Every day, the vast majority of working Americans and their employers get up, go to work, and play by the rules.  They pay their taxes and recognize their responsibilities to each other.  And they recognize that as employers and employees, they are engaged in a common effort to provide goods and services to customers in a competitive marketplace.  And all that they ask for is a fair and level playing field.  But today, a tax loophole tilts the playing field against those playing by the rules.

The Section 530 safe harbor in tax law currently encourages some employers to avoid paying their taxes in full and deny their employees basic protections, thereby placing employers who play by the rules at a disadvantage, striping the government of billions in uncollected business taxes, and exposing employees to a loss of overtime, workers compensation, and other protections.  The problem is particularly acute in the construction industry, but it also exists in other growing industries, ranging form high-tech, to trucking, to janitorial services, to home care. 

We are introducing the Independent Contractor Proper Classification Act of 2007 (ICPC) to fix the problem and treat all workers and employers properly and fairly.  That should lead to better tax compliance, fair pay and benefits, proper coverage in workers’ compensation, and competition on a level playing field for workers and business.

A 2006 University of Missouri study of employee misclassification in Illinois found that between 2001 and 2005 the percentage of misclassified employees in the state went from 5.5% to 8.5%, a 55% increase.  It also estimated that misclassification of workers in 2005 resulted in a $53.7 million loss of unemployment insurance taxes and a $149 million to $250 million loss of income tax, and that $97.9 million in workers’ compensation premiums were not paid properly in 2004.  There are other studies out of New York, Massachusetts, and Maine that show similar outcomes.

The way it works is this, an employer can cut its payroll costs by up to 30% if it calls a worker an “independent contractor” instead of an “employee” and issues a Form 1099 instead of Form W-2 to the Internal Revenue Service (IRS). As long as it treats like workers the same, the employer does not have to withhold taxes from the worker’s pay, forcing workers to pay all their own payroll taxes as if he or she were self-employed.  And, at the same time, the employers fail to pay their fair share of federal and state payroll taxes.  Section 530 bars the IRS from penalizing the employer if he falls under the safe harbor, requiring a change in the treatment of workers even if the IRS concludes that those workers should be treated as employees, and it bars the IRS from writing rules, regulations and guidance on the matter.

Genuine independent contractors make up a small part of the American workforce because, by definition, an independent contractor operates his or her own business.  They have specialized skills, they invest capital in the business, and they perform a new service, not just routine services already that other workers already provide.  Most workers, especially in labor intensive jobs like construction are not operating a business of their own.

There are legitimate independent contractors in every industry.  And it is not our intent to undermine their work.  By ensuring that the IRS can require employers to properly classify the people working for them as well as give them guidance on how to do that, we will ensure that both true independent contractors and true employees are treated as such.

This legislation will close the Section 530 loophole.  It will allow the government to collect the taxes employers owe and level the playing field for all workers and employers.  The legislation will also address the serious need for more enforcement of federal tax and employment laws to identify those employers in major industries that wrongly classify their workers as independent contactors and require greater cooperation between the IRS and the Department of Labor in enforcing the law.

In the end, everyone is a winner.  The vast majority of  employers who pay their fair share of taxes and recognize their workers as employees will be able to compete on a level playing field against employers who will held accountable for cheating the system.  Workers benefit by receiving the basic employment rights of all other employees.  And the “tax gap” is narrowed by collecting literally billions of dollars in unpaid federal taxes that are now denied the federal treasury due to misclassification of independent contractors.

Opposition to closing this loophole would favor businesses not complying with their obligations to their workers or complying with their tax obligations over those playing by the rules.  Maintaining the status quo would be a disservice to all employers competing in the marketplace and doing the right thing.

The legislation we are introducing will end the practice of allowing employers to continue to misclassify workers for employment tax purposes and eliminate the employer’s defense that misclassification is a common practice in the employer’s industry.   Thus, in industries like construction, where especially large numbers of employers misclassify their workers, the safe harbor provision will no longer apply just because it is common practice in the industry to violate federal laws.

Also, our legislation allows the IRS to write rules, regulations, and guidance for employers on how to properly classify their employees for employment tax purposes.  Current law bars the IRS from writing rules, regulations, and guidance on this matter.  To help beef up enforcement of existing tax laws, the bill also improves on an IRS procedure that allows individual workers to ask the IRS to make a determination whether they are, in fact, wrongly classified as independent contractors by their employers.

Of special significance, the legislation would also require the IRS to communicate with the Department of Labor because employers who misclassify employees for tax purposes, may also be misclassifying workers to avoid compliance with any number of labor laws including minimum wage and overtime pay.  It also requires the DOL to start tracking misclassification cases to get a better handle on the true scope of the problem.

Finally, the legislation would require employers to notify independent contractors of their rights, including their right to seek a determination from the IRS about whether they are properly classified as an independent contractor.

The GAO has reported that at least 10 million workers in the United States are classified as independent contractors, which is an increase of more than two million workers in just six years.  Other studies have found that as many as 30% of employers misclassify their workers as independent contractors, especially in problem industries like construction.  Meanwhile, the U.S. Department of Labor still fails to track how many workers are denied minimum wage and overtime pay despite the rampant problem of misclassification of independent contractors. 

A 2006 University of Missouri study of employee misclassification in Illinois found that between 2001 and 2005 the percentage of misclassified employees in the state went from 5.5% to 8.5%, a 55% increase. 

While many workers are legitimately employed as independent contractors, those who are not are denied worker’s compensation, overtime pay, and the other benefits due them, while their employers fail to pay their payroll taxes.  And employers playing by the rules should not have to compete with employers who are not playing by the rules.

The following studies have quantified the problem:

The Section 530 Safe Harbor requires the IRS to excuse misclassification and allow an employer to continue reporting employees as 1099 independent contractors if the employer (1) has been treating similarly situated workers as independent contractors, (2) has been consistently reporting the workers as independent contractors to the IRS and has been issuing 1099’s to the workers or (3) has a reasonable basis to classify employees as subcontractors.  The first two are known as the consistency requirements.

A consistent employer still needs to satisfy the reasonable basis test.  The reasonable basis test is satisfied if the employer (a) reasonably relied on a court decision or IRS ruling issued to the employer, (b) was a subject of an IRS employment-classification audit of similarly situated workers and the IRS did not reclassify the workers, and (c) relied on a long-standing practice of a significant segment of the industry.  

So an employer can be misclassifying his workers, but as long as he does it consistently and other people in the industry do it too, the IRS can do nothing about it.  And the law also bars the IRS from writing rules, regulations, or guidance on compliance with the law on this issue, thereby further discouraging compliance.

Lastly, the U.S. Department of Labor has failed to aggressively enforce the minimum wage and overtime laws to identify and prosecute cases where low-road employers misclassify their workers as independent contractors. Indeed, the agency in charge of enforcing the nation’s wage and hour laws does not even track cases where employers routinely violate the federal law by misclassifying their workers as independent contractors.    

Section 2:  Reformation of Safe Harbor to Close its Use as a Tax Loophole

• Amends Section 530 to allow the IRS to require employers to reclassify workers that they have misclassified in the past.
• Eliminates the ban on the IRS issuing regulations or revenue rulings on employee/independent contractor status.
• Eliminates the ability of employers to rely on others in the industry misclassifying employees as a basis for continuing to misclassify their employees.

• Directs the IRS to develop a process for workers to ask for an evaluation of their proper classification.
• It requires safeguards against employer retaliation and payment of attorney’s fees to employees who were misclassified.
• Directs the IRS to audit employers if an employee requests an evaluation of their classification and the IRS finds that the employee was misclassified; and
• Directs the IRS to inform the Department of Labor of misclassification practices.

• IRS and DOL are required to issue annual reports on misclassification and their efforts to curtail the practice.
• Requires the DOL to conduct investigations in industries that IRS data show to have high rates of misclassification for tax purposes and to track cases involving misclassification of independent contractors involving the Wage and Hour Division.

• DOL will provide information on any poster required under the FLSA of the employee right to challenge their status as an independent contractor.
• Requires each employer to notify any independent contractor of their federal tax obligations as an independent contractor, the labor and employment law protections that do not apply to independent contractors, and the right of the independent contractor to seek a classification determination from the IRS.
• Requires employers to retain for three years a list of the independent contractors they have hired.