Close-up of paycheck being handed to someone.

Overview

Employee misclassification is the practice of labeling workers as independent contractors, rather than employees. The practice allows employers to avoid paying unemployment and other taxes on workers, and from covering them on workers compensation and unemployment insurance. 

The practice reduces labor costs for the employer but creates an unlevel playing field when businesses are involved in competitive bidding on projects. Sometimes referred to as the "underground economy," employee misclassification also has negative consequences for state and federal governments, which are being shorted millions of dollars in tax revenue. Workers who are misclassified as independent contractors work without the legal protections typically afforded to employees, such as wage and hour laws, workers compensation, and unemployment benefits.

Legal Considerations

Defining an employee is a complex issue, involving laws, rules, court cases, and myriad state and federal agencies. The simplest standard is that if an employer has the right to control the work, the worker is an employee, not an independent contractor. More complicated standards require that an employer exercise behavioral and financial control over the worker for the worker to be considered an employee. Factors include the amount of direction provided over the means and results of the work, the possibility of profit or loss for the worker, and whether the worker is free to provide similar services to other businesses.

While the legal requirements are complex and may result in inadvertent miscategorization of workers, a big incentive in misclassifying workers is the savings on labor costs, which typically are a major portion of overhead for businesses. It’s estimated that a business can save 30 percent of their labor costs by using independent contractors rather than employees. That provides a real incentive for businesses to classify their workers as independent contractors, even if the workers are truly employees. While not always a deliberate attempt to flout the law, such savings allow a business to gain a competitive edge over other businesses.

Businesses must abide by state and federal labor laws, including minimum wage and overtime laws, for their employees. Independent contractors are not protected by most state and federal employment laws, including the Fair Labor Standards Act.  They have no workers' compensation coverage if they are injured on the job and are not entitled to unemployment benefits should they lose their job.

Implications

Misclassification of workers has serious consequences for state and federal governments. Improperly classifying workers as independent contractors rather than employees deprives the state and federal governments of properly due tax revenue, including income, Social Security, Medicare, and unemployment taxes, that are needed to pay for public services and benefits such as unemployment insurance.

A report by the Government Accountability Office estimated that in 2006 alone, the federal government lost out on $2.72 billion in Social Security, unemployment, and income taxes because of employee misclassification. States report similar tax losses. Rhode Island estimated that more than 6 percent of its workers were improperly classified as independent contractors, costing the state an estimated $50 million in uncollected income, unemployment, and other payroll taxes. A study on misclassification in Illinois showed the state lost close to $125 million in income tax revenue from 2001 to 2005.  A New York task force investigating workplace fraud found that, in 2008, misclassification cost the state more than $4.8 million in unemployment taxes alone, a significant loss when that tax revenue is needed to pay unemployment claims.

Employers pay taxes on employees, but not on independent contractors, so misclassification of workers may result in tax evasion. For an employee, a business must withhold income, Social Security and Medicare taxes from the employee’s wages, plus pay the employer’s share of Social Security and Medicare taxes, pay unemployment taxes, and provide workers compensation insurance coverage. If a worker is considered an independent contractor, the worker is responsible for paying their own income and self-employment taxes, which can result in underpayment of taxes if a worker does not understand or comply with these obligations.  

State Action

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Federal Action

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