Independent Contractor Misclassifications Get Worse

The problem of companies evading taxes by misclassifying employees as independent contractors appears to be growing.

A new report by the Treasury Department’s inspector general found that the Internal Revenue Service has taken action to address the problem, but does not yet have any agency-wide employment tax program to coordinate decisions and efforts among its business divisions. Meanwhile the report found that the limited data available indicates that the worker classification issue is growing significantly, causing tax revenues not to be reported or paid.

IRS research indicates that employers often misclassify workers as independent contractors for various reasons. They may do so unintentionally because of a lack of knowledge or because of poor advice. Some employers may have the protection of Section 530 of the Revenue Act of 1978 and, as a result, can legally treat workers as independent contractors who would otherwise be employees. Finally, there are employers who deliberately misclassify workers as independent contractors to cut costs and to gain a greater competitive advantage over employers who correctly treat their workers as employees.

These employers avoid paying their share of employment taxes as well as other expenses such as workers’ compensation, unemployment insurance and other benefits.

Misclassified workers are a significant portion of the employment tax gap, the report noted, but because IRS studies on the issue are over 20 years old, the IRS does not know the size of the problem today and is unable to determine the overall effectiveness of its actions to address this issue. However, the IRS conducted a preliminary analysis of fiscal year 2006 operational and program data and found that underreporting attributable to misclassified workers is likely to be markedly higher than the $1.6 billion estimate from tax year 1984 indicates.

The Treasury Inspector General for Tax Administration recommended that the IRS develop and implement an agency-wide employment tax program to address the issue of worker classification to improve coordination among the business divisions, improve compliance and reduce the tax gap. TIGTA also recommended that the IRS consider conducting a formal study to measure the impact of worker misclassification on the employment tax gap. IRS officials agreed with the recommendations.