Employee Misclassification: Improved Coordination, Outreach, and Targeting Could Better Ensure Detection and Prevention
Released: 2009-09-09T00:00:00

Letter

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.