to 2010. IRS employment tax officials told us they may need to  extend the study if they have not collected sufficient data to provide  reliable estimates. For the misclassification part of the employment tax  compliance study, they said they hope to estimate the number of  employers that misclassify employees, the number of employees who are  misclassified, and the resulting loss of tax revenue. The officials also said  they are uncertain whether IRS will be able to collect sufficient data to  estimate the extent of misclassification within particular industries or  geographic regions.
A study commissioned by DOL in 2000 found that from 10 percent to   30 percent of firms audited in nine selected states had misclassified  employees as independent contractors. The study also estimated that if  only 1 percent of all employees were misclassified nationally, the loss in  overall unemployment insurance revenue because of employers’  underreporting of unemployment taxes across all states would be nearly  $200 million annually. In addition, the Bureau of Labor Statistics  periodically conducts a survey of contingent workers (defined as workers  holding jobs that are expected to last only a limited period of time),  including independent contractors. The most recent survey, conducted in  2005, revealed that 10.3 million U.S. workers were classified as  independent contractors—approximately 7.4 percent of all workers.  However, the survey did not indicate how many of these workers were  misclassified.
State officials we interviewed told us that in their opinion,  misclassification has generally increased over recent years. State activity  in this area may support this view. For example, officials from New  Hampshire’s Department of Labor said the agency recently hired four new  investigators to focus exclusively on investigations of employee  misclassification. Summary data states reported to DOL’s Employment  and Training Administration, which oversees state administration of the  unemployment insurance program, showed that from 2000 to 2007 the  number of misclassified workers uncovered by state audits had increased  from approximately 106,000 workers to over 150,000 workers, as shown in  figure 1. While these counts reveal an upward trend, they likely  undercount the overall number of misclassified employees, since states  generally audit less than 2 percent of employers each year.
State officials, however, told us that summary data they reported to DOL’s  Employment and Training Administration (ETA) did not include all  misclassification identified by their investigations. For example, officials  from one state said they did not report cases to DOL that did not meet  ETA’s prescriptive audit criteria that mandate, among other things,  extensive testing of an employer’s payroll records. Furthermore, the  official pointed out that the data ETA collects do not include cases  involving workers in the underground economy, where workers are paid in  cash and income is not reported to states or IRS.
Studies conducted by states, universities, and research institutes have  been generally limited in scope—for example, confined to one state or a  specific industry within a state. However, some of these studies have  noted that misclassification is especially prevalent in certain industries,  such as construction. For example, a study conducted by Harvard  University on the extent of misclassification in the construction industry in  Maine estimated that approximately 14 percent of construction firms  misclassified at least some of their employees each year from 1999 to  2002. Maine state officials told us that following the study, they began  targeting construction firms for their unemployment insurance audits and  found higher levels of misclassification—up to 45 percent of the firms  audited misclassified at least some of their employees.
Misclassification may undermine workers’ access to protections, such as  unemployment insurance and workers’ compensation. For example, one  group that advocates for workers cited an instance of a construction  worker who fell three stories, was severely injured, and incurred hospital  expenses of over $10,000 related to the injury. Because the worker was  misclassified as an independent contractor, his employer did not provide  workers’ compensation coverage for the employee. Several union officials  told us that misclassification of workers is especially prevalent in the  construction industry where workers are often paid entirely in cash and,  as a result, are not noted on the employers’ records at all, either as  employees or independent contractors. These officials told us they believe  that some employers have been emboldened to begin operating on a cash  basis by the ease with which they are able to misclassify their workers.
The WHD investigation case files we reviewed provided detail on several  instances where misclassified employees did not receive minimum wages  or overtime pay. For example, one case involved a medical transcription  service that hired workers—whom WHD determined had been  misclassified as independent contractors under FLSA—to work out of  their homes transcribing medical files they downloaded from the  company’s computer system. When the system was not accessible,  workers were not paid—although they were required to remain available  until the system became operational—and, as a result, they were not paid  the minimum wage required by FLSA.

	DOL Has Taken Limited Steps to Detect and Address Misclassification

DOL’s detection of employee misclassification is generally the indirect  result of its investigations of alleged FLSA violations, particularly  complaints involving nonpayment of overtime or minimum wages. WHD  officials have stated to Congress that the misclassification of an employee  as an independent contractor is not itself a violation of FLSA or other laws  WHD enforces. Misclassification, however, is often associated with FLSA  violations—in particular, recordkeeping violations and the failure to pay  overtime or minimum wages. When WHD finds FLSA violations resulting  from misclassification, it assesses back wages owed to workers as  appropriate. In addition, although there is no penalty for recordkeeping  violations, WHD requires businesses to place any workers the employer  reclassifies as employees on the company payroll records, as per FLSA  rules.
Our review of the case files also showed that WHD investigators, in the  course of their investigations, did not consistently review documents that  could indicate that employees had been misclassified. Specifically,  investigators may ask employers about independent contractors or  uncover misclassification through worker interviews, according to the  information contained in the case files. However, they did not, as a matter  of course, review employer records such as IRS Forms 1099-MISC that  show payments made to independent contractors. Reviewing these  records could aid WHD investigators in identifying workers who have  been misclassified. Although one district director told us it is standard  practice for investigators in his office to ask for this type of information  during an investigation, it is not WHD policy to do so.
Many of the experts we interviewed said that targeted investigations of  employers or industries could increase the detection of misclassification.  Approximately 80 percent of the investigations WHD concluded in 2008  involving misclassification were initiated because of complaints from  workers about possible labor violations. However, several experts we  spoke with pointed out that some workers, such as immigrants or those in  low-wage industries, are often less likely to file complaints with WHD.  Thus, a lack of targeted investigations coupled with the reluctance of  misclassified workers to complain may result in less effective enforcement  of proper classification. WHD officials told us that their ability to conduct  targeted investigations in recent years has been limited by reductions in  agency resources combined with consistently high levels of worker  complaints about possible labor law violations. According to WHD  policy, the first priority of the agency’s enforcement is to respond to complaints.
WHD conducts few investigations targeted at misclassification, though it  has begun to place a greater focus on misclassification within existing  agency initiatives. WHD concluded over 24,500 FLSA cases in fiscal year  2008, and misclassification was the primary reason for the violation  identified in 131 investigations. Most of these investigations (80 percent)  were initiated by complaints from workers rather than being targeted by  WHD. In the 26 investigations that were targeted by WHD, the agency  identified 341 misclassified employees who were owed back wages of over  $88,000. In the 1990s, WHD implemented initiatives to conduct targeted  investigations within low-wage industries with a history of FLSA  violations, such as restaurants, hotels, and nursing homes. These  initiatives enabled WHD to detect employee misclassification to the extent  it was prevalent in those industries. WHD officials told us that in fiscal  year 2007, in part because of heightened congressional interest in  misclassification, they instructed their district directors to place a special  emphasis on those low-wage industries within their districts with a history  of misclassifying employees. During fiscal year 2009, for example, the New  Orleans district office planned to conduct targeted investigations of the  staffing and janitorial industries in its region, although it limited this effort  to three investigations.
Examples of state efforts support the potential effect of targeted  investigations aimed at detecting misclassification. New York’s  Department of Labor has created a task force that conducts investigations  and audits aimed specifically at detecting misclassification. Among other  activities, the task force conducts sweeps, or targeted investigations of  businesses located within a certain area or within industries where  misclassification is prevalent. In conducting investigations during 2007 and  2008 that targeted approximately 300 businesses in the retail and  commercial industries, the task force found that 67 percent of the  businesses were in violation of unemployment laws, labor standards, or  workers’ compensation laws. In addition, at the request of investigators,  the task force scheduled follow-up audits of about half of these employers.  As of December 2008, it had completed 54 of these audits and found in  approximately 70 percent of them that employers had continued to  misclassify at least some employees as independent contractors.
In addition, the task force conducted targeted investigations of over   600 businesses, primarily in the construction industry. It found labor  violations in nearly half of these businesses and ordered follow-up  investigations. Just over half of these investigations have been completed,  resulting in nearly 7,800 employees being identified as misclassified. The  state determined that the misclassification led to $2.2 million in unpaid  wages, over $3.5 million in unpaid unemployment taxes and associated  penalties, and over $1 million in penalties related to workers’  compensation. As a result of all investigations conducted during a 16- month period ending December 31, 2008, the task force detected 12,300  instances of misclassification, with approximately $12 million in  associated unpaid wages. In contrast, in fiscal year 2008, WHD identified  1,619 instances of misclassification nationwide during its investigations  and assessed about $1 million in unpaid wages.
DOL has begun to track cases of misclassification in its WHD  investigations database. However, although DOL’s Occupational Safety  and Health Administration (OSHA) may identify misclassification during  its safety and health inspections, it does not record this information in its  inspections database. In addition, in their responses to our survey, a  majority of state workforce agencies noted that their states collect data on  the occurrences of misclassification, but most of those states do not send  this information to DOL. For example, an official in one state agency told  us that in 2008 his state conducted investigations that led to the detection  of approximately 46,000 instances of misclassification, but that DOL  collected no information associated with those cases. Since this  information would likely include the names of employers that  misclassified their employees, and the industries involved, collecting it  could enable DOL to focus its investigations more effectively on certain  employers or industries with a known history of misclassification.

		DOL Makes Only Limited Use of Education or Penalties to Deter Misclassification

Although education and outreach to workers could help reduce the  incidence of misclassification, DOL’s work in this area is limited. The DOL  Web site contains publications on the employment relationship under  FLSA, some of which mention the use of independent contractors.  However, the Web site does not provide material that focuses specifically  on the subject of employee misclassification. In addition to publications,  the DOL Web site provides printable workplace posters, some of which  employers are required to display in their workplaces. However, none of  WHD’s posters contain information on employment relationships or  misclassification.
DOL employees sometimes hand out to workers pamphlets that contain  general information on workers’ rights. Also, DOL staff provides  information materials at seminars and training sessions for employers.  While these materials address what constitutes an employment  relationship, they do not specifically mention misclassification. Similarly,  WHD district directors we interviewed told us that their staffs do not  conduct employer and worker outreach activities specifically on  misclassification. However, some said their staffs may provide information  about misclassification when answering questions from employers or  workers. Finally, an OSHA official told us that the agency does not  conduct any outreach or education directly related to misclassification,  although officials in one region told us that workers were misclassified as  independent contractors at over 80 percent of the construction sites they  inspected.
According to our survey, few states regard DOL’s efforts to educate  workers and employers on employee misclassification to be effective. In  fact, 16 states had no awareness of DOL education or outreach on the  subject. Of the states that were aware of DOL’s outreach activities, only   5 reported that they thought outreach for workers was effective, and only  6 stated that it was effective for employers. Further, some experts we  interviewed also expressed the view that DOL’s education and outreach  efforts on misclassification are inadequate and that improvement is  needed, especially for vulnerable populations. For example, some noted  that immigrants are less likely to know their rights and are more likely to  be misclassified than other types of workers.
WHD district directors we interviewed noted that there are challenges  associated with reaching vulnerable populations, such as immigrant  workers. Some noted that many noncitizens, whether documented or not,  are wary of government and therefore reluctant to approach DOL officials  or attend DOL-sponsored events. Despite this challenge, the directors told  us that their offices coordinate with immigrant population communities in  order to educate workers on labor issues. For instance, staff from the  Boston and New Orleans district offices told us they participate in  presentations, information sessions, and forums with the Hispanic  communities in their districts in coordination with the Mexican  consulates. These activities are generally broad in scope but may include  specific information on misclassification.
When WHD identifies misclassification, the division does not use all  available remedies—such as assessing financial penalties, pursuing back  wages owed to workers who have been misclassified, and conducting  follow-up investigations of employers that have misclassified workers—to  penalize employers who have violated FLSA and help ensure future  compliance. WHD levied penalties in less than 2 percent of the cases  involving misclassification it completed in fiscal year 2008—2 of 131  investigations. In contrast, the division levied penalties in 6 percent of the  cases involving FLSA violations from 2000 to 2007. WHD can only levy  penalties for violations of the minimum wage or overtime pay provisions  of FLSA when the violations are willful or repeated, though a WHD district  director noted that it can be difficult to prove that employers are willfully  misclassifying employees. In addition, although WHD determined that  there were back wages to be paid in most of these cases, we found that  investigators did not always follow up to ensure that employees were paid  the back wages assessed. For example, in one case we reviewed, the  employer did not provide documented proof that she paid back wages of  over $5,000 owed to her employees, but WHD closed the case and  recorded the back wages as paid. Further, WHD officials told us that if the  division uncovers violations caused by misclassification, it does not  generally conduct follow-up investigations to ensure that the employees  are properly classified.

	IRS Has Several Enforcement and Education Efforts That Focus on Misclassification but Faces Challenges in Undertaking These Efforts

IRS’s misclassification enforcement strategy relies on identifying and  examining employers that have potentially misclassified employees. IRS  primarily identifies employers to examine for potential misclassification  through four sources:    The Determination of Worker Status (Form SS-8) Program, in which  workers or employers request that IRS determine whether a specific  worker is an employee or an independent contractor for purposes of  federal employment tax and income tax withholding through the  submission of Form SS-8. IRS examines some of the employers it  determines to have misclassified workers through the SS-8 program.
The Employment Tax Examination Program (ETEP), in which IRS uses  specific criteria to identify for examination employers that have a high  likelihood of having misclassified employees.
General employment tax examinations, meaning examinations of tax  returns that are started because of separate employment tax issue that  lead to examinations of classification issues.
The Questionable Employment Tax Practices (QETP) program, through  which IRS and states share information on worker classification-related  examinations and other questionable employment tax issues. IRS  examines some employers that states have determined to have  misclassified employees.
IRS’s Small Business/Self Employed Division (SB/SE) conducts the  majority of IRS’s misclassification-related examinations. It made  applicable assessments (taxes and penalties) in 71 percent of such  examinations that it closed during fiscal year 2008, resulting in a total of  almost $64 million in assessments, as shown in table 3. A description of  the four programs though which IRS primarily generates misclassification- related examinations follows table 3. Also following table 3 is a  description of IRS’s Classification Settlement Program (CSP), which  enables qualifying employers under examination for misclassification- related issues to lower their misclassification-related tax liabilities if they  agree to properly classify their workers in the future.
Through its SS-8 program, IRS provides workers or employers that file  Forms SS-8 with its determination on the correct classification of the  workers in question. IRS also uses the program to identify employers that  may have misclassified employees and therefore would be fruitful to  examine. In fiscal year 2008, 72 percent of all Form SS-8 requests filed  resulted in IRS determinations that the workers in question were  employees, 25 percent were closed without any advice given, and   3 percent resulted in determinations that the workers in question were  independent contractors or had other results. IRS’s SS-8 unit makes these  determinations, in part, using information workers or employers provide  on Forms SS-8. After making classification determinations, IRS sends  letters to employers to provide them with guidance on how to voluntarily  amend their tax returns to comply with the determinations. IRS’s SS-8 unit  then uses specific criteria to determine which cases it should refer for  examination, including the amount of compensation the worker in  question earned, the number of similar workers hired by the employer, and  whether the case likely involves fraud. The majority of employers the SS-8  unit determined to have misclassified employees are very small  businesses, which generally are not referred because examining such  businesses is generally not cost effective. As a result, IRS officials  estimated that for recent tax years, only an average of 2 percent to   3 percent of employers it identified to have misclassified employees  through SS-8 determinations were referred for examination, and an even  smaller percentage resulted in examinations.
For ETEP, IRS uses a computer matching program to identify annually  employers that potentially misclassified employees. The match criteria  include employers that reported paying compensation to workers (on  Form 1099-MISC), the amount of compensation the workers reported on  their tax returns, and the portion of the workers’ total income that was  paid by the employers. IRS uses these criteria to identify employers to  examine with the greatest potential for tax assessments. IRS officials told  us that generally IRS examines about 1 percent to 3 percent of the  employers it identifies annually through ETEP to have potentially  misclassified employees. IRS does not examine some employers that it  determines based on the ETEP match to have potentially misclassified  employees, such as those that no longer appear to be in business; appear  to have legitimate reasons for meeting the ETEP selection criteria, such as  employers who compensate real estate agents, who are statutorily defined  as independent contractors; or are protected by section 530. For tax year  2006, IRS identified over 33,000 employers through ETEP. In fiscal year  2008, IRS examined 221 employers it identified through ETEP, as reflected  in table 3.
Over half (58 percent) of the misclassification-related examinations of  employers that SB/SE conducted in fiscal year 2008 arose through the  course of IRS examining employers for other types of employment tax  noncompliance. IRS examiners in all divisions are trained about  misclassification issues, but the depth of training depends upon the  division and group in which the examiners work.
According to IRS employment tax officials, QETP, initiated in December  2007, has proven to be a useful source of timely leads on potential  misclassification cases. QETP is a collaborative initiative between IRS  and, currently, 34 participating states through which IRS and state  workforce agencies share information on misclassification examinations.  IRS employment tax officials told us that the examination information that  states provide through QETP is especially useful to the agency because it  is timely, making it easier for IRS to contact and collect money from  noncompliant employers.
In addition to its programs that generate misclassification examinations,  IRS uses CSP to offer settlements to employers that it is examining for  misclassification. Through CSP, which IRS initiated in 1996, employers  under examination that meet certain criteria can lower their  misclassification-related assessments if they agree to correctly classify  their workers in the future and pay proper employment taxes. As of  November 2008, IRS had entered into about 2,800 settlement agreements,  of which about 2,500 involved SB/SE. Employment tax officials in this IRS  division estimated that their CSP agreements signed through the end of  2006 have resulted in at least approximately $76 million in taxes  voluntarily reported by participating employers without further IRS  intervention. Of employers that entered into agreements through the end  of 2006, IRS determined that 64 percent appear to be in compliance with  their agreements. IRS has not been able to determine, through a review of  filing histories, whether the remaining 36 percent of employers have  complied with their CSP agreements. IRS would need to examine these  employers to determine if they are in compliance with their agreements.

		IRS Uses Various Methods to Educate Taxpayers about Proper Classification

IRS provides extensive general information on its Web site on worker  classification issues for employers and workers, including flyers, IRS  forms, fact sheets, a Web cast, and a training manual providing in-depth  information on how IRS examiners determine a worker’s correct  classification. IRS also held a national phone forum on worker  classification determinations in May 2009 targeted at tax professionals and  small business employers and organizations. IRS officials noted that a key  IRS worker classification Web page was recently linked to IRS’s main page  and was viewed nearly 800,000 times in fiscal year 2008.
IRS’s outreach strategies include the use of handouts, e-mail lists, and  industry newsletters. In 2008, IRS began conducting worker classification  workshops. IRS employment tax officials said that IRS targets these  workshops toward persons working as payroll professionals, who are  most likely to handle workers’ pay paperwork, and paid tax return  preparers. IRS does not generally conduct outreach on classification  issues for workers.

		IRS Faces Challenges in Enforcing Compliance with and Educating Taxpayers about Classification Regulations

IRS’s programs aimed at enforcing proper worker classification and  educating taxpayers about this issue face three main challenges. First,  because misclassification is a complex issue, addressing proper  classification can be labor intensive for the IRS officials involved. For  example, in determining whether workers are employees or independent  contractors, IRS examiners must look to the common law, which can be a  complex process. The examiners must collect and weigh evidence on the  related common law factors to determine what is relevant for classifying  each relationship between the respective businesses and the workers in  question.
Second, given competing agency priorities, IRS has limited resources to  allocate to these programs. With regard to enforcement, it has resources to  examine only a small percentage of the potential misclassification cases it  detects. As shown in table 3, SB/SE completed examinations of less than  1,200 employers in 2008, a very small number when compared to the  millions of small business and self-employed taxpayers in the United  States. IRS focuses its examinations on employers with potential for large  assessments or cases that likely affect a number of workers. To encourage  voluntary compliance, IRS sends SS-8 determination letters to employers,  and has also sent “soft notices” to employers it determined had not  reclassified their workers after receiving these letters. However, IRS  officials told us that SS-8 determination letters and soft notices can be  ineffective if the letter or the notice signals that IRS will not further pursue  the noncompliant employers. For example, according to these officials,  only about 20 percent of employers that are sent SS-8 determination letters  but that are not selected for examination voluntarily comply with IRS’s  classification determination. With regard to education, IRS uses indirect  methods to reach the millions of businesses across the United States, such  as sending correspondence to a large list of contacts in various industries  and posting information in industry newsletters. According to IRS  employment tax officials, information on misclassification is generally  passed down two or three levels in order to reach employers.
Third, according to IRS officials we interviewed, section 530 is both a  major reason that it cannot examine many of the suspected cases of  misclassification it identifies and an impediment to its ability to educate  taxpayers on misclassification issues, as discussed below.
Before examining each potential misclassification case, IRS examiners  must verify whether the employer in question qualifies for section 530  protection. This verification process can be time and labor intensive,  because examiners must determine whether the employers in question  meet the three tests for section 530 protection.
Section 530 also restricts IRS’s ability to issue regulations and Revenue  Rulings with respect to the classification of any individual for purposes of  employment taxes. Because of this limitation, IRS restricts the educational  information it issues to informal general guidance and SS-8 determinations  and rulings, which provide recommendations on how to classify specific  workers. However, as noted previously, applying the classification rules  can be complex. IRS employment tax officials told us that businesses  regularly request IRS’s guidance on how to classify workers. In  accordance with section 530, IRS officials do not answer such inquiries  but instead recommend that the businesses file Form SS-8 requests, which  take time for the businesses to file and for IRS to process. Representatives  of worker, business, and paid tax return preparer groups pointed to a great  deal of confusion about proper worker classification. In an interview,  representatives of IRS’s Taxpayer Advocate Service told us that IRS should  have the ability to issue guidance on the rules it enforces, in the interest of  effective tax administration.

	Collaboration among Federal Agencies Is Limited, but States Report Successful Collaboration to Address Misclassification among Their Agencies and with IRS

DOL and IRS typically do not exchange the information they collect on  misclassification, and DOL does not share information internally.  However, when an employee is misclassified there is a potential for  violations of both tax and labor laws, and sharing information could  enable multiple agencies to address the consequences of misclassification.  For example, WHD does not always send information on cases involving  misclassification to other federal and state agencies, although WHD’s  policies and procedures direct it to share such information with other  federal and state agencies. WHD officials said they may not provide  referrals to states or other federal agencies because the definition of an  employee varies by statute and the division does not want its investigators  to interpret statutes outside its jurisdiction. WHD officials told us there  were no legal limitations on sharing information from an investigation,  although they said they were reluctant to share information on open cases  because they did not want to compromise their investigations.
Although WHD has a memorandum of understanding stating that it will  share information with IRS, WHD officials said they are concerned about  referring cases to IRS because they fear that employers would be reluctant  to cooperate with the division if they knew that it refers cases to IRS.  However, in these cases, WHD could obtain a subpoena to compel the  employer to provide WHD with records. Similarly, WHD depends on  complaints from workers to drive much of its workload and locate  employers that are in violation of the laws under its purview. According to  these officials, if workers who were not paying taxes properly knew that  WHD shared information with IRS about its investigations, they might be  less likely to file complaints or cooperate during investigations.
In cases where WHD refers a case involving misclassification to states or  other federal agencies, or to other divisions within DOL, it does not track  these referrals centrally. Therefore, officials do not know how often or to  whom cases are referred. In addition, officials are not able to ensure that  cases are referred consistently across offices. Some district offices,  however, keep track of the forms used to make such referrals. The  referrals are usually made by the district offices, which maintain records  of the referrals in their files and send the originals to the agencies to which  WHD has referred the cases.
OSHA may uncover misclassification during its inspections of potential  health and safety violations but generally does not refer these cases to  WHD or IRS. OSHA officials told us that although they have a number of  memorandums of understanding with other agencies and divisions within  DOL, these pertain to issues such as child labor and migrant workers and  not to misclassification. However, we found that OSHA has a  memorandum of understanding with WHD dating from 1990 that states  that, in order to secure the highest level of compliance with labor laws, the  agencies will exchange information and referrals where appropriate. This  agreement also states that both agencies will report the results of any  referrals to the other agency and will establish a system to monitor the  progress of actions taken on referrals. However, while OSHA tracks  referrals and results in its database, WHD has not established such a  system.
ETA, which oversees unemployment insurance, collects only summary  data from states on the number of employees they have found to be  misclassified during unemployment insurance audits. While DOL funds the  administration of state unemployment insurance programs, states are  responsible for all tax collection, benefit payment, and investigations and  audits. Therefore, officials told us that detailed employer or employee- specific information is available only at the state level, and ETA is unable  to refer potential misclassification cases to WHD. Moreover, since state  agencies are administrators of their own programs, officials told us that  ETA does not investigate instances of misclassification that occur in state  unemployment insurance programs.
Other federal agencies with jurisdiction over laws affected by  misclassification told us that they do not work with DOL or track cases  involving misclassification. Officials from the National Labor Relations  Board, which enforces the right of employees to bargain collectively, told  us that the agency does not work with DOL. Equal Employment  Opportunity Commission officials said that they have not worked with  DOL in any substantial way, although they do have a memorandum of  understanding with DOL.
According to officials, IRS does not share misclassification-related  information with DOL and shares only limited information with other  federal agencies. In general, IRS is prohibited from sharing taxpayer  information with other agencies per section 6103 of the Internal Revenue  Code. IRS and the Social Security Administration have memorandums of  understanding in place to facilitate information sharing on employment  tax cases and issues, but they do not regularly share information on  misclassification, according to IRS employment tax officials. However, the  officials told us that the two agencies are creating a joint employment tax  task team, and noted that the Social Security Administration can use IRS  employment tax information to ensure that misclassified workers are  given Social Security credit for wages earned. Contracting officers from  several federal agencies we interviewed said that they saw relatively high  volumes of potential misclassification among workers on federal  construction contracts, and that the payroll information they collect could  be of value to IRS. However, many of these agencies did not have  information sharing relationships with IRS.

		DOL Generally Does Not Work with States, but IRS Shares Information with Them

Less than 25 percent of states collaborate with DOL to identify employee  misclassification. In responding to our survey, 12 states said that they have  some type of collaborative arrangement with DOL in this area. These  arrangements may include sending information to DOL, receiving  information from DOL, and conducting joint investigations with DOL of  cases involving potential misclassification. Approximately 56 percent of  states we surveyed said that they collect data on misclassification beyond  the summary unemployment insurance audit data they are required to  report to DOL’s ETA on a quarterly basis. Although this information could  be useful to DOL in pursuing potential FLSA violations stemming from  misclassification, state officials we interviewed said that they are not  required to report it to DOL. For example, officials told us that they do not  report information on employees who were misclassified but paid in cash  and whose wages were not reported to IRS or state revenue agencies. DOL  could use information on these employees to target investigations of  possible FLSA violations, such as improper payment of overtime.
IRS and state workforce agencies share information on misclassification  as part of QETP. IRS, DOL, and state workforce agencies collaborated to  create QETP in September 2005. In its first year, 5 states participated and  additional states have been added over time. Currently, IRS and workforce  agencies from 34 states share information on audits involving  misclassification as part of QETP. IRS employment tax officials  remarked that QETP sends an important message to employers and  workers that IRS and states are working together on compliance issues.  According to the IRS officials, the state agencies audit employers to  determine whether they have classified workers correctly and paid state  unemployment taxes as appropriate. We surveyed participating state  agencies, and most respondents reported that audit information IRS  provided was helpful.
In addition to sharing audit reports for employers that were fo misclassified their employees, IRS also shares other types of  misclassification-related data with some states. Nineteen of the state  workforce agencies we surveyed reported that they receive Form 1099- MISC data from IRS. The state agencies may use these data to identify potential cases of misclassification. According to IRS employment tax  officials, IRS also shares the worker classification determinations it m through its SS-8 program with some state agencies; IRS issues these  determinations following employers’ or workers’ requests for  determinations of employment status. Fourteen of the state workforce  agencies we surveyed reported receiving this information from IRS.
Some state workforce agencies surveyed noted that IRS’s QETP  information sharing and communication practices could be improved. Fo example, two states commented that the information they receive fr IRS is somewhat dated. Some states that participated in our survey  reported frustration over not receiving requested information from IRS or  difficulty contacting IRS officials. IRS officials with whom we spoke were  aware that some states were not receiving QETP referrals, and stated that IRS was in the process of centralizing its QETP administration in order to rectify the problem. They also said that IRS is in the process of clearing  out a backlog of referrals from states. According to IRS employment tax  officials, IRS has completed the centralization of QETP administration  taken steps to clear the backlog of referrals from states. Finally, some  and  states we surveyed also reported several key barriers to effectively using  information provided by IRS. These included resource limitations w ithin  their own agencies, data system incompatibilities, and difficulties  complying with IRS’s legal requirements for safeguarding taxpayer data.

		Some States Identifying Misclassification through Collaborative Initiatives Involving Their Revenue, Labor, and Enforcement Agencies

Some states have made efforts to address misclassification and have  reported successful collaboration among their own agencies. States are  particularly concerned because of misclassification’s impact on worker compensation programs and unemployment tax revenue, among other  programs. In addition, states may incur additional costs, such of providing health care to uninsured workers, as a result of  misclassification. Some states have passed legislation related to  misclassification. For example, Massachusetts passed legislation that  standardizes the definition of an employee and penalizes employers for misclassification, regardless of whether it was intentional. The statuteauthorizes the state Attorney General to impose substantial civil and  criminal penalties and, in certain circum obtaining state public works contracts.  stances, to ban violators from  Several states have recently created interagency initiatives or joint task  forces aimed at detecting misclassification, often by executive order of  states’ governors. These task forces share information across revenue,  labor, and enforcement agencies. For example, the New York State Jo Enforcement Task Force on Employee Misclassification, which was  formed in September 2007, is led by the New York Department of Lab and includes revenue agencies, other enforcement agencies, and the  Attorney General’s office. Since its inception, the task force has engag joint enforcement sweeps, coordinated assignments, and systematic  referrals and data sharing between state agencies. New York state officials  told us that they now consider it customary to use a multiagen cy approach  and cross-agency coordination to deal with misclassification.
However, some of these state task forces have encountered challenges particularly in coordination among state agencies. The agencies must  overcome or ease restrictions on sharing information outside their  jurisdictions, which may require state legislative action. State officials we interviewed cited other challenges, such as the fact that the lead agency  does not have oversight authority over task force members, which makes  it difficult to direct their efforts; the limited resources of many state  agencies; and dealing with the added layers of bureaucracy involved in  tracking cases and enforcing compliance together.  ,  While these task forces are relatively recent innovations, state officials  told us that they have already been effective in uncovering  misclassification. New York state officials told us that the state uncovers  many more misclassified employees through task force activities than  solely through the unemployment insurance audits required by DOL. The  state estimated that in just over a year’s time, its misclassification task  force uncovered 12,300 instances of employee misclassification and, as  noted earlier, $157 million in unreported wages. The task force’s  enforcement activities also resulted in over $12 million in workers’ back  wages being assessed against employers.

	Various Options Could Help Address Misclassification Challenges

As far back as 1977, we have analyzed options for addressing tax  noncompliance arising from employee misclassification. In 1977, we  recommended a specific definition to clarify who should be considered an  independent contractor, and in 1979, we concluded that some form of tax  withholding could be warranted to reduce tax noncompliance among self- employed workers. In 1992, we offered options to improve independent  contractor tax compliance, such as ensuring that their taxpayer  identification numbers (TIN) are valid, informing them of their  classification status and tax obligations, and closing gaps in the payments  that are required to be reported on Form 1099-MISC. For this report, we  explored current options to address the challenges raised by employee  misclassification, some of which are similar to the options we analyzed in  these prior reports.
We identified 19 options to address the challenges raised by employee  misclassification by reviewing literature and speaking with various groups,  including those representing (1) labor and advocacy, (2) independent  contractors and small businesses, and (3) tax professionals. These  options would require either legislative or administrative actions. Table 4  lists the 19 options. The list is not ranked in any order, but rather is  grouped in seven broad categories.
We asked 11 external stakeholders to provide input on these 19 options,  including (1) the extent to which they supported or opposed each option  and (2) the benefits and drawbacks of each option (see app. II for a  summary of these benefits and drawbacks for each option). These  stakeholders included 4 groups that represent the views of small  businesses, independent contractors, and those who hire them (i.e.,  independent contractor groups); 4 groups that represent the views of  organized labor (i.e., labor groups); 2 groups that represent the tax  preparation and advice community; and 1 federal agency that uses  contractors. We received responses from 9 of these groups.

		No Option Had Unanimous Support or Opposition

Stakeholders did not unanimously support or oppose any of the 19  options. Although views were mixed, stakeholders generally expressed  support for the options more frequently than they expressed opposition.  For example, at least seven of the nine responding stakeholders supported  three options (see table 5).
In contrast, five of nine stakeholders opposed one option—narrowing the  definition of “a long-standing recognized practice of a significant segment of  the industry” under section 530 of the Revenue Act (option 5). While all  three independent contractor groups opposed this idea on the grounds that  the protection was important, two labor groups that opposed the option did  so because it only narrowed rather than eliminated this protection.

		Labor Groups and Others Were Generally More Supportive of Options Than Independent Contractor Groups

In general, labor groups, a group representing tax preparers, and a federal  agency that hires contractors tended to be more supportive of the   19 options than independent contractor groups. We analyzed whether the  majority of stakeholders in each group—that is, over half of them—stated that  they supported, opposed, or were neutral on the 19 options. Table 6 shows that  a majority of the labor group respondents (i.e., at least 3 of the 4) supported 9  options and opposed none. Similarly, the tax professional group and the federal  agency both supported 10 options and opposed none. In contrast, a majority of  the independent contractor respondents (i.e., at least 2 of the 3) supported 7  options and opposed 8. A blank cell in the table indicates that the stakeholders  for the group lacked a majority view on the option.

		Stakeholders Identified Various Benefits and Drawbacks to the Options

We asked stakeholders what they perceived to be the benefits and  drawbacks of each option. We did not follow up on these responses to  clarify and understand the basis for the stakeholders’ perceptions on  benefits and drawbacks. As a result, absent other relevant data, these  responses did not allow us to uniformly assess whether the benefits  outweighed the drawbacks for each option, or vice versa. Table 7 lists  examples of types of benefits and drawbacks identified across all the  options.
We found that some of the stakeholders had different perceptions of  whether an outcome for an option would be beneficial. For example, some  respondents said that creating an online classification system could help  reduce confusion over classification rules and unintentional  misclassification. However, other respondents stated that such a system  would produce inconsistent determinations and could be manipulated to  achieve desired classification determinations. Similarly, some  stakeholders said that requiring a separate TIN for independent  contractors could increase voluntary tax compliance or help facilitate IRS  compliance and enforcement efforts. However, others expressed the  opinion that a separate TIN could be conducive to tax fraud or  manipulation of the classification system. Finally, some perceived that  expanding CSP to include employers that volunteer to disclose their  misclassified employees would benefit such employers by reducing their  financial exposure while others viewed this same outcome as allowing  them to escape financial sanctions for misclassifying. (See app. II for  summaries of the types of benefits and drawbacks for each option.)
We also asked IRS officials to share their insights on the benefits and  drawbacks of the options from a tax administration perspective. Some of  their insights included the following:    Expanding CSP to include employers that voluntarily ask to participate  could help reduce employee misclassification, although allowing voluntary  participation raises issues of equity and may create a safe harbor from  examination. For example, this expansion could bring into compliance  employers that voluntarily disclose that they have misclassified employees  but would reduce the financial sanctions they face for having done so. IRS  employment tax officials said that they recently created a team to explore  these and other issues related to such an expansion and that they hope to  start soliciting comments on a proposal from across IRS starting in  summer 2009.  “Soft” (i.e., non enforcement) notices to educate employers that appear to  be misclassifying employees and to encourage them to correct their  classifications might not be effective unless IRS is able to follow up with  employers that do not change their classification behavior. Notices also  are more effective if they are sent strategically rather than using a  “shotgun” approach. Furthermore, sending notices to employers in certain  industries without sufficient justification for targeting them likely would  create a backlash that IRS would have to manage.
Expanded information sharing with other federal agencies generally can  help IRS to be more effective at enforcing proper worker classification.  However, section 6103 protections against improper disclosure of tax data  generally hamper such sharing and one-way information sharing can  create resentment among other agencies.
Creating standardized documents on worker rights and tax obligations can  impose burdens on businesses, although such burdens could be reduced  by requiring employers to provide such documents only to newly hired or  retained workers rather than to all workers. Also, IRS may not currently  have the authority to require employers to provide such documents to  workers.
Requiring a separate TIN for each independent contractor could help  compliance but would impose some costs on businesses and IRS to  reprogram its computers.
Requiring Forms SS-8 for all newly retained independent contractors  would create tremendous costs for IRS, and it may not be able to review  the forms quickly enough to affect some independent contractors who  employers retain on a short-term basis.
An online classification system that uses factors like those that IRS uses to  make Form SS-8 determinations could provide guidance to those unsure  about classifying workers. However, the system should not be used to  make classification determinations because those entering the data could  manipulate their entries to receive a desired outcome.
Some of the identified options relate to goals, objectives, and strategies in  IRS’s Strategic Plan for 2009-2013. For example, IRS’s plan envisions  placing more emphasis on providing more targeted and timely guidance  and outreach on how to voluntarily comply and creating opportunities for  taxpayers to proactively resolve tax disputes as soon as possible as part of  its goal to improve service to make voluntary compliance easier. To  enforce the law to ensure that everyone meets their tax obligations, IRS  plans to strengthen its partnerships with other government agencies to  leverage resources in a way that allows quick identification and pursuit of  emerging tax schemes through education as well as enforcement. IRS also  seeks to expand its enforcement approaches by allowing for alternative  treatment of potential noncompliance. These approaches include  expanding the use of soft notices to educate taxpayers and to encourage  them to self-correct to avoid traditional enforcement contacts, such as  examinations, as well as expanding incentives and opportunities for  taxpayers to voluntarily self-correct noncompliant behavior.

	Conclusions

Misclassification can have a significant impact on federal and state  programs, businesses, and misclassified employees. It can reduce revenue  that supports such programs as Social Security, Medicare, unemployment  insurance, and workers’ compensation. Further, employers with  responsible business practices may be undercut by competitors who  misclassify employees to reduce their costs, for example, by not paying  payroll taxes or providing benefits to workers. Employers may also exploit  vulnerable workers, including low-wage workers and immigrants, who are  unfamiliar with laws pertaining to employment relationships, including  laws designed to protect workers. For example, misclassified workers may  not be paid properly for overtime or may not know that their employers  are not paying worker’s compensation premiums.
Although misclassification is a predictor of labor law violations, and  although state examples show that targeting misclassification is an  effective way to uncover violations, DOL is not taking advantage of this  opportunity by looking for misclassification in its targeted investigations.  As a result, employers may continue to misclassify employees without  consequences and workers may remain unprotected by labor laws and not  receive benefits to which they are entitled. Furthermore, because DOL  conducts limited education and outreach on misclassification, many  workers have insufficient information on employment relationships and  may not understand their employment status and rights. In addition,  vulnerable populations, including low-wage workers and immigrants, may  not know they are misclassified and, as result, may not receive the  protections and benefits to which they are entitled. By not regularly  sharing information on cases involving misclassification, federal and state  agencies are also losing opportunities to protect workers and to make the  most effective use of their resources. Also, because DOL is not working  with states active in this area to identify misclassification, it is not using its  resources most effectively by establishing a collaborative effort between  federal and state agencies to address misclassification.
Many of the IRS-related options we analyzed to address misclassification  were generally perceived to have merit as means to address  misclassification, but all have some drawbacks, according to those  stakeholders we surveyed. Although several options had support from  many of those who provided input, we had no reliable measure of the  extent of misclassification and did not have sufficient information to  weigh the benefits compared to the drawbacks of the options given the  scope of our work. Even so, qualitative information provided by the  stakeholders can help policymakers and tax administrators judge whether  any of the options merit pursuit.
Likewise, some actions have potential to address misclassification in a  cost-effective manner while also adhering to IRS’s strategic vision for the  next few years. For example, IRS and DOL can do more to educate  employers and workers. Given that most complaints come from workers,  further educating them about the consequences of misclassification may  be especially useful. Developing a standard document on classification  rights and related tax obligations that all new workers would either be  given by employers or referred to on agencies’ Web sites would be  particularly well targeted. Similarly, IRS could build on its existing state  contacts to resolve current concerns with the QETP initiative, which  mutually benefits both federal and state parties. Regularly collaborating  with participating states can help ensure that issues are addressed by both  IRS and states in a timely manner. Finally, expanding CSP to allow for  voluntary self-correction of classification decisions could prompt  compliance among employers that IRS is unlikely to pursue through  enforcement because of limited resources. Soft notices targeted to  employers that appear to be misclassifying would give them a chance to  self correct before IRS decides whether to examine them and should be  tested to determine their effectiveness.

	Recommendations for Executive Action

We are making six recommendations to the Secretary of Labor and the  Commissioner of Internal Revenue to assist in preventing and responding  to employee misclassification.
To increase its detection of FLSA and other labor law violations, we  recommend that the Secretary of Labor direct the WHD Administrator to  increase the division’s focus on misclassification of employees as  independent contractors during targeted investigations.
To enhance efforts to protect workers and make the most effective use of  their resources, we recommend that the Secretary of Labor direct the  WHD Administrator and the Assistant Secretary for OSHA to ensure that  information on cases involving the misclassification of employees as  independent contractors is shared between the two entities and that cases  outside their jurisdiction are referred to states and other relevant agencies,  as required.
To identify promising practices in addressing misclassification and use  agency resources most effectively, we recommend that the Secretary of  Labor and the Commissioner of Internal Revenue establish a joint  interagency effort with other federal and state agencies to address the  misclassification of employees as independent contractors. Because tax  data may provide useful leads on noncompliance, the task force should  determine to what extent tax information would assist other agencies and,  if it would be sufficiently helpful, seek a legislative change through the  Department of the Treasury to allow for sharing of tax information with  appropriate privacy protections.
To enhance understanding of classification issues by workers—especially  those in low-wage industries—we recommend that the Secretary of Labor  collaborate with the Commissioner of Internal Revenue to offer education  and outreach to workers on classification rules and implications and  related tax obligations. Such collaboration should include developing a  standardized document on classification that DOL would require  employers to provide to new workers.
To maximize the effectiveness of the relatively new QETP initiative, we  recommend that the Commissioner of Internal Revenue create a forum for  regularly collaborating with participating states to identify and address  data sharing issues, such as ensuring clear points of contact within IRS for  states and expeditious sharing of data.
To increase proper worker classification, we recommend that the  Commissioner of Internal Revenue extend the CSP to include employers  that volunteer to prospectively reclassify their misclassified employees,  and as part of this extension test whether sending notices describing the  program to potentially noncompliant employers would be cost effective.  Employers to which IRS would send notices could include those referred  for examination but who may not be examined because of higher  priorities, resource limitations, or other reasons.

	Agency Comments and Our Evaluation

In their comments on a draft of this report, both DOL and IRS generally  agreed with our recommendations, and either agreed to implement or to  take steps consistent with our recommendations, such as exploring their  implementation. WHD, OSHA, and IRS provided written comments on the  draft, which are reprinted in their entirety in appendixes III (DOL  comments from WHD and OSHA) and IV (IRS comments). In addition,  ETA provided technical comments, which we incorporated.
DOL agreed with our recommendation to increase WHD’s focus on  misclassification of employees as independent contractors during targeted  investigations. WHD commented that it would reexamine its training  documents and field guidance to ensure that employee classification was  addressed during all stages of an investigation. In addition, WHD agreed to  focus on increasing compliance for workers in industries where  misclassification is prevalent.
DOL also agreed that there is value in sharing information on cases  involving the misclassification of employees as independent contractors  between WHD and OSHA and with state agencies. WHD and OSHA stated  that they are both committed to working closely together to exchange  information and improve protections afforded workers. In addition, WHD  said that it would assess its current referral processes to ensure that they  adequately provided for referrals to other agencies in cases related to  employee misclassification.
In their comments, the agencies expressed support for our  recommendation to establish a joint interagency effort to address  misclassification. DOL stated that a joint effort between DOL and IRS may  prove useful in WHD’s efforts to enforce wage and hour laws, and that  WHD would participate in any such interdepartmental effort. Similarly,  IRS stated that coordination between departments and agencies at the  federal and state levels is an effective way to encourage voluntary  compliance and agreed to work with the Secretary of Labor to explore  developing a joint effort, subject to disclosure rules under section 6103 of  the Internal Revenue Code and other privacy rules.
In addition, DOL and IRS agreed to explore opportunities to collaborate to  offer education and outreach to workers on the topic of worker  classification, including developing a standardized document that DOL  would require employers to provide to new workers. WHD agreed to reach  out to IRS to explore opportunities for joint outreach to workers, and IRS  agreed to collaborate with the Secretary of Labor, make education and  outreach materials available to DOL, and work with the Secretary of Labor  to explore developing a standardized document on classification for DOL  to provide to new workers.
Finally, IRS agreed to work with state workforce agencies participating in  QETP to establish a forum to identify and address data sharing and IRS  points of contact issues using its Enterprise Wide Employment Tax  Program. IRS also said it would consider expanding the CSP to employers  not under examination and commented that if it decides to expand the  program, it will consider all options, including issuing notices and soft  letters and soliciting volunteers through outreach and education. We  appreciate that IRS will consider these actions and continue to believe that  extending the CSP to include employers that volunteer to prospectively  reclassify their misclassified employees would be an effective way to  increase proper worker classification and that it would be useful to test  whether sending notices would be a cost-effective feature of an expanded  program.
As we agreed with your offices, unless you publicly announce the contents  of this report earlier, we plan no further distribution of it until 30 days  from the date of this letter. At that time, we will send copies of this report  to the Secretary of Labor, the Commissioner of Internal Revenue, and  relevant congressional committees. The report is also available at no  charge on GAO’s Web site at http://www.gao.gov.
Please contact Andrew Sherrill at (202) 512-7215 or sherrilla@gao.gov or  Michael Brostek at (202) 512-9110 or brostekm@gao.gov if you or your  staffs have any questions about this report. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. Key contributors to this report are listed in appendix V.

Appendix I: Scope and Methodology

To determine what is known about the extent of the misclassification of  employees as independent contractors and its associated tax and labor  implications, we reviewed studies on misclassification conducted by the  Internal Revenue Service (IRS), the Department of Labor (DOL), and  others. We reviewed IRS’s estimate on the extent of misclassification and  the associated revenue loss for tax year 1984. We also interviewed IRS  officials responsible for planning an update to that estimate. From DOL,  we reviewed a study it commissioned in 2000 on the extent of  misclassification. We also analyzed the information states report to it  regarding their findings of misclassification during their audits of  employers. We analyzed summary data that the states reported for the  years 2000 to 2007. These data included the number of employers in each  state, the number of audits completed, and the number of misclassified  employees identified during these audits. We also reviewed  misclassification studies conducted by states, universities, and research  institutes. Finally, we interviewed officials from federal and state agencies  to obtain their views on misclassification and its consequences for  workers.
To describe actions taken by DOL to address employee misclassification,  we examined DOL policies and documentation, including DOL’s Wage and  Hour Division’s (WHD) Field Operations Handbook and the Occupational  Safety and Health Administration’s Field Operations Manual. We  interviewed agency officials at the national and district levels, as well as  several investigators from WHD, and spoke with employer and labor  advocates to obtain their perspectives on DOL’s efforts. In some cases, we  relied on interviews conducted for a previous closely related GAO  testimony, issued in July 2008. We also obtained and analyzed WHD data  on cases involving misclassification concluded during fiscal year 2008. We  could not obtain data for other time periods because WHD did not flag  cases to indicate whether they involved misclassification before fiscal year  2008. We assessed the reliability of the data and determined them to be  sufficiently reliable for the purposes of this report. However, because DOL  only flagged cases as involving misclassification when it was the primary  reason for Fair Labor Standards Act (FLSA) violations, and because WHD  officials told us that not all investigators understood how to properly flag  these cases, this information may be incomplete.
In total, we examined data for 131 cases involving 1,619 misclassified  employees who were denied payment for overtime or were paid less than  minimum wage. Using these data from the WHD database, we  judgmentally selected 26 case files to review. We selected cases based on  factors such as the number of employees misclassified, the total amount of  back wages computed, whether a single employee was owed over $10,000  in back wages, whether civil money penalties were assessed, and whether  the case resulted from a complaint or was directed by the agency. We  conducted reviews of 13 case files in the WHD New Orleans and Boston  offices and requested copies of the remaining selected case files from  WHD. Because we judgmentally selected these files, our findings from the  reviews of case files are not projectable to all WHD cases.
To obtain information on state coordination with DOL and IRS, state  perspectives on DOL’s education and outreach efforts, and whether states  collect data on cases involving misclassification, we conducted a Web- based survey of unemployment insurance directors in all states, the  District of Columbia, and Puerto Rico. We administered two versions of  this survey: one for states participating in the Questionable Employment  Tax Practices (QETP) program and one for states that do not participate in  the QETP program. After we drafted the questionnaire, we asked for  comments from a knowledgeable official at the National Association of  State Workforce Agencies as well as from an independent GAO survey  professional.
We conducted two pretests of the survey, one with a state participating in  the QETP program and one with a state that does not participate in the  QETP program, to check that (1) the questions were clear and  unambiguous, (2) terminology was used correctly, (3) the questionnaire  did not place an undue burden on agency officials, (4) the information  could feasibly be obtained, and (5) the survey was comprehensive and  unbiased. We received responses from all 32 states on the survey for QETP  participants, for a response rate of 100 percent. We did not receive a  response from 1 state on the survey for states that do not participate in  QETP, for a response rate of 95 percent. We were unable to contact the  official in Puerto Rico within the study’s time period. Finally, we  interviewed officials in 4 states to obtain more information about their  efforts to address misclassification and, where applicable, reviewed  documentation on these efforts.
To describe actions IRS takes to address employee misclassification, we  interviewed officials from the employment tax group within IRS’s Small  Business/Self Employed Division (SB/SE), which conducts the majority of  IRS misclassification-related examinations. We also obtained data on  SB/SE examinations of worker misclassification for tax year 2008  generated from four sources: (1) the Determination of Worker Status  (Form SS-8) program, (2) the Employment Tax Examination Program  (ETEP), (3) QETP, and (4) general IRS employment tax examinations,  including cases referred from other divisions within IRS. SB/SE conducted  all IRS misclassification examinations generated by ETEP and QETP, over  97 percent of the examinations generated by the SS-8 program, and the  majority of general examinations IRS conducted during fiscal year 2008.  We also obtained data from IRS’s Classification Settlement Program. We  assessed the reliability of these IRS data sources and found them to be  sufficiently reliable for the purposes of this report. To obtain information  on IRS’s education and outreach activities that address misclassification,  we interviewed officials from the employment tax group within SB/SE,  interviewed independent contractor and labor advocates, and reviewed  educational materials on classification IRS makes available on its Web  site.
To understand how DOL and IRS cooperate with each other and with  states and other relevant agencies, we examined agency policies and  procedures for sharing information on misclassification and referring  cases involving misclassification, and interviewed agency and state  officials. We also reviewed information IRS provided on its arrangements  with states through the QETP program.
To describe options that could help address challenges in preventing and  responding to misclassification, we reviewed GAO and other federal  agency reports and recommendations and other organizations’ studies on  misclassification of employees. We also interviewed 19 relevant  stakeholders representing various groups, including (1) labor and  advocacy groups, (2) groups that represent small businesses and  independent contractors, (3) groups that represent tax professionals,   (4) authors who have published on misclassification issues, and (5) federal  agencies, to help identify options and summarize any associated trade-offs.  Based on those discussions, we identified 19 options to include in this  report. We originally identified over 100 options but reduced the list to   19 options that directly addressed misclassification challenges and issues,  were not already being implemented, and were distinct from each other. In  addition, we did not include other options that we have recently analyzed  or recommended in prior reports on misclassification or that are indirectly  related to worker misclassification, such as for information reporting on  payments made to independent contractors.
We surveyed 11 stakeholders for their views on the 19 options we  identified, asking them to state their level of support or opposition to the  options and what they perceived to be the strengths and drawbacks of  each option. These stakeholders included 4 groups that represent the  views of small businesses, independent contractors, and those who hire  them (i.e., independent contractor groups); 4 groups that represent the  views of organized labor (i.e., labor groups); 2 groups that represented the  tax preparation and advice community; and 1 federal agency that uses  contractors. We received responses from 9 of these groups. We analyzed  the responses we received in order to present summary information in the  report.
We conducted this performance audit from August 2008 through July 2009  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Appendix II: Stakeholder Views on Options to Address Misclassification Challenges

We identified 19 options to address challenges involved with preventing  and responding to worker misclassification by reviewing related literature  and interviewing knowledgeable persons about misclassification. As we  identified these options, we asked these stakeholders for their views on  the options, including what they considered to be the benefits and  drawbacks of each. These stakeholders included IRS officials and  representatives of organizations representing workers, independent  contractors, tax professionals, and a federal agency that hires contractors.
The following is a summary of the options and their perceived associated  benefits and drawbacks. Neither the list of options nor the list of their  perceived associated benefits and drawbacks is exhaustive. Some of the  options are concepts rather than fully developed proposals with details of  how they would be implemented. Additional detail could bring more  benefits and drawbacks to light. The benefits and drawbacks are not  weighted and are not listed in order of importance or by frequency of  mention. Options should not be judged by the number of benefits and  drawbacks. Some of the options overlap, covering more than one problem,  while other options only deal with specific aspects of a problem.
A. Clarify the employee/independent contractor definition and  expand worker rights  1.  Clarify the distinction between employees and independent  contractors under federal law by unifying multiple definitions, limiting  the number of factors used to make determinations, and making the  factors more conclusive    Could reduce manipulation of classification rules    Could improve equity and efficiency of classification rules    Could improve worker protection if an expansive definition is adopted    Could improve objectivity of rules/reduce confusion     Lobbying and political compromises could weaken the definition    Lobbying and political compromises could lead to a more restrictive    Could lead to increased litigation if a new definition has no history or    Could create transitional costs and upheavals in working relationships    Could deter use of independent contractors    A “one-size-fits-all” approach may cause imbalances and more  problems than it solves in certain industries  IRS and government agencies could incur costs to administer a new  definition    Could sidetrack key anti-abuse reforms    No need to harmonize definitions since courts work well in doing so    Could encourage more employers to engage in fraud  2.  Allow workers to challenge classification determinations in U.S. Tax    Could increase equity and protections for workers    Could reduce incentives for misclassification    Could result in more or unnecessary litigation    Would be unfair to businesses    Could deter use of independent contractors    Too narrow to limit challenges to just Tax Court and just workers  3.  Ensure that workers have adequate legal protection from retaliation  for filing a Form SS-8    Could help reduce misclassification/improve misclassification    Could help improve worker protection and justice    Could result in more litigation    Limits ability of employers to end contractual relationships as needed    Could reduce use of independent contactors    Not necessary because retaliation is rare and independent contractors  can protect themselves through a contract    Does not include worker protection for other actions to challenge  4.  Define misclassification as a violation under FLSA    Could help increase voluntary compliance    Would allow federal agencies, including DOL, to take greater    Could increase costly lawsuits for businesses    Could deter use of independent contractors    Unfair to penalize businesses and contractors for confusing and  subjective regulations  B. Revise section 530 of the Revenue Act of 1978  5.  Narrow the definition of “a long-standing recognized practice of a  significant segment of the industry” so that fewer firms qualify under  this reasonable basis for the section 530 safe harbor    Could reduce incentive to misclassify and increase voluntary    Could help reduce tax gap related to misclassification    Opens the door to eroding the protection of section 530    Could create inequities among those who use independent contactors    Could lead to economic disruption or upheaval in some industries  Ignores unique issues that some industries possess    Unnecessary because current definition can be hard to meet    Only narrows rather than eliminates “industry practice”  6.  Lift the ban on IRS/Treasury regulations or revenue rulings clarifying  the employment status of individuals for purposes of employment  taxes    Could reduce requests for individual classification determinations and    More consistent application of the rules    Could allow IRS to more effectively prevent misclassification and    Could improve understanding and reduce confusion over classification    No need because existing case law is sufficient    Could erode section 530 protection    Could increase litigation and lobbying costs  IRS cannot fix the classification problem without congressional  guidance    A national standard would not affect state definitions    Political influences could slant the new guidance  C. Provide additional education and outreach  7.  Require service recipients to provide standardized documents to  workers that explain their classification rights and tax obligations    Could help reduce misclassification by reducing errors    Could help educate workers about classification    Could discriminate against some independent contractors    Relies on employers instead of IRS to inform workers    Could be ineffective if workers cannot understand the documents    Employers would incur costs and burdens  8.  Expand IRS outreach to service recipient, worker, and tax advisor  groups to educate them about classification rules and related tax  obligations, targeting groups IRS deems to be “at risk”
Could improve uniformity of classifications    Could reduce misclassification by reducing errors    Could deter use of independent contractors    Could divert IRS resources from enforcement    Does not target tax advisors who facilitate misclassification    Could lead to unfair targeting of business groups    Could lead to independent contractors suing their clients  9.  Create an online classification system, using factors similar to those  used in the SS-8 determination process, to guide service recipients and  workers on classification determinations    Uses electronic instead of paper-based processes    Could minimize the need for SS-8 determinations    Could provide more information to workers and service recipients    Could streamline decision making on classifications    Could reduce confusion and unintentional misclassification  IRS would incur costs to develop system    Still relies on subjective weighting of evidence and is likely to produce    Not all workers have access to computers    Could be manipulated by employers to attain desired classification  10.  Increase the use of IRS notices to service recipients in industries with a  potentially high incidence of misclassification to educate them about the  classification rules and ask them to review their classification practices    Could improve understanding of correct classification  IRS would incur costs to develop and mail notices    Could be ineffective if not combined with IRS enforcement    Could expose employers to more litigation    Could create adversarial relationships between employers and workers    Could be unfair to targeted industries  D. Withhold taxes for independent contractors  11. Require service recipients to withhold taxes, with rates at an adequate  level to induce compliance, for independent contractors whose  taxpayer identification numbers (TIN) cannot be verified or if notified  by IRS during the TIN verification process that the contractors are not  fully tax compliant    Could help improve voluntary filing and tax compliance by having    Would impose costs and burdens on employers    Does not hold employers financially accountable for misclassification    TIN verification is not effective    Could result in withholding errors  12. Require universal tax withholding for payments made to independent  contractors using tax rates that are relatively low (e.g., 1 percent to 5  percent of payment amounts)

Appendix III: Comments from the Department of Labor

Appendix IV: Comments from the Internal Revenue Service

Appendix V: GAO Contacts and Staff Acknowledgments

	GAO Contacts

	Acknowledgments

In addition to the contacts named above, Revae Moran, Acting Director;  Tom Short, Assistant Director; Amy Sweet, Analyst-in-Charge; Jeff Arkin,  Analyst-in-Charge; Susan Bernstein; Jessica Bryant-Bertail; Scott Charlton;  Doreen Feldman; Jennifer Gravelle; Maura Hardy; David Perkins; Ellen  Phelps Ranen; Albert Sim; Andrew J. Stephens; and Gregory Wilmoth  made key contributions to this report.

Summary:
Why GAO Did This Study

When employers improperly classify workers as independent contractors instead of employees, those workers do not receive protections and benefits to which they are entitled, and the employers may fail to pay some taxes they would otherwise be required to pay. The Department of Labor (DOL) and Internal Revenue Service (IRS) are to ensure that employers comply with several labor and tax laws related to worker classification. GAO was asked to examine the extent of misclassification; actions DOL and IRS have taken to address misclassification, including the extent to which they collaborate with each other, states, and other agencies; and options that could help address misclassification. To meet its objectives, GAO reviewed DOL, IRS, and other studies on misclassification and DOL and IRS policies and activities related to classification; interviewed officials from these agencies as well as other stakeholders; analyzed data from DOL investigations involving misclassification; and surveyed states.

What GAO Found

The national extent of employee misclassification is unknown; however, earlier and more recent, though not as comprehensive, studies suggest that it could be a significant problem with adverse consequences. For example, for tax year 1984, IRS estimated that U.S. employers misclassified a total of 3.4 million employees, resulting in an estimated revenue loss of $1.6 billion (in 1984 dollars). DOL commissioned a study in 2000 that found that 10 percent to 30 percent of firms audited in 9 states misclassified at least some employees. Although employee misclassification itself is not a violation of law, it is often associated with labor and tax law violations. DOL's detection of misclassification generally results from its investigations of alleged violations of federal labor law, particularly complaints involving nonpayment of overtime or minimum wages. Although outreach to workers could help reduce the incidence of misclassification, DOL's work in this area is limited, and the agency rarely uses penalties in cases of misclassification. IRS enforces worker classification compliance primarily through examinations of employers but also offers settlements through which eligible employers under examination can reduce taxes they might owe if they maintain proper classification of their workers in the future. IRS provides general information on classification through its publications and fact sheets available on its Web site and targets outreach efforts to tax and payroll professionals, but generally not to workers. IRS faces challenges with these compliance efforts because of resource constraints and limits that the tax law places on IRS's classification enforcement and education activities. DOL and IRS typically do not exchange the information they collect on misclassification, in part because of certain restrictions in the tax code on IRS's ability to share tax information with federal agencies. Also, DOL agencies do not share information internally on misclassification. Few states collaborate with DOL to address misclassification, however, IRS and 34 states share information on misclassification-related audits, as permitted under the tax code. Generally, IRS and states have found collaboration to be helpful, although some states believe information sharing practices could be improved. Some states have reported successful collaboration among their own agencies, including through task forces or joint interagency initiatives to detect misclassification. Although these initiatives are relatively recent, state officials told us that they have been effective in uncovering misclassification. GAO identified various options that could help address the misclassification of employees as independent contractors. Stakeholders GAO surveyed, including labor and employer groups, did not unanimously support or oppose any of these options. However, some options received more support, including enhancing coordination between federal and state agencies, expanding outreach to workers on classification, and allowing employers to voluntarily enter IRS's settlement program.