Enforcement Emphasis on Employee Classification is Likely to Decrease Payroll Tax Evasion

Jan 18, 2011   

The Labor and Employment Relations Association (LERA) held its annual meeting on January 7 through January 9, 2011. Among the topics discussed by LERA speakers was the recent “crackdown” on employers who evade payroll taxes by misclassifying or underreporting their workers.

Unless otherwise excluded, IRC §3402(a) requires employers to withhold income taxes on the wages paid to all employees. Issues often arise with regard to employers treating workers as independent contractors instead of employees.

Rev. Rul. 87-41, 1987-1 C.B. 296, provides:

[a]n individual is an employee for federal employment tax purposes if the individual has the status of an employee under the usual common law rules applicable in determining the employer-employee relationship. . . An employee is subject to the will and control of the employer not only as to what shall be done but as to how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so. . . Conversely, individuals (such as physicians, lawyers, dentists, contractors, and subcontractors) who follow an independent trade, business, or profession, in which they offer their services to the public, generally are not employees.

Significantly, Treas. Reg. §31.3401(c)-1(e) provides that if an employer-employee relationship exists, the designation or description of the relationship by the parties as anything other than that of employer and employee is immaterial. Thus, for a worker who constitutes an “employee” as described above, the employers erroneous issuance of a Form 1099 carries no weight.

Despite these principles offered by the Internal Revenue Service (IRS), Deputy Director and Chief Economist for the Fiscal Policy Institute in New York James A. Parrott reported that 95 percent of restaurants in Brooklyn have “some kind of misclassification.” Parrott also reported that New York enforcement sweeps targeting the restaurant industry identified nearly 500 million dollars in unreported taxes.

Data compiled by the Commerce Departments Census Bureau revealed a 20 percent increase in the number of New York workers who were paid as independent contractors and received IRS Forms 1099 between 2000 and 2005. During the same time period, private payroll employment in New York, which consists of workers who received W-2 forms, only increased by 0.5 percent.

Although misclassification was commonly attributed to illegal immigration, Matthew Capece, an attorney with the Carpenters and Jointers of America, indicated that it now “encompassed many documented citizens of the U.S.” Capece further described the severity of the problem in the construction industry, stating, “There is much more outright fraud and problems with nonreporting than unintentional or negligent behavior And this is not about ma and pa businesses renovating kitchens. Its about a problem that is widespread within the residential construction industry.”

Panelists at the LERA annual meeting described how numerous employers minimize payroll tax liabilities by treating workers as independent contractors or paying them cash “under the table.” Notwithstanding the amount of revenue lost by both the federal government and states, Panelists also emphasized the problems created by misclassification on the workers.

In addition to not being covered by workers compensation, unemployment insurance, or state temporary disability insurance, misclassified and underreported workers lose overtime pay and access to healthcare coverage and other benefits, such as retirement benefits and paid time off.

State enforcement agencies, such as the New York Enforcement Tax Force on Employee Misclassification, continue to conduct “sweeps” for worker misclassifications. Between September 2007 and March 2010, the New York Enforcement Tax Force on Employee Misclassification has identified nearly 35,000 cases of employee misclassification, $457 million in unreported taxes, $13.2 million in unemployment insurance taxes due, and $14 million in unpaid wages.

New Yorks and other states enforcement efforts are likely to reduce payroll tax evasion, as well as assist unaware employees who incorrectly receive Forms 1099 and consequently lose benefits to which they are entitled.

If you have any questions regarding payroll taxes, worker classifications, or any other tax provision, please contact Fuerst Ittleman, PL at contact@fidjlaw.com.