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Testimony of Thomas E. Perez, Secretary of the Department of Labor, Licensing and Regulation
HB 1590 House Economic Matters Committee

 

March 20, 2008

Good afternoon Chairman Davis, Vice Chairman Rudolph and members of the Committee. HB 1590 addresses the misclassification of employees as independent contractors, a pervasive practice that cheats the state out of revenue, creates an unlevel playing field for businesses and deprives workers of their basic rights in the workplace.

Employee misclassification is a practice often used intentionally by employers to reduce their tax burden and avoid various laws designed to create protections in the workplace. Recent DLLR audits have found that about 20 percent of Maryland employers misclassify employees as independent contractors.

Misclassification is an already prevalent issue that in recent years has emerged as a serious threat to workers, law-abiding employers and the economy in general, and it is one method employers use to operate in the underground economy. It has been estimated that an employer who misclassifies a worker as an independent contractor instead of as an employee can save up to 30 percent of the payroll costs associated with employing that person.

But misclassifying employees to save money is cheating, and those savings come at a significant cost to the rest of us. The ramifications are far-reaching.

The Effects of Misclassification

An employee who is misclassified is left unshielded by various laws designed to protect workers but only guaranteed to "employees," including minimum hourly wage requirements, overtime pay, safety and health standards, medical leave, antidiscrimination laws and access to unemployment insurance and workers' compensation.

Consider the following examples, taken from the October 2007 report by American Rights at Work, which examined FedEx Ground, an employer that classifies its drivers as independent contractors:

  • Rich Farrell, a medic in the Army National Guard, worked as a FedEx Ground driver in New Jersey until he was activated following 9/11/2001. While deployed overseas for six months, FedEx terminated Farrell's contract and hired a new driver for his route. They refused to rehire him upon his return, and he had to sell the truck the company required him to purchase. Had Farrell been classified properly as an employee, it would have been illegal for FedEx Ground to discriminate against him for serving in the military, and he would have been protected from termination. But Farrell, like most FedEx Ground drivers, was classified as an independent contractor.
     
  • In August 2006, FedEx Ground driver Tony Marcellino was killed in a traffic accident while delivering packages. Because Marcellino was misclassified as an independent contractor, his widow and children were not eligible to collect death benefits they would have been eligible to receive under California's Workers' Compensation Act if Marcellino had been properly classified as an employee.

Misclassification hurts more than the workers themselves. Competing law-abiding employers are put at a distinct competitive disadvantage, as they have a higher cost of business simply because they're playing by the rules. And they're doubly disadvantaged because underpayment of unemployment insurance taxes and workers' compensation premiums by employers who misclassify means law-abiding employers pay more. In industries where misclassification is most prevalent, such as construction, employers who cheat are able to underbid honest businesses, giving the unscrupulous employers an unfair advantage.

When a misclassified employee is hurt on the job, and the employer has shirked his or her responsibility to secure workers' compensation coverage, employers who have obeyed the law and done their duty pay for the worker's medical treatment, through the uninsured employers' fund. When an unscrupulous employer is able to charge less for goods or services because he or she has evaded various tax and worker protection laws, upstanding members of the local business community are damaged simply because they've done the right thing.

Because it allows employers to evade certain tax obligations - including paying unemployment taxes and the employer's share of social security and Medicaid, as well as withholding a worker's income taxes - taxpayers lose significantly. The IRS estimates that noncompliance with tax payment and reporting laws is highest among individuals whose income tax is not withheld or reported by a third party, as is the case with workers identified as independent contractors. When a misclassified employee fails to pay income taxes because his or her employer did not abide by withholding laws, taxpayers lose money that, particularly in tight budget times, is critical to pay for the programs and services important to us all.

The Unemployment Insurance Trust Fund also takes a hit from misclassification, because it is deprived of the taxes that should be paid for misclassified workers. Unemployment insurance is a critical social safety net, and when the trust fund is underfunded, money that could be spent to help displaced workers find employment is lost.

Misclassification in Maryland

Maryland's Unemployment Insurance Division conducts random audits each year of two percent of the state's employers. Over the last several years audits have found an average of about 20 percent of employers misclassifying employees as independent contractors.

Based on UI audits, it is estimated that employee misclassification accounts for between $15 million and $25 million unpaid to the Unemployment Insurance Trust Fund each year. And that estimate is likely conservative, as the audits are random and do not target industries where misclassification is most prevalent. Also, the audits represent two percent of covered employers, or employers who report at least some wages and pay some unemployment insurance tax. If an employer does not report any wages, or operates in the "underground economy," they would not be captured by the audits.

Maryland's audits have shown results in line with what other states have found through extensive academic studies of misclassification:

  • An analysis of audit data from 2001 to 2005 in Illinois found that 17.8 percent of audited employers had misclassified workers, and 7.5 percent of all employees statewide were misclassified as independent contractors, amounting to $39 million each year in missed unemployment insurance taxes, $124.7 million in unpaid income taxes and $95.9 million in workers compensation premiums not paid.
     
  • A New York study found that an average of 704,785 employees were misclassified each year, resulting in a loss of $175 million in unemployment insurance taxes each year. The researchers estimated that misclassification impacted approximately 10 percent of the state's private sector workforce.
     
  • In Massachusetts, audit data collected between 2001 and 2003 suggested that 4.5 percent of the state's workers were misclassified as independent contractors. Statewide, 13 percent of employers had misclassified workers, costing the state about $91 million in income taxes, between $12.6 million and $35 million in unemployment insurance taxes and up to $91 million in workers compensation premiums.

In its report to Governor O'Malley, DLLR's transition team cited a recent report from a Maryland nonprofit that called the misclassification of employees one of the six most pervasive wage violations faced by low-wage workers in Maryland. Misclassification occurs frequently in construction and maintenance work, and has been prevalent among home health care workers. Hispanic day laborers often bear the burden, which includes abuse of safety and health standards and wage and hour laws. By identifying an employee as an independent contractor, an employer shifts the responsibility for safety and health to the workers themselves, because they are technically classified as self employed.

Addressing Misclassification: State and Federal Actions

Misclassification has received increased attention recently, both in the states and at the national level, as states have attempted to crack down on employee misclassification and the IRS has been searching for ways to close the federal tax gap. A number of states have taken legislative or executive action to address misclassification.

New Jersey's Construction Industry Independent Contractor Act of 2006 implemented stiff penalties for misclassification, allowing the Commissioner of Labor to assess a penalty of up to $2,500 for a first violation and up to $5,000 for each subsequent violation. If a violation is made knowingly, the employer is subject to debarment. The law also created criminal penalties. The law also establishes a uniform definition of employee across various statutes.

The governor of Illinois signed a law in August 2007 establishing a uniform definition of employee for construction workers, and requiring information sharing across agencies that enforce various labor laws. Employers who misclassify are subject to a civil penalty of up to $1,500 per violation found in a first audit, and up to $2,500 per violation found by any subsequent audits.

Kansas enacted a law in 2006 to make the misclassification of employees for the purpose of avoiding income tax withholding, reporting requirements or unemployment insurance contributions a violation subject to penalties under the state income tax laws.

Legislation currently under consideration in Kentucky would clarify the definition of an employee, and create civil penalties of up to $1,000 for the first act of misclassification and up to $2,500 for each subsequent violation.

Meanwhile, a number of governors have issued executive orders to coordinate enforcement efforts across state agencies. Within the last six months at least four governors, in Michigan, New York, New Jersey and Massachusetts, have created task forces for joint enforcement efforts. The panels typically bring together state agencies that enforce wage and hour laws, workers' compensation, unemployment insurance, tax laws and other labor-related laws to share information about misclassification and crack down on the practice.

Efforts have also been made at the federal level. The Independent Contractor Proper Classification Act of 2007, which was introduced in September in the United States Senate, would close a loophole employers use to misclassify workers. The IRS has also been working to crack down on misclassification, which it views as a contributor to the federal tax gap. The IRS has entered into agreements with a number of states to share information when employers are found misclassifying workers.

In December 2007, the IRS ordered FedEx Ground to pay $319 million in back taxes plus interest after an audit of calendar year 2002 determined that the company's drivers were employees, not independent contractors. The IRS is conducting similar audits of the company for calendar years 2004 through 2006 and could order payment of additional taxes. FedEx planned to appeal the finding.

Several other high-profile developments have occurred in the case of FedEx Ground, a subsidiary of FedEx Corp. In recent years, workers and labor advocates have challenged the company's business model, which labels drivers as independent contractors, requiring them to purchase or lease their own trucks and to cover other related expenses. Some drivers and labor advocates argue that drivers have little control over when, where and how their work is accomplished, and they are therefore employees, not independent contractors.

A 2004 decision by the Los Angeles County Superior Court found that FedEx Ground drivers in California were, in fact, employees. The court ordered the company to reclassify its drivers. An appeals court upheld the ruling in 2007. The company is also currently involved in a class action lawsuit that claims the drivers are employees and should have access to the benefits and rights legally granted to employees. Meanwhile, several state labor agencies have determined that FedEx drivers are employees.

An investigation of FedEx's worker classification is underway at DLLR. Because of the pending nature of the investigation, I cannot comment on the specifics of the investigation.

House Bill 1590

Current Maryland law does not provide enough incentive for employers to properly classify workers. As penalties are minimal, and in some contexts non existent, costs associated with getting caught misclassifying workers are no more than a cost of doing business.

House Bill 1590 prohibits employers from misclassifying employees in order to avoid compliance with a host of labor-related laws. The Act includes a statutory presumption that a worker is an employee and places the burden of proof on the employer. The Act requires DLLR, DBM, the Comptroller of Maryland, the Workers' Compensation Commission and other state agencies to cooperate by sharing information concerning suspected misclassification of employees. The Act provides for debarment from state contracts for repeat offenders.

Under the proposal, employers who misclassify employees are subject to various penalties, depending on which laws they violate. In the Labor and Industry context, the Commissioner of Labor and Industry may assess civil penalties of up to $3,000 for each misclassified worker. The penalty may be doubled for willful or repeat violations. The act also provides for a private right of action for an individual who has been misclassified. The court may award the individual up to three times the wages owed, reasonable costs, counsel fees and any other appropriate relief.

Employers who mistakenly misclassify for the purpose of payment of unemployment insurance taxes can be charged an interest rate for back taxes of two percent per month. Employers who knowingly misclassify or do so repeatedly are subject to penalties of up to $3,000 per employee. If any individual other than an employer knowingly advises an employer to misclassify employees, the individual is subject to a civil penalty of up to $5,000.

The Workers' Compensation Commission can assess a civil penalty of up to $5,000 when it discovers misclassified employees, and can order the employer to secure workers' compensation coverage for the employees. Willful violations can lead to a civil penalty of up to $10,000.

Conclusion

This bill will provide state agencies with the necessary tools to crack down on misclassification in Maryland. By addressing misclassification, we can ensure that workers are properly covered by protective labor laws, and that law abiding businesses are afforded a level playing field.

Addressing misclassification will allow us to lower tax rates for businesses that obey the law, just as officials did in Florida by reforming the workers' compensation system to crack down on misclassification. Addressing worker misclassification will also allow us to address the underground economy, which is undermining employers who play by the rules.

This bill will give workers the protections deserve, provide fairness for employers, and ensure the State of Maryland is not deprived of the taxes it is owed by unscrupulous employers willing to break the law to get ahead.