The Law of Unintended Consequences has struck again! In 2009, the stimulus package distributed huge sums of money to the housing industry to be spent on affordable housing. The money was to be managed by Housing and Urban Development (HUD). Five years later, the evidence is growing that these programs inadvertently contributed to the business practice widely adopted by the construction industry to improperly classify workers as independent contractors.
An investigation in North Carolina by The News & Observer and Charlotte Observer identified nearly $470 million dollars each year in uncollected federal and state tax revenue. In the wake of other investigative journalism revealing that construction companies in 28 states have knowingly misclassified their workers, we are once again looking at the issue of misclassification, and why it matters.
For the novice, misclassification is the practice of listing one’s own workers as independent contractors to cut costs. Cases of unsuspecting workers being exploited through this illegal practice abound, and keep surfacing while the employers who are not caught continue along on their merry path, unperturbed.
Why is the practice continuing, given the numerous efforts of Internal Revenue Service to eliminate it? In previous blogs, we have described increased funding for IRS investigators and amnesty programs offered by many states for companies who acknowledge improper classification.
The government has now proposed a Payroll Fraud Prevention Act that prohibits employers from wrongly classifying an employee as a non-employee to cover non-standard work arrangements.. The Act doubles the amount of liquidated damages for maximum hours, minimum wage and notice of classification violations, while subjecting violators to a civil penalty of up to $1,100 for each violation and a penalty of up to $5,000 for each repeat or willful violation.
The IRS simplifies its common-law rule further to read: Anyone who performs services for you is your employee if you can control what will be done and how it will be done.
Employers are mandatorily required to issue a classification notice to both non-employees and employees describing the various workers’ classification statuses as an employee or non-employee; along with the link to a DOL website which details the rights of employees under the new law; and instruct workers to contact the DOL if they wish to clarify their own classification status. Penalties for non-compliance with this requirement are also heavy.
Why is the promulgation of a new Payroll Fraud Prevention Act considered necessary? Why is non-compliance so prevalent in certain industries or locations? In the construction industry, the practice has been attributed to the pressure to win government bids by being the low-cost supplier, the need to control construction costs when building materials are skyrocketing, the increasing population of immigrants who are uninformed of their rights or desperate for work taking on these low-paying jobs, and the decline of unions in America. Whatever the reason, the illegality of misclassification has not to date been a deterrent to this practice.
These malpractices continue mainly because the IRS can audit only about 3% of potential violators in a year, making the chances of being caught quite low. Traditionally, the focus of IRS audits has been on larger employers. This allows small employers who employ low wage earners to escape the net, taking the level of misclassification in some states above 35%. The IRS also finds it difficult to collect taxes from workers who file r tax returns as independent contractors, mainly because they under-report their wages. Some estimates of this understatement are as high as 56% to 81%.
Effects of Misclassification
Misclassification impacts all of us.
o An injury on the job will not require the company to cover medical bills.
o The worker will not merit unemployment insurance if laid off.
o The worker will not benefit from employer contributions to social security or other benefits.
Misclassifying workers to keep costs down and avoid taxes cannot be a business decision. Misclassifying workers or working with suppliers that misclassify their workers is a drain on the economy, and carries with it risks that can extend as far as the failure of your company.
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