This article by Timothy W. Emery, Esq., a partner with Emery Reddy, PLLC, Attorneys at Law.

Companies that cut costs by misclassifying regular employees as “independent contractors” will face tighter regulations and stricter penalties in 2010. The Obama administration has already begun to crack down on companies that misrepresent worker status, recently hiring one hundred additional enforcement agents to effect compliance with the law. Meanwhile, auditors at the IRS have launched an intensified campaign to determine if over 6,000 major companies are using misclassification as a way to cheat on taxes.

Business experts have shown that a growing number of companies wrongfully classify regular workers as “independent contractors” to avoid paying unemployment insurance premiums and Social Security and Medicare taxes on the wages of their employees. Since taxes are not generally paid on the compensation of independent contractors, employers reduce business costs by improperly applying this designation to individuals who should be regarded as regular employees (some of these “contractors” even have company office space and work the same hours as employees).

In a recent New York Times article, Steven Greenhouse indicated that companies wrongfully classify about 3.4 million workers as contractors; the Department of Labor largely corroborates these figures, and estimates that up to 30% of U.S. companies participate in worker misclassification at some level.

The practice has enormous economic repercussions. In Ohio, for example, close to 100,000 misclassified workers have cost the state an estimated $35 million a year in unemployment insurance taxes, and over $100 million in worker’s compensation premiums. With federal and state governments currently struggling under record deficits, businesses can expect a significant increase in penalties for misclassification in the near future. Steven Greenhouse reports that the attorney general of California is currently seeking $4.3 million from a single construction company accused of misclassifying its workers. When implemented on a comprehensive, nation-wide scale, these measures could yield significant results. According to the Obama administration’s 2010 budget estimates, tightened enforcement could translate into $7 billion in revenue over 10 years.

Yet wrongful classification of workers is not merely a matter of concern for government officials; the practice has implications on a more personal level as well, denying basic employment rights to workers. Employers often misrepresent regular W-2 employees as contractors to circumvent minimum wage, overtime and antidiscrimination laws. If workers are designated as contractors and then laid off, they are ineligible for unemployment insurance. Those who are injured on the job cannot receive workers’ compensation benefits.

Prominent members of the business community have responded to the impending crackdown with alarm. When the IRS or state tax authorities identify instances of wrongfully misclassifying workers, companies often face fines and penalties, and can be liable for back-taxes on the reclassified employee. Most employers maintain that worker misclassification is unintentional, resulting from confusion and ambiguity in the legal distinctions between independent contractors and regular employees.

While current developments demonstrate a growing political will to enforce compliance with the law, cases of misclassifying workers have repeatedly emerged in the national spotlight in recent years. Last year the attorneys general of several states threatened to sue FedEx Ground for wrongfully classifying its drivers.  According to allegations by the Teamsters, FedEx has used misclassification to prevent drivers from unionizing (since independent contractors, unlike traditional employees, cannot form unions).

Yet perhaps the most prominent case of misclassification surfaced in 2007, when the private security firm Blackwater USA came under investigation for evading payment of millions of dollars in taxes by classifying workers in Iraq as “independent contractors.” Henry Waxman, chairman of the House Committee on Oversight and Government Reform, accused Blackwater of engaging in an “illegal tax scheme” that allowed it to avoid an estimated $31 million in employment-related taxes in the last year of its contract alone. The company also attempted to prevent one of its guards from contacting members of Congress after the worker discovered this illegal practice. In a letter to Blackwater’s CEO, Waxman wrote that “it is deplorable that a company that depends on federal tax dollars for over 90 percent of its business would even contemplate forbidding an employee to report corporate wrongdoing to Congress and federal law enforcement officials.” Despite the fact that it routinely misclassifies workers as contractors, Blackwater has been awarded more than $1 billion in government contracts since 2001.

According to guidelines established by the IRS, an employee is defined as anyone who works for an employer when that employer controls what will be done on the job and how those services will be performed. Independent contractors, on the other hand, are defined in a such as way that the payer or employer can only control the result of the work performed, but not the means of accomplishing that result. This distinction is codified in revenue ruling 87-41 (generally referred to as “the twenty factor test”). For a more extensive discussion on properly classifying employees and contractors, see the official guidelines as detailed on the IRS website.