President Obama’s proposed $3.8 trillion federal budget for 2011 includes $117 billion for the U.S. Department of Labor. The Department’s Wage and Hour Division, which will receive $244 million under the new budget (an increase of almost $20 million from last year), pledges to use the money to increase its number of investigators, to train investigators to detect misclassification of workers as independent contractors, and to focus on industries where misclassification is most prevalent.

Misclassification of employees as independent contractors is expected to cost the Treasury Department over $7 billion in lost payroll tax revenue over the next ten years. To help make up for this shortfall, the proposed budget includes a joint proposal by the Departments of Labor and Treasury. The joint proposal, a $25 million initiative, would enhance the ability of both agencies to penalize employers who misclassify their employees and would attempt to eliminate or reduce opportunities under current law for employers to misclassify workers. The initiative also provides for competitive grants to boost states’ incentives to address the problem, as well as the hiring of 100 new enforcement personnel to target worker misclassification.

The President’s proposal also is likely to build momentum for legislation, already introduced called theTaxpayer Responsibility, Accountability, and Consistency Act of 2009, that would revise the Revenue Act of 1978’s safe harbor provision (which allows an employer to treat a worker as a contractor if certain requirements are met) to make it more difficult for employers to classify workers as independent contractors for employment tax purposes. The legislation also would significantly increase employer penalties in the event of misclassification. In addition, states also are enacting new laws to impose harsher penalties for misclassification. Colorado, for example, passed a law in 2009 that included penalties of up to $5,000 per employee for the first offense and up to $25,000 per employee for subsequent violations. Other states have passed similar laws.

In light of these developments, which continue a trend that has been building for the past several years, employers will need to be vigilant to ensure that their independent contractor relationships will pass muster. Misclassifying an employee as an independent contractor will be a very costly mistake.