President Barack Obama's proposed 2011 budget suggests tough times ahead for employers who rely heavily on independent contractors in order to keep down labor costs.
If the budget is approved, the Internal Revenue Service will add 100 new enforcement personnel as part of a $25 million plan to crack down the misclassification of workers as independent contractors. Though it's a mere drop in the $3.8 trillion spending plan, it's expected to more than pay for itself: Obama claims stronger misclassification enforcement will add $7 billion to the federal bank account over 10 years.
The issue is particularly hot when you consider that 50 percent of jobs created during the economic recovery are contingent labor, according to figures from labor law firm Littler Mendelson. Obama's plan also comes on the heels of several other policies designed to close the $350 billion tax gap the president says is caused by noncompliance with tax law. In November, for example, he issued an executive order to reduce improper payments to contractors by "intensifying efforts to eliminate payment error, waste, fraud and abuse in the major programs administered by the Federal Government."
This month the IRS also began a three-year audit of 6,000 companies (2,000 per year.) And don't assume the agency is only interested in big targets -- unlike routine employment tax audits that often are triggered by questions about company returns, the 6,000 audits are being chosen by statistical sampling -- luck of the draw.  And if you aren't chosen this round, you may be soon. "It's essentially a recon mission in preparation for a much bigger onslaught, and they've said as much," observed talent management firm MBO Partners' 1099 Risk Blog.

Estimates are that companies can hold down labor costs by as much as 30 percent if they use independent contractors, because they don't have to pay Social Security and Medicare taxes, provide vacation or sick leave, pay for workers' compensation and unemployment compensation insurance, or worry about minimum wage or overtime provisions. (Employers also get a break on potential legal headaches – among other statutes, independent contractors aren't protected by Title VII of the Civil Rights Act, which prohibits discrimination.) It's a gamble, though: The price is steep for companies found guilty of misclassification. In 2000, Microsoft had to hand over nearly $100 million in taxes, missed payments, and penalties.
On top of the federal legislation, at least half of states are getting tough, too – and again, small companies aren't immune. New misclassification legislation and stricter enforcement in Illinois, for example, resulted in a $328,500 penalty in December against a Chicago-area housing contractor that failed to keep proper records and tried to pass off 18 workers as contractors instead of employees. The math: civil penalties of $1,500 per day for 218 total days of misclassification plus $1,500 for the poor record-keeping. Similarly, in New York, a 2009 taskforce uncovered 12,300 cases of misclassification, resulting in $6 million in employment taxes and penalties.
There's also increased court scrutiny – and increased potential for lawsuits. MBO Partners estimates that the resulting civil and class action lawsuits could cost businesses an eye-popping $8 million – and that's per worker.  Warned labor lawyers Brian LaFratta and Joel Rice of Fisher & Phillips: "The heightened governmental attention to these issues will also lead to more private civil lawsuits, as the damages available in such cases make them attractive to plaintiffs' attorneys."
How to avoid costly mistakes? According to the New York Times, truck drivers, construction workers, home health aides and high-tech engineers top the most-misclassified list. The problem is that there isn't a universal definition of employee, and what you actually call the person in an employment agreement is irrelevant. The acid test of "employee" versus "contractor" is how much control he or she has over the scope of his or her job, and the person's exposure to costs and risk. Confused? The IRS has published this information and these 10 tips. Plus there's even an IRS form (Form SS-8) you can file to get the agency's advice on the subject.
If you think you've already erred on the wrong side, it's better to fix it before the IRS comes calling – and, because penalties can be charged by the day, to fix it sooner rather than later.

What do you think? Do employers routinely misclassify workers as contractors? And should the Obama administration crack down on this behavior?