Since 2009, the U.S. Department of Labor (DOL) has been cracking down on misclassification of workers. The DOL has just issued another document that confirms its determination to enforce those provisions of the Fair Labor Standards Act and the Internal Revenue Code that require employers to do the following for employees (but theoretically not for independent contractors):

  1. Withhold income taxes on the employee’s wages.
  2. Withhold Social Security taxes (FICA) and withhold Medicare taxes.
  3. Transfer the withholdings to the Internal Revenue Service (IRS).
  4. Pay unemployment compensation taxes (FUTA).
  5. Pay the employer’s share of Social Security and Medicare taxes.

The document is a memorandum issued by David Weil, the administrator of the Wage and Hour Division of the DOL and stresses that businesses need to start with a presumption that a worker is an employee.

Businesses often try to classify workers as independent contractors because it saves the employer money: the employer does not have to pay Social Security and Medicare taxes for independent contractors. Paperwork is also reduced because the business doesn’t have to withhold income tax, Social Security tax, or Medicare tax and prepare the forms necessary to transfer the withholdings to the IRS.

Although the DOL began a crackdown on misclassification of workers in 2009, the crackdown intensified when the IRS joined the effort in 2011. Efforts intensified when the Alabama Department of Labor (ADOL) signed a memorandum of understanding in 2014 that allows the two agencies (IRS and ADOL) to cooperate in exposing misclassifications. So now both the IRS and the ADOL will be helping the DOL ferret out misclassifications of workers as independent contractors.

What is misclassification?

Workers can be classified as either employees or independent contractors. If a worker is an employee, the employer must do several things. First, the employer must withhold income taxes on the employee’s wages, withhold Social Security taxes (FICA), and withhold Medicare taxes. Second, the employer must transfer the withholdings to the IRS, pay unemployment compensation taxes (FUTA), and pay the employer’s share of Social Security and Medicare taxes. (Employee income is reported with IRS Form W-2.)

If a worker is an independent contractor, the employer does not withhold income tax, Social Security tax, or Medicare tax and does not have to pay the employer’s share of the Social Security and Medicare taxes. In short, it’s less expensive to pay an independent contractor than to pay an employee because the employer’s share of the Social Security and Medicare taxes don’t have to be paid. (Independent contractor income is reported with IRS Form 1099.)

Well, less expensive so long as the classification of the worker is correct.

What happens if an employee is misclassified?

If the IRS determines that an employer has misclassified a worker as an independent contractor, the employer will probably have to pay at least three things: (1) back wages to the worker, (2) back withholding of the Social Security and Medicare taxes, and (3) a penalty. For the Bowlin Group, LLC, and Bowlin Services, LLC, of Kentucky, this resulted in payment of approximately $1 million. Reclassification may also have expensive implications for employee benefit plans. When the DOL reclassifies a worker as an employee instead of an independent contractor, the employer may have to pay extra money to keep their benefit plans legitimate.

Why the crackdown on misclassification?

The answer is very simple: The IRS and various federal study groups have estimated the IRS fails to collect $2 to $3 billion a year because of misclassification. Facing a deficit, the federal government is looking for ways to collect more taxes. Misclassification also results in the Alabama Department of Revenue not collecting some taxes that are due as well—which might explain why the DOL and the ADOL signed the memorandum of understanding.

What should government contractors do?

Although not inherently illegal, classification of workers as independent contractors must be done carefully and only where appropriate, not simply as a way to reduce payroll overhead or ease administrative burdens. Government contractors, especially those in high-technology fields, may resort to classification of workers as independent contractors because the highly skilled workers may be “employed” for only a short time on a special aspect of a government project. But skill is not the determining factor. The fundamental question to ask is this: Is the worker economically dependent on the employer (even in the short term) or is the worker really in business for himself or herself? A worker who is economically dependent on the employer is an employee; the worker who is in business for himself or herself is an independent contractor.

Government contractors are well advised to check with their accountants and lawyers to make sure their classifications of workers as independent contractors are legitimate. This is especially important because the Office of Federal Contract Compliance Programs (OFCCP) has also become involved in the DOL’s enforcement efforts. (See page 97 of “Federal Contract Compliance Manual,” issued in October 2014.) As part of an audit, the OFCCP can review both the contractor’s W-2s and 1099s. And the President has issued an executive order that requires contracting officers to check on whether bidders have violated federal labor laws.