IRS’ ‘safe harbor’ loophole frustrates those fighting labor tax cheats

A 1978 provision, known as the safe harbor, provides blanket protection to tens of thousands of business to identify their workers as independent contractors for tax purposes even though the worker is, in fact, an employee. Experts say the safe harbor is one of the greatest barriers to IRS collecting taxes on companies who misclassify their workers. Workers enter the IRS building in Washington, D.C. on Dec. 11, 2014.
A 1978 provision, known as the safe harbor, provides blanket protection to tens of thousands of business to identify their workers as independent contractors for tax purposes even though the worker is, in fact, an employee. Experts say the safe harbor is one of the greatest barriers to IRS collecting taxes on companies who misclassify their workers. Workers enter the IRS building in Washington, D.C. on Dec. 11, 2014. McClatchy

IRS revenue officer Dean Prodromos was rarely a welcome guest when he arrived in the lobby of a company asking about its books.

The longtime Sacramento, Calif., tax examiner took comfort in knowing he was helping to level the playing field for the good guys by stopping the bad ones. But Prodromos, a former naval officer who first used math calculations to track enemy submarines, still agonizes over one kind of case he couldn’t stop: those in which companies wrongly identify employees as independent contractors. It’s a common practice known as misclassification.

When he’d run those cases up the IRS chain of command, they were often returned with a blunt, if cryptic-sounding, message: “Safe harbor.”

“The service feels these cases are a loser,” Prodromos said, referring to the IRS by its nickname.

Every year, billions of tax dollars are squandered in the United States because of a decades-old loophole in federal law that allows tens of thousands of businesses to do the wrong thing – simply because they’ve been doing it all along.

The safe harbor rule, officially known as Section 530 of the Revenue Act of 1978, is a blanket protection. It means many companies can identify their workers as independent contractors for tax purposes even though the workers are, in fact, employees.

Under the safe harbor rule, the company just has to have a “reasonable basis” for doing so. Generally, companies must just show they’ve been doing it continually and that others in their industry do it the same way.

“It’s gotten widely out of control with the result of Section 530,” Prodromos said. “It’s the Wild West out there.”

It was one of the biggest frustrations for Prodromos, who spent more than three decades at the IRS hunting down tax cheats. The safe harbor rule was supposed to be only a temporary one-year protection to give companies that had complained of heavy enforcement an opportunity to update their labor practices while Congress clarified the rules.

“Well, my entire career went by and that never happened,” he said.

Instead, Congress made the safe harbor permanent.

The role of safe harbor

Misclassification is a widespread practice; companies can save 20 percent or more on labor costs by not paying state and federal taxes and workers’ compensation for their workers. Those that abuse the system are able to cheat competitors and exploit desperate workers, denying them unemployment benefits and often overtime and workers’ compensation.

In a five-part series earlier this year, McClatchy found that the practice costs taxpayers billions of dollars each year at a time when state and federal governments are desperate for tax revenue. The investigation into federal construction jobs found high rates of misclassification.

McClatchy estimates that more than a third of construction workers in Southern states such as North Carolina and Texas have been wrongly classified as independent contractors. The losses are huge, McClatchy estimates. In Texas alone, $1.2 billion in tax revenue is squandered annually. In North Carolina, losses reach about $467 million a year, and in Florida, about $400 million.

Several agencies have played a role in allowing the abuse to continue, McClatchy reported. The U.S. Department of Housing and Urban Development has doled out billions for public housing projects, but it didn’t pay attention to whether workers were employees or contractors. The U.S. Department of Labor hasn’t enforced labor laws and the IRS has failed to step in, McClatchy found.

IRS officials declined to answer specific questions on whether the safe harbor rule was a barrier to collecting taxes from some businesses. Spokesman Eric Smith said the IRS evaluated whether companies qualified for the safe harbor as part of regular worker-classification checks during tax audits.

Examiners such as Prodromos, 66, see the safe harbor provision as the greatest impediment to solving the problem. IRS officials interviewed for a 2009 report by the Government Accountability Office said the safe harbor was a major reason they couldn’t examine many suspected cases of misclassification they identified.

In its last comprehensive estimate of misclassification, in 1984, the IRS calculated that about 15 percent of employers misclassified a total of 3.4 million employees as independent contractors.

Among those workers, the IRS said, about 9 percent, or about 306,000, fell under the safe harbor provision. But that number now is likely much larger, as the labor force has expanded by 30 million in the past three decades.

A ‘slap at the IRS’

Catherine Ruckelshaus, general counsel of the National Employment Law Project, a research and advocacy group for low-wage workers, said law firms were providing employers with group seminars on how to take advantage of the safe harbor and that more businesses were classifying their workers as independent contractors in an effort to reduce costs.

“Just Google it,” Ruckelshaus said. “You get a lot of employer websites on this.”

Even when the IRS determines that a company is clearly misidentifying employees as independent contractors, often little is done to retrieve the money. Consider:

– The safe harbor provision blocks the IRS from retroactively forcing employers to fix their workers’ status or to pay back taxes.

– Only 17 percent of employers appeared to comply with misclassification rulings by issuing W-2 tax forms to their workers, according to a 2013 report by the Treasury Inspector General for Tax Administration, a federal agency that oversees IRS practices.

– The IRS says it collects 99 percent of what it’s owed from employees on the payrolls of companies. But workers who file taxes for income that they must declare themselves underreport their wages by 56 percent, with little risk of punishment.

The IRS was once more aggressive with enforcement. The agency started clamping down on violators of employment tax laws in the late 1960s and 1970s. Many in the business community didn’t like it and made their feelings known to Washington. In response, lawmakers added the safe harbor in the 1978 law to help businesses while Congress clarified the rules. Four years later, Congress made the temporary provision permanent.

“And that was Congress’ slap at the IRS when the IRS was active in this area,” said Steve Miller, a former IRS acting commissioner.

Miller said the IRS applied the safe harbor liberally, giving companies the benefit of the doubt provided they’d treated their workers as independent contractors all along, “regardless of the fact you’re not an independent contractor if you look at the factors.”

A competitive disadvantage

According to the rules, employers are supposed to treat workers as employees unless they qualify as independent contractors according to a few criteria: Does the worker determine when and how the work is done? If so, he or she is likely an independent contractor. But if the employer sets the hours, provides the tools and determines the manner in which the work is done, that person is an employee.

Prodromos describes the safe harbor as a secret tax on the good guy: Businesses that comply with the laws and pay appropriate taxes end up having to pay a greater share of the tax burden and often get undercut on competitive bidding.

“The guys who are trying to do the right thing, they’re at a very large competitive disadvantage,” he said.

The 2009 GAO report on misclassification recommended narrowing the definition of the safe harbor so fewer employers could use it as a basis to qualify for that provision of the section.

President Barack Obama has proposed revising the safe harbor multiple times. In his 2012, 2013, 2014 and 2015 budget proposals, he recommended narrowing the loophole. The U.S. Treasury estimates that doing so could generate an additional $9 billion in tax revenue over 10 years.

And several bills have been introduced in Congress. One, introduced by Sen. Sherrod Brown, D-Ohio, would narrow the rules and permit the IRS to further clarify how companies should classify their workers, which it’s not allowed to do now.

“Current law effectively institutionalizes employee misclassification by allowing long-term violators to hide under blanket safe-harbor provisions,” Brown said in a statement.

Uncertain future

In recent years, momentum seemed to be building for a change. Congressional hearings were called last year, and more had been expected in the upcoming year to discuss the finding of McClatchy’s yearlong investigation that showed the practice was pervasive on federal construction contracts.

But in Washington, things evolve rapidly. And they did on Nov. 4, when Republicans won control of the Senate. They’ll now lead both chambers of Congress. And that doesn’t bode well for those who want to change the safe harbor.

Some of the strongest opponents to revising the safe harbor are big-time donors and business groups aligned with Republicans.

The agenda of incoming Senate Majority Leader Mitch McConnell for next year is still under construction, said Michael Brumas, a staffer in the Kentucky Republican’s office. He wasn’t able to discuss whether the safe harbor legislation was under consideration.

Matt Capece, a lawyer with the United Brotherhood of Carpenters and Joiners of America, sees a ray of opportunity that Republicans might take up the matter next year as part of tax overhaul efforts. Addressing misclassification is seen as a potential revenue booster. Companies that aren’t paying taxes would have to pay them.

The possibility that the safe harbor issue might come up as part of tax restructuring has some business advocates on guard. Groups such as the Associated General Contractors of America think legislation such as Brown’s might do more harm than good. While some think the safe harbor should be clarified, the contractors’ group opposes attempts to revise it or carve out selected industries.

“There is this inclination to single out the construction industry, when our sense is that this is a broad-based economic issue,” said Brian Turmail, spokesman for the Associated General Contractors of America.

When Prodromos was in the Navy, he took an oath to support and defend the country. He felt a similar way about his work with the IRS.

But years of working cases that went nowhere wore him down. He was pushed to focus on easier-to-prove cases that were less likely to end up in the courts.

It was as though he had a front-row seat watching companies thumb their noses at the IRS and there was nothing he could do about it. Prodromos retired from the IRS in 2003 after a 35-year career.

“You want to do a do a good job,” Prodromos said, “but there is only so much you can do.”