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Monday, January 9, 2012

Tax Gap: Misclassification of Employees as Independent Contractors

James M. Bickley
Specialist in Public Finance

The misclassification of employees as independent contractors contributes to the tax gap. Consequently, congressional interest has been expressed about the importance of the proper classification of workers. The Internal Revenue Service (IRS) defines the gross tax gap as the difference between the aggregate tax liability imposed by law for a given tax year and the amount of tax that taxpayers pay voluntarily and timely for that year.

A business owner must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In contrast, a business owner does not have to withhold or pay any taxes on payments to independent contractors. Employers are more likely to withhold and submit taxes than independent contractors are to voluntarily pay their tax liabilities. In 1984, the IRS made its last comprehensive misclassification estimate, which found that 15% of employers misclassified 3.4 million workers as independent contractors, causing an estimated total tax loss of $1.6 billion in Social Security tax, unemployment tax, and income tax.

Under common-law rules, a worker is an employee if the employer can control what the worker does and how the worker does it. The definition of “employee” has been affected by Section 530 “Safe Harbor Rules,” IRS Ruling 87-41, and current IRS common law rules. Congress enacted Section 530 of the Revenue Act of 1978 (P.L. 95-600), which established “safe harbor rules” generally allowing an employer to treat a worker as not being an employee for employment tax purposes, regardless of the individual’s actual status under the common-law test. In January 1987, the IRS issued Revenue Ruling 87-41 specifying 20 factors that identified whether or not an employee-employer relationship existed under common law. Currently, the IRS states that three categories of common-law rules provide evidence of the degree of control and independence: behavior, financial, and type of relationship.

On February 4, 2009, the Treasury Inspector General for Tax Administration (TIGTA) issued a report concerning IRS actions to address the misclassification of employees as independent contractors. In the 112th Congress, two companion bills have been introduced concerning the misclassification of employees: the Payroll Fraud Prevention Act (S. 770) and the Employee Misclassification Prevention Act (H.R. 3178). In his FY2012 budget, President Barack Obama proposed to “increase certainty with respect to worker classification” by a modification of the Section 530 of the Revenue Act of 1978. In September 2011, the IRS announced two new programs concerning misclassification of employees: a “Memorandum of Understanding” with the Department of Labor and a new “Voluntary Classification Settlement Program.”

In conclusion, the misclassification of employees as independent contractors contributes to the tax gap and imposes numerous costs on the economy. A reduction in this misclassification would reduce federal, state, and local tax gaps and provide other important benefits. But, this decline in misclassification would impose significant costs. Accurate data on the current size of the tax gap caused by misclassification are unavailable. Furthermore, the magnitude of many effects of improved classification are unavailable or inherently subjective. With the current state of knowledge, whether or not the benefits of curtailing misclassification of workers outweigh the costs is a value judgment.

Date of Report: December 23, 2011
Number of Pages: 18
Order Number: R40807
Price: $29.95

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