Worker Classification — Is Congress Ready to Take Action?
Worker classification has been a longstanding problem for workers, employers and the government. Focus on the federal tax gap has brought renewed interest to the problem.
December 13 , 2007
by Annette Nellen, CPA/Esq.
Proper classification of workers for tax purposes is important as different rules apply to employees versus independent contractors. Contractors may deduct expenses for adjusted gross income (AGI), owe self-employment tax and take advantage of tax-favored benefit plans for those who are self-employed. Employees have unemployment benefits, split payroll taxes with the employer and can be covered under employer-provided benefit plans.
Some employers misclassify workers to reduce employment tax liabilities. Tax compliance by contractors is not as high as it is for employees. In addition, misclassified workers may be deducting business expenses as a contractor that they would not be able to deduct as employees. And, less federal unemployment tax (FUTA) is collected when workers are misclassified as contractors.
Tax Classification Rules
Generally, for tax purposes, classification of a worker as an employee or a contractor depends on whether the employer has the right to control the worker performing the services with respect to the results to be achieved and the method of achieving the results. A set of 20 common law factors are analyzed to help determine if the right to control exists (Rev. Rul. 87-41, 1987-1 CB 296). There is no specific guidance on how the factors are to be weighted, which along with the nature of the factors, makes for a subjective determination and an increased likelihood of differing interpretations among the parties involved.
In addition, the Revenue Act of 1978 prohibited the IRS from issuing regulations or revenue rulings on worker classification until Congress enacted legislation (“Section 530”). The Act also provided some safe harbors where the IRS may not reclassify workers misclassified as employees for employment tax purposes (see IRS Publication 1976 (PDF) for the basics as well as an IRS Web site on worker classification).
Tax Gap Concerns
Both intentional and unintentional errors exist in the worker classification area. IRS data from 1984 found that about 15 percent of employers incorrectly classified workers as contractors. For workers classified as employees, over 99 percent of compensation was reported. However, when workers were misclassified as contactors, about 77 percent of income was reported if employers filed Form 1099, and only 29 percent if no Form 1099 was filed. (Sole Proprietors’ Tax Gap, GAO-07-1014, p. 64) The General Accountability Office (GAO) estimates that for 2006, this data would indicate an employment and income tax gap of $2.72 billion (GAO, Employee Misclassification (PDF)).
The worker classification issue generates gaps in federal and state income taxes, employment taxes and workers’ compensation payments. A study conducted in Illinois found that misclassification resulted in annual losses of about $39 million in unemployment insurance and $125 million in income taxes (Pinkham, et al., The Economic Costs of Employee Misclassification in the State of Illinois, 5/8/07 testimony).
Worker Classification Proposals
Various proposals have been offered over the years by the GAO, Treasury, the Small Business Administration, members of Congress and others. Such proposals include ones to reduce the number of factors to consider in classifying workers, elimination of Section 530, increased penalties for failure to file a Form 1099 and withholding on payments made to contractors. A 2006 report from the National Taxpayer Advocate included a proposal to not challenge the classification of workers who are a party to a voluntary withholding agreement (testimony of Nina E. Olson, The Causes and Solutions to the Federal Tax Gap (PDF)).
New Tax Form
In October 2007, the IRS released a new reporting form that may help in identifying situations where a worker has been misclassified. Form 8919 (PDF), Uncollected Social Security and Medicare Tax on Wages, must be filed by a worker if employment taxes were not withheld, the worker was not an independent contractor and one or more of seven specified reasons applies to the worker. These reasons include receiving a statement from the IRS that the worker is an employee and filing Form SS-8 (PDF), Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, but not yet hearing back from the IRS. For the following three reasons the individual must have filed a Form SS-8:
Form 8919 calls for information on the employer and the wages paid so the taxpayer can compute the amount of Social Security and Medicare taxes owed. The form will be useful for an employee with an employer who is entitled to Section 530 relief. In such a situation, the worker as an employee, is subject to employment taxes (the employment tax relief is only for the employer and does not apply for income tax purposes).
The form may also encourage more workers concerned that they have been misclassified as contractors to file a Form SS-8 to get a determination from the IRS (and to bring the situation to the attention of the IRS). It may also help the IRS to find workers properly classified as contractors who prefer to be employees and are not paying self-employment tax.
While solutions to the problem have not been enacted, the issue has not been forgotten by Congress. On May 8, 2007, the House Subcommittee on Select Revenue Measures held a hearing on the “Effects of Misclassifying Workers as Independent Contractors.”
Among proposals for improving worker classification rules is S. 2044 introduced in September 2007 by Senator Obama and co-sponsored by Senator Clinton. S. 2044 includes various measures to reduce misclassification situations. Section 530 is cut back significantly by allowing the IRS to reclassify workers, repealing the ban on guidance and removing the safe harbor based on industry practice as a reason for treating a worker as a contractor. Senator Obama notes that S. 2044 will reduce the tax gap by bringing “billions of dollars in unpaid federal taxes … back into the system.”
Worker classification has been a confusing and abused area of the law for decades. Despite numerous proposals over the years, improvements have not been made. With increased focus on the tax gap and attention by Congress and presidential candidates, perhaps legislation will be enacted in the near future. Issues of health insurance and changes in the workforce (such as greater worker mobility, growth of knowledge workers, and fewer employer-provided pensions) may also drive the debate and solutions.
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Annette Nellen, CPA/Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.