The IRS's Worker-Classification Rules Aren't Working

Internal Revenue Service headquarters in Washington Photograph by Andrew Harrer/Bloomberg

The U.S. Internal Revenue Service has ramped up payroll audits of small employers to determine whether they’re misclassifying employees as independent contractors to dodge taxes, the Wall Street Journal reported recently. Congress should stop this effort, which brings in little revenue and imposes an unfair burden on business owners because the classification rules are simply too confusing. Fix them, then tackle enforcement.

Federal officials claim that business owners have increased their use of independent contractors to avoid paying Social Security and Medicare taxes. However, the Treasury Inspector General for Tax Administration concedes (PDF) that the last time the IRS studied this question was in 1984, so it isn’t really sure. My guess is that the large majority of employers are seeking to manage labor costs legally to remain competitive.

Most of small business owners’ increased reliance on contract workers—IRS data on sole proprietors show an uptick from 2003 to 2010—probably reflects the disproportionate rise in benefits costs and the increasing need for flexibility in changing work force size. It also reflects the byzantine tax code and conflicting tax court opinions, which offer no clear standard for worker classification and lead many business owners to make mistakes in classifying employees.

The increased payroll tax audit effort hardly seems worth the cost. Worker misclassification accounts for virtually none of the taxes Americans owe—but do not pay—every year. My estimate, using the IRS’s most recent figures (PDF), puts it at 0.8 percent of the tax gap (the difference between what was collected and what was owed).

Even a complete revamping of independent contractor rules would bring in little revenue. The Congressional Research Service estimates (PDF) that if the IRS were able to modify its “safe harbor” rules to make it more difficult for business owners to classify workers as independent contractors, the tax agency would collect less than an additional $900 million per year. Moreover, the CRS notes that bringing in the additional revenue “would impose significant costs” that would reduce the net gain to the Treasury.

Payroll tax audits also unfairly burden small business owners, many of whom who are in complete compliance. While IRS audits will always ensnare some law abiding citizens, the agency should consider who is being hit by their increased vigilance. Research by Nicole and Mark Crain of Lafayette College shows that companies with fewer than 20 employees spend more than three times the per-employee cost of tax compliance as businesses with 500 or more employees do, while those with from 20 to 499 workers spend 47 percent more.

Despite widespread belief that a big part of the misclassification results from the difficulty of understanding complex rules, the federal government has done little to improve education before resorting to increased audits. A 2009 Government Accountability office report (PDF) criticized the government’s efforts, which it said many experts view as inadequate.

Before allowing the IRS to audit a greater number of small business owners, Congress should take responsibility for its own contribution to the classification problem: It has failed repeatedly to pass legislation that would have made it easier for business owners to correctly classify workers as employees or as independent contractors. Again, let’s make the rules clear before we subject small business owners to further payroll audits.

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