This post was contributed by Tony D. Dick Esq., an Associate in McNees Wallace & Nurick LLC’s Labor and Employment Practice Group in Columbus, Ohio.

In recent weeks, identical bills were proposed in the House (H.R. 4123) and Senate (S. 2145) to eliminate the so-called “safe harbor” in the federal tax code that protects businesses that have misclassified employees as independent contractors and, thus, have avoided paying payroll taxes, unemployment insurance, workers’ compensation premiums and other costs. These bills mark the second time in 18 months that such legislation has been put forward. Though unlikely to pass, especially in this gridlocked Congress, the bills are just the latest in a number of recent endeavors by state and federal lawmakers and law enforcement agencies to curb independent contractor misclassification.

While the bills recognize that many workers are properly classified as independent contractors, the U.S. Department of Labor (DOL) estimates that as many as 30% of employers are misclassifying employees as independent contractors. According to the IRS, approximately $54 billion in tax revenues are lost annually because of independent contractor misclassification.

In light of these large numbers, this past September, the IRS and DOL announced a joint initiative aimed at businesses that misclassify employees as independent contractors. Under the agreement between the two agencies, the IRS and DOL will begin to share information with each other and coordinate vigorous efforts to crack down on the misuse of the independent contractor designation. The agencies will also provide educational materials to businesses using independent contractors and to employees who may be misclassified. 

For employers who cannot take advantage of the safe harbor, the IRS also announced an employment tax “amnesty” program that allows businesses to rectify past independent contractor misclassifications at a reduced cost. 

The IRS’s Voluntary Classification Settlement Program permits employers to prospectively reclassify independent contractors as employees. Employers who choose to participate in the program will only have to pay 10% of the employment tax liability that would have been due for the most recent tax year.   Self-reporting business will not only avoid interest charges and penalties, but also will not be subject to IRS audits of their payroll taxes for prior years. Of course, participating employers are required to treat the reclassified workers as employees and pay all applicable state and federal payroll taxes going forward. 

While the program may help employers avoid federal employment tax obligations, it has its drawbacks. Nothing in the IRS’s amnesty plan prohibits DOL or the previously misclassified workers, themselves, from pursuing claims against the self-reporting company, including claims for unpaid overtime wages and other penalties. Moreover, those that avail themselves of the program are not shielded from state agencies who seek to redress misclassifications.

The DOL and IRS announcements dovetail with President Obama’s most recent federal budget, which sets aside $46 million to combat independent contractor misclassifications, including $25 million for grants to states to identify misclassification and recover unpaid taxes and $15 million for additional personnel in DOL’s Wage and Hour Division to investigate misclassification.

States have also stepped up efforts to eliminate independent contractor misclassification. A growing number of states, including Ohio, New York, New Jersey, Massachusetts, Michigan, Iowa and Oregon have created their own misclassification task forces comprised of various state workforce and tax agencies. Dozens of states have also entered into Memorandums of Understanding with DOL to share information about companies that have misclassified independent contractors. In addition, more than 20 states have passed legislation aimed at ending the misuse of independent contractor status. Many of these laws are industry specific.

In Pennsylvania, for example, the Construction Workplace Misclassification Act was signed into law in late 2010. Under the law, an individual that performs construction work may be classified as an independent contractor only if the individual: (1) has a written contract; (2) is free from control regarding the manner in which he/she performs services; and (3) is customarily engaged in an independently established trade, business, or profession. Delaware has also enacted a law that presumes construction workers are employees, rather than independent contractors, unless the employer demonstrates the individual meets an enumerated test. And, in Maine, workers in the trucking and messenger service industries are presumed to be employees unless the employer can prove otherwise. Under these statutes, penalties for misclassification can include monetary fines, stop work orders, and even criminal charges.

Massachusetts, on the other hand, has taken a different tact. The state recently created a law that actually allows private citizens to sue companies that have misclassified independent contractors. Under the law, the plaintiffs are entitled to recover 25% of workers’ compensation premiums not paid by an employer due to non-compliance, plus liquidated damages. The remainder is deposited into the state’s Workers’ Compensation Trust Fund.

None of these efforts should come as a surprise given the fragile economy and ever-widening budget deficits. Given federal and state misclassification initiatives, employers must recognize that the classification of independent contractors can create significant risk. Unfortunately there are no bright-line tests for determining the proper classification of workers. When creating new positions and evaluating existing ones, employers should give careful consideration to the various factors used to distinguish between employees and independent contractors, properly document the nature and functions of the position, and avoid actions that are inconsistent with those classifications and applicable law. 

Where a position poses a close call, legal counsel should be consulted. Additionally, an employer considering participation in the IRS amnesty program should discuss the options with an attorney.  Otherwise, you may be exposing your business to significant and potentially avoidable liability.