According to the U.S. Department of Labor, 30 percent of companies misclassify employees. Misclassification is defined as employees being referred to as independent contractors and it is a violation of the law. The United Accountability Office produced a report titled “Employee Misclassification,” which states that approximately 3.4 million employees are passed off as contractors who are in fact employees. The practice is done to avoid paying unemployment and payroll taxes as well as lowering insurance costs. The extensive use of this illegal practice is lost revenue for state and federal governments. They are finally getting sick of it and starting to take action. For us in the construction industry, we are all far too familiar with this practice and the rest of the world is finally waking up. It is particularly difficult to catch employees who are misclassified in construction as they tend to move around from one location to another.

The recent recession has escalated the practice of misclassification and, with it, the fact that state governments are losing more revenue than ever. The perfect storm scenario has caused many states to escalate the efforts in catching misclassification violators. Colleen Gardner is New York’s labor commissioner and recently testified the state of New York identified more than 35,000 instances of “employee misclassification” in a period of just over 24 months. Gardner went on to explain that through misclassification, the state lost approximately $14 million in tax revenue. This prompted the “Construction Industry Fair Play Act” that was passed in August 2010 in an effort to curtail worker misclassification; other states are following suit.

About 25 states have substantially increased their effort to catch the offenders, for both employees and employers. In California, a framing contractor was found guilty of employee misclassification and as the subcontractor filed for bankruptcy protection, the state went up the ladder to the general contractor and project owner for the lost tax revenues. The state attorney general was able to prove the general contractor and building owner had to know the bid submitted was “not reasonable” and as such were deemed complicit.

Government Action

The Obama administration has hired 100 more enforcement personnel and they plan to look closely at the construction industry. The IRS began auditing an additional 6,000 companies for compliance. The Federal “Employee Misclassification Prevention Act” was introduced to the U.S. Senate, requiring every company to keep records of non-employee workers and to inform all new employees of their rights. The point is: If you are cheating by knowingly misclassifying as an employer or employee, you stand a higher chance than ever of being caught. For those that who want to play fair and be sure they are on solid ground if an auditor comes by, the following might help:

- Know the rules and document your relationship with your independent contractor.

- Keep documentation and review it annually.

- Conduct a self audit to qualify employees and independent contractors.

- Verify that independent contractors have insurance and other customers; being a company’s sole customer is a red flag to an auditor.

- The litmus test often used for employee to independent contractor is control. Does the worker have control? Is he/she allowed to work for other people at the same time?

The problem for the construction industry are the piece workers, who are legal, but are really just employees. Employers should be wary of minimum wage and overtime laws as they would correspond to piece work rates. Some in our industry “misclassify” and pay employees the amount as if they were a “subcontractor” and then 1099 the “employee” at the end of the year. The confusion is some of these employees could have much of that “control” used to test the misclassification theory but they are not “real” independent contractors. They do not bid work, they do not have an office, they do not carry insurance and do not have a license. These are the ones the government is trying hard to clamp down on. It is tough.

Misclassification hurts all those contractors who play strictly by the rules. Those that knowingly cheat the system beware: You are playing with fire and the penalties when caught are extreme. For those that say, “I cannot compete if I put them on the payroll and pay taxes,” how do you think the contractors who play by the rules feel? If the industry as a whole cleans up its act, we could all compete honestly and fairly. The firms with the best supervisors, best trained help should succeed-not those willing to cheat the system. The added bonus is the states would be in far less dire financial straits.