Madam Chairman and Members of the Subcommittee: We are pleased to be here to assist the Subcommittee in its inquiry into the classification of workers either as employees or independent contractors for federal tax purposes. Proper classification of workers has been the subject of several of our reports and congressional testimonies. Today, I would like to make 4 points taken from these reports and testimonies. • First, in deciding how to classify workers, employers may misclassify employees as independent contractors. In its most recent estimate on misclassification, IRS has estimated that 756,000 of 5.15 million employers (15 percent) misclassified workers as independent contractors in 1984. Many factors can cause misclassification, including cost considerations and confusion over the classification rules. For example, not incurring the costs of employment taxes (i.e., social security tax, unemployment tax, and income tax withholding) and employee benefits can give employers cost advantages over competitors who use employees. Further, both we and the Treasury Department have found that the common law rules used for classifying workers are unclear and subject to conflicting interpretations. • Second, even with the confusing rules, IRS is responsible as the nation’s tax administrator to enforce compliance with them. Under its Employment Tax Examination Program (ETEP), IRS has completed 12,983 audits, resulting in $830 million in recommended tax assessments and 527,000 workers reclassified to “employee” status between fiscal years 1988 and 1995. • Third, deliberations over any changes to the classification rules may need to consider potential impacts on income tax compliance. IRS has found that independent contractors compared to employees have lower compliance in paying income taxes and account for a higher proportion of the income tax gap. We identified two approaches that could boost independent contractor compliance within the existing common law rules. They include (1) improved information reporting on payments made to independent contractors and (2) withholding income taxes from such payments. • Fourth, aside from tax issues, an important consideration in these deliberations is the body of laws that create a safety net for American workers. Such laws generally apply only to employees. If changes to the classification rules lead to more workers being classified as independent contractors instead of employees, these worker protection laws would cover fewer people. I would like to discuss each of these points in more detail after providing an overview on factors that affect the classification decision. The rules for classifying a worker as either an employee or an independent contractor come from the common law. Under common law, the degree of control, or right to control, that a business has over a worker governs the classification. Thus, if a worker must follow instructions on when, where, and how to do the work, he or she is more likely to be an employee. IRS has adopted 20 common law rules to help employers classify workers (see appendix I). If workers are determined to be employees, employers must withhold and deposit income and social security taxes from wages paid as well as pay unemployment taxes and the employers’ share of social security taxes. In addition, the employers may be subjected to laws that govern the use of employees and any benefits provided to them. Employers do not have these responsibilities if the workers are independent contractors. Independent contractors must pay their own income and social security taxes on payments received. They have no unemployment tax responsibility but may purchase benefit packages to cover this contingency as well as others (e.g., health insurance). Ultimately, the decision to classify a worker as an employee or independent contractor depends on each employer’s circumstances. And, the extent to which a worker accepts the classification and understands its consequences plays a role. misclassification involved all industry groups and up to 20 percent of the employers in some industry groups. This noncompliance produced an estimated tax loss for 1984, after accounting for taxes paid by the misclassified independent contractors, of $1.6 billion in social security tax, unemployment tax, and income tax that should have been withheld from wages. In another set of estimates, IRS issued an employment tax gap report in 1995 that included the estimated tax gap associated with misclassification. This estimated tax gap was $2.3 billion in 1987 and $3.3 billion in 1992 for just social security and unemployment taxes. In doing these estimates, IRS did not identify the reasons for the misclassification but factors such as costs and unclear classification rules can play a role. For example, employers can lower their costs, such as payments of employment taxes or benefits, by using independent contractors. This cost advantage could be offset if an independent contractor can negotiate higher payments to purchase their own health, retirement, or other benefits. Otherwise, the incentive to misclassify workers as independent contractors exists. Second, many employers struggle in making the classification decision because of the unclear rules. Until the classification rules are clarified, we are not optimistic that the confusion over who is an independent contractor and who is an employee can be avoided. The Treasury Department characterized the situation in 1991 in the same terms as it used in 1982; namely, that “applying the common law test in employment tax issues does not yield clear, consistent, or satisfactory answers, and reasonable persons may differ as to the correct classification.” the cases reviewed, section 530 prohibited IRS from assessing $7 million of $17 million in recommended taxes and penalties against employers for misclassifying employees. The employers usually avoided the assessments by claiming a prior audit protection, even when the prior audit did not address employee classification or occurred over 20 years earlier. Section 530 also has precluded IRS from issuing clarifying regulations since 1978. IRS is responsible as the nation’s tax administrator to enforce the classification rules. Because of concerns about misclassification and income tax noncompliance by independent contractors, IRS centralized a portion of its employment tax compliance efforts into an Employment Tax Examination Program (ETEP) during 1987. IRS’ strategy was to identify any misclassification and require employers to correct it. Employers whose employees are reclassified are liable for the portion of the employment taxes that they would have owed if the worker had been classified as an employee for the audited tax years. From 1988 through 1995, IRS completed 12,983 ETEP audits. These audits recommended $830 million in employment tax assessments and reclassified 527,000 workers as employees. In addition, the IRS Examination Division auditors, as part of their regular income tax audits, also may address classification issues. However, the Examination Division does not accumulate data to identify audit results on these issues. Since late 1995, IRS has implemented initiatives to improve its enforcement of the classification rules and ease the burdens on those being audited. For example, IRS is revising its training to better ensure consistent application of the rules. IRS has circulated a draft of its training program so that employers know how IRS intends to interpret the rules. Further, IRS is testing ways to expedite and improve the settlement of disputes with employers over misclassification. These initiatives are too new for us to know whether they are working. Since 1977, we have supported measures to simplify the classification rules. However, the development of clearer rules for all types of working relationships and businesses is neither simple nor easy. In an effort to clarify the classification rules, we proposed a straightforward test in 1977 (see appendix III for details of this proposal). In sum, we proposed excluding workers from the common law definition of employee when they met each of four criteria. If the worker met three of the criteria, we proposed that the common law criteria should be applied. Otherwise, we proposed that the worker should be considered an employee. Our proposal was not widely accepted for various reasons, which we had recognized. For example, Treasury and IRS were concerned about lower tax compliance and lost tax revenue from having more self-employed workers and fewer employees. We have viewed our 1977 proposal as a good starting point for clarifying the classification rules. In doing so, the deliberations also may need to consider the potential impact on income tax compliance. IRS studies since the 1970s have documented a much lower level of income tax compliance by independent contractors compared to employees. IRS data for 1988 suggest that independent contractors accounted for most of the income tax gap created by those self-employed individuals who underreported their business income. do not distinguish between independent contractors and other self-employed individuals such as those who make or sell goods. Recognizing these concerns, our 1992 report identified other approaches to improve independent contractor compliance within the framework of the existing classification rules. These approaches would (1) require businesses to withhold taxes from payments to independent contractors or (2) improve information reporting on payments made to independent contractors. While each approach would increase to some extent the burdens on independent contractors and businesses that use them, we believe each approach can help improve income tax compliance. For example, withholding is the cornerstone of our tax compliance system for employees. It has worked well with over 99 percent of wages voluntarily reported. In addition, it provides a gradual and systematic method to pay taxes and better ensure credit for social security coverage. As early as 1979, we concluded that noncompliance among independent contractors was serious enough to warrant some form of tax withholding on payments to them. We continue to believe that withholding taxes from payments made to independent contractors has merit as a way to improve their income tax compliance. Several administrative problems would need to be resolved. For example, independent contractors with substantial business expenses, which lower taxable income, may have too much tax withheld from gross payments made to them. Appendix IV discusses such problems and possible solutions. returns but only 29 percent of the income not covered by information returns. While other options may exist, our 1992 report identified eight options that could strengthen information reporting and close potential loopholes: (1) Significantly increase the $50 penalty for not filing an information return. (2) Do not penalize businesses for past noncompliance with information reporting laws if they begin to file information returns when the penalty is increased. (3) Require IRS to administer an education program to make the business community aware of the filing requirement and of IRS’ intention to vigorously enforce it. (4) Lower the $600 reporting threshold for payments to independent contractors. (5) Require information reporting for payments to incorporated independent contractors. (6) Require businesses to separately report on their tax return the total amount of payments to independent contractors. (7) Require businesses to validate the tax identification numbers (TIN) of independent contractors before making any payments and withhold a portion of the payments until the TIN is validated. (8) Require businesses to provide independent contractors with a written explanation of their tax obligations and rights. Each of these options involves tradeoffs between taxpayer burden and tax compliance. Appendix V summarizes the pros and cons of each option. contractors. Changes to the classification rules could increase the number of unprotected independent contractors. For example, unemployment insurance is nearly universal, covering over 90 percent of American workers. This 60-year old program provides short-term financial support for covered workers who, through no fault of their own, become unemployed. It also helps the unemployed from having to turn to public assistance programs. During economic downturns, payments made to the unemployed may take on added significance, serving a macro-economic role of helping to stabilize the economy. However, federal law does not require coverage of independent contractors for unemployment insurance, although one state (California) has provisions that would allow independent contractors to apply for self-coverage. While we have not made an extensive survey to determine all affected laws, they are quite numerous. They include basic protections involving issues such as minimum wage, mandatory overtime pay, discrimination, occupational safety and health requirements, workers compensation insurance, and employer-sponsored fringe benefits such as pensions. Thus, if clarification of the classification rules pushes significantly more employees into independent contractor status, the worker protection laws would cover fewer people. Madam Chairman, this concludes my testimony. I would be pleased to answer any questions you or other members of the Subcommittee may have.

Summary: GAO discussed the classification of workers as employees or independent contractors for federal tax purposes. GAO noted that: (1) the Internal Revenue Service (IRS) has adopted 20 common law rules to help employers classify workers; (2) the rules require employers to withhold and deposit income and social security taxes, and pay the unemployment and social security taxes for workers determined to be employees; (3) employers that use independent contractors do not have these responsibilities because they pay their own social security and income taxes; (4) classifying a worker as an employee or independent contractor depends on the employer's circumstances, and the extent to which the worker accepts the classification; (5) in 1984, IRS estimated that about 756,000 employers misclassified their workers as independent contractors; (6) this noncompliance resulted in an estimated tax loss of $1.6 billion; (7) misclassifications occur because it is cheaper to hire independent contractors, but the rules for doing so are unclear; (8) IRS completed 12,983 employment tax examination program audits from 1988 to 1995, and recommended $830 million in employment tax assessments and that 527,000 workers be reclassified as employees; and (9) IRS is revising its training program to better ensure consistent application of common law rules, circulating a draft of its training program so that employers know how to interpret the rules, and testing ways to expedite disputes over worker misclassifications.