Misgivings of Misclassification of Workers: Tax Gaps.

Author:McGee, Paul F.


In recent times, discussions on television or radio and news articles in popular newspapers regarding the 'gig economy', 'independent contractors vs. employees', and the growth of temporary employment have become quite common and frequent. Often, these discussions revolve around two main themes: 1) labor standards and other rights for independent contractors and 2) loss of government revenue at both state and federal levels. Both themes tend to become more complex when the possibility of misclassification of employees as independent contractors is added in the mix. Carre and Wilson (2004) summarized the extent and cost of misclassification in the construction industry in Massachusetts. National estimates for independent contractors increased from 6.7 percent to 7.9 percent of the labor force (United States General Accountability Office, 2015). These estimates differ depending upon the source because the definitions of temporary workers or contingent workers or independent contractors vary. However, it is beyond dispute that the share of people choosing the contingent work style is and will continue to be on the rise (Agostino & Krieger, 2015). This paper offers a summary progress report on the misgivings of misclassification with a discussion on loss of tax revenues.

The first section will survey the issues surrounding the use of independent contractors, the current tests used by the different branches of the federal government including the Internal Revenue Service. The article will then explore the costs of misclassification and the steps taken by some states to reduce or eliminate these costs. Loss of tax revenues by various branches of government are examined in the third section. The conclusion and opportunities for future research section will offer some recommendations for reducing the inappropriate misclassification of employees in the future such as in providing some continuity between states and the federal government definitions and tests to determine independent contractor status. The need for standardizing a myriad of diverse tests used in determining a worker's status and developing better databases for tracking is heightened so that benefits for workers and government revenues are not negatively impacted on a continuing basis.


In an earlier paper (Goodof & Christenson, 2015), the authors discussed in detail the costs and benefits of use of independent contractors rather than employees. According to them, in a normal situation, competitive advantage arises from the introduction of new products or services, from securing a patent, having the ability to produce a product at a cheaper price, being first into a new market, or having a niche product (Porter, 1985). Competitive advantage can also arise from the careful use of independent contractors and in a number of cases from the misclassification of workers as independent contractors. The use of independent contractors is not illegal. To the contrary, if properly used, employers are able to gain a great deal of flexibility leading to significant cost savings. Utilization of contractors fills specialized needs and works as a buffer for changing economic conditions. This common form of 'non-standard employment' is frequently used during periods of unexpected increases in demand for goods and services (Stone and Arthurs, 2013). There are a number of ramifications, however, when workers are misclassified as independent contractors (Goodof & Christensen, 2015).

An independent contractor should be exactly what the name describes, independent (Moran, 2010). The definition from Black's Law Dictionary (2011) defines the independent contractor as one assigned a specific task but left alone to determine how to accomplish it. This definition gives little help in determining who is an independent contractor but is the basis of a number of state statutes defining independent contractors. The Internal Revenue Service and the states have dealt with the definition issue for a number of years. In the society in which we now live, the tax ramifications have been huge. Independent contractors pay their own taxes whereas employees have their taxes withheld by their employers. The issue of who is or is not an independent contractor does not solely impact the area of employee benefits and owners' profits, but also the collection of taxes in this era of budget deficits.

Federal Government Agency Definitions

There is no universally accepted standard for determination of independent contractor status. The Employer's Supplemental Tax Guide 2016 defines independent contractors as "people such as doctors, veterinarians, and auctioneers who follow an independent trade, business, or profession in which they offer their services to the public, are generally not employees" (DPE Fact Sheet, 2016; I.R.S., 2016). However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor when the person for whom the services are performed only has the right to control or direct the result of the work and not the means and methods of accomplishing such result. This definition is not really very helpful and, in fact, creates confusion among all parties as each case may differ as to the result and rarely does one only direct the result. In addition, there are a number of tests that are used depending on the unit of government examining a case.

The Internal Revenue Service had a twenty factor test that was utilized to determine the proper classification of an independent contractor (Moran, 2010). The twenty factors were divided into three categories; behavioral control, financial control and relationship of the parties. Some of the factors included, inter alia, instructions, training, order or sequence, assistance, furnishing of tools or equipment and materials, reports, payment by salary, work on premises, set hours, not working for others or for the public, lack of investment, payment of business expenses, not realizing profit or loss, rendering services personally, continuing relationship, right to discharge or terminate (Moran, 2010). The IRS (2016) has now simplified its test into the following three factors; (i) behavioral control (directing how the job is done), (ii) financial control (controlling the business aspects of the job) and (iii) relationship between the parties (how the parties perceive themselves) (Agostino & Krieger, 2015). The U.S. Department of Labor and other agencies have different definitions to determine status. Federal courts have used the common law test of right to control the work process in cases involving the Federal Insurance Contributions Act, Federal Unemployment Tax Act, Income tax withholding, Employment Retirement and Income Security Act, National Labor Relations Act. The Courts have used an economic realities test for the Fair Labor Standards Act, Title VII of the Civil Rights Act of 1964, Age Discrimination in Employment Act, Americans...

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