States Going After Employers Who Misclassify Workers as Independent Contractors

When construction slowed during the recession, some companies hired workers and wrongly designated them as independent contractors to avoid paying insurance, taxes, fair wages and overtime.

Danny Odom, chief operating officer of Odom Construction Systems, Inc. in Knoxville, Tennessee, says he wouldn’t even though the decision put the company of about 225 employees at a disadvantage as the practice would shave about 30 percent off his labor costs. He testified in support of legislation that went into effect July 1 allowing the state to fine competitors who misclassify employees.

“It’s principle for us,” Odom said in an interview. “We weren’t willing to stick our heads in the sand. It’s exploiting those guys and we just don’t want to make money off of people that are being exploited.”

States from New York to California are taking steps to crack down on employers who improperly classify their workers or fail to declare their income. Thirty states have laws on worker misclassification, up from 23 in 2010, according to Construction Citizen, a website that says it seeks to advance social responsibility in the industry.

“There was money to be had,” Linda Donahue, senior extension associate with The Worker Institute at Cornell University in Ithaca, New York, said in an interview. “The success at identifying those employers has led to pretty substantial revenue for the states.”

An employer can save on average $3,710 annually in employment taxes for each worker earning a salary of $43,007, according a June 14 report from the Treasury Inspector General for Tax Administration

“The misclassification of employees as independent contractors is a nationwide problem affecting millions of workers that continues to grow,” according to the report.

To recover lost revenue states must first identify such workers. In May, Connecticut said that after a 12-month audit it had reclassified 3,487 workers and uncovered $68.2 million in unreported payroll representing $1.3 million in lost payroll taxes. In February, a New York state task force said it found 20,200 instances of workers treated as contractors in 2012, representing more than $282.5 million in unreported wages.

Massachusetts identified 5,491 misclassified workers last year, according to Lauren Jones, a spokeswoman for the state Department of Unemployment Assistance. That contributed to $46 million in unreported wages.

“It is fraud plain and simple that drains governments at every level of much needed revenue,” Sarah Leberstein, a staff attorney with National Employment Law Project in New York, said in an interview.

Investigations at the state level back up the latest national audits, which suggest the problem is worsening. A Department of Labor study of nine states in 2000 found that up to one third of employers misclassified workers. In 1984, an Internal Revenue Service report put the figure at 15 percent, leading to 3.4 million misclassified workers and a $1.6 billion revenue loss. The agency is in the process of updating its estimates.

“There’s just a general increase in lawlessness among employers,” Ross Eisenbrey, vice president of the Economic Policy Institute, a Washington-based non-profit group affiliated with organized labor.

In Tennessee, the growth of the construction industry led to worsening wages and unregulated workplace arrangements, according to a 2010 report co-authored by William Canak, professor of sociology at Middle Tennessee State University.

Using U.S. Labor Department data, the report found that 9,098 construction workers in Tennessee were misclassified in 2006, leading to losses in unemployment insurance payments of up to $14.9 million and missed workers compensation premiums of as much as $91.6 million.

In addition, federal income tax loss for 2007 filings was high as $73.4 million while Social Security and Medicare losses ranged from $7.8 million to $42 million. On-the-job construction deaths reached 33 in 2008, indicating “a strong correlation between construction fatalities and the characteristics of the underground economy,” according to the report.

Even though they have been mislabeled, workers dubbed independent contractors are liable for taxes and fees that employers would otherwise be responsible to cover.

Workers often don’t pay, according to Matt Capece, a representative of the general president of the United Brotherhood of Carpenters who investigates payroll fraud. The tax revenue loss is compounded by employers who pay their workers off the books, shielding that income from states and the IRS.

Misclassification is prevalent in the construction industry where independent contractors often work alongside regular employees.

Contractors own their own business, work for different customers, control their hours, and are responsible for a portion of their payroll taxes, unemployment tax, or workers’ compensation insurance.

George Perry, a construction worker from Dayton, Ohio, did not fit that description. Still, he said he agreed in 2010 to be labeled an independent contractor as a condition for work building housing for the homeless under a federal grant.

“I went along with it because I felt my back was up against the wall,” Perry, 57, said in an interview. “I have a family. My fiance was in school. I’m the only bread winner.”

Prevailing Wage

Perry said he was initially paid $10 an hour, less than half of the prevailing wage for the type of work he was doing. He and his co-workers were told to file tax returns as if they were independent contractors or face layoff.

The following year he was hurt on the job leaving him unable to perform heavy work. After being terminated, he was denied unemployment benefits because he was wrongly labeled a contractor.

“There’s all kinds of losers and victims here,” Capece said in an interview. “Of course the workers. Good employers. State and federal governments are losing revenue.”

General contractors often use workers supplied by labor brokers who process paychecks and distribute tax forms, Capece said. Employers and labor brokers may use check cashing companies to hide payments to misclassified workers.

“It’s a great system for the specialty contractor because they get the low labor rate of the law breaking labor subcontractor, plus they use that subcontracting relationship as a shield for liability,” Capece said.

Employers that refuse to use mislabeled workers may have higher labor costs than competitors and are often underbid on construction projects.

“It’s going to take a little time for the investigators to become savvy enough to understand what they need to see,” said Tennessee construction company executive Odom. “They’re going to have to learn what they need to look for when they go onto a job site. A lot of them have had their head in the sand.”

–Editor: Jon Morgan, Gail DeGeorge