An unfair market

Federal and state governments are cracking down on the underground construction economy

Unscrupulous contractors who are a part of the underground construction economy pose challenges to professional contractors who operate their businesses lawfully. These contractors, who also are referred to as part of the "informal" or "shadow" construction economy, refuse to play by the same rules as reputable contractors. As a result, lawful contractors are placed at a disadvantage in competitive bids and are losing job opportunities to employers that pay their employees under the table or intentionally misclassify them as independent contractors.

Not only does the underground construction economy affect state and federal coffers, but it also places great social burdens on underground workers. Thankfully, federal and state agencies have increased their efforts to combat the underground construction economy, which, in turn, will help restore fair competition.

The common problem

The underground construction economy is composed of workers who are not reported on employers' payrolls or intentionally misclassified as independent contractors. Although reputable employers can unintentionally misclassify workers as well, most enforcement efforts are directed at employers that engage in intentional misclassification schemes.

Willful misclassification can occur in several ways. An employer could simply refer to employees as independent contractors even though they don't operate their own businesses. An employer may require an employee to sign a boilerplate agreement where the worker represents he or she is an independent contractor without any evidence of such a relationship. And an employer may even choose to pay employees in cash with no formal payroll treatment whatsoever.

Employers that do not report workers on payroll remove these workers from employer records entirely, making it difficult for governments to account for these workers. However, misclassification and underreporting of workers have the same effect: They rob workers of legally required wages and protections and deprive governments of much-needed revenues.

As a result, federal and state agencies often use the phrase "underground economy" to describe the intentional misclassification of workers by employers and the practice of paying workers off the books.

Employers are required to pay payroll taxes and other deductions for employees but not for independent contractors. Under the Federal Insurance Contributions Act, employers are required to withhold income, Social Security and Medicare taxes from employees. Under the Federal Unemployment Contributions Act, employers also are required to contribute to federal and state unemployment insurance funds. And employers are required to comply with wage and hour laws, such as the Fair Labor Standards Act (FLSA), and other state laws that regulate issues such as minimum wages, overtime pay and family leave. However, under a misclassification scheme, employers would avoid paying these costs, creating serious consequences for federal, state and local governments.

The costs

Recent studies have shown the underground economy is a serious issue. One of the most comprehensive studies regarding the underground construction economy describes the construction industry in California. The study, conducted in 2014 by the Economic Roundtable, concluded 143,900 jobs (one out of every six jobs) in California's $152 billion construction industry were part of the underground construction economy in 2011. Of these, 104,100 jobs were unreported by employers, and more than 39,000 employees were misclassified as independent contractors.

According to the study, in 2011, underground construction activity in California deprived the federal government of $301 million in tax revenues. California also lost $473 million in tax revenue, which included $63 million in uncollected unemployment insurance, $146 million in state disability taxes and missing workers' compensation contributions of $264 million. The California report also found specialty trades, such as drywall contractors, have the highest rates of underground activity, with more than 25 percent of all workers employed in the underground economy in 2012.

Studies conducted by other states describe similar situations. The Texas Workforce Commission estimates roughly 35,000 workers in Texas were misclassified between 2010 and 2012. Of those, about 4,300 workers were a part of the underground construction industry. According to a report by Texas' Legislative Budget Board, misclassified workers deprived the state of $2.4 million in contributions to the state's unemployment insurance fund.

In Maine, 11 percent of all employers and 14 percent of construction employers misclassified 4,792 workers. Misclassification of construction workers deprived Maine of an average annual loss of $314,000 in unemployment compensation taxes, $6.5 million in workers' compensation premiums, and $10.3 million in Social Security and Medicare taxes.

A 2010 report from Indiana found 47.5 percent of all employers audited between 2007 and 2008 misclassified workers as independent contractors. Of these employers, 8,200 were in the construction industry.

And the Minnesota Office of the Legislative Auditor estimated in 2005 14 percent of all employers—roughly 17,500—misclassified workers. Moreover, these misclassification numbers were higher in construction—15 percent of all construction employers and 31 percent of all drywall contractors misclassified employees in Minnesota.

In general, a construction worker who is employed in the underground economy is paid less than a formal worker. Indeed, in California it is estimated for every dollar a formal construction worker earns, an unreported worker makes 52 cents and a misclassified worker makes 62 cents. Households supported by informal construction workers were three times more likely to live in poverty than those supported by formal construction workers. In addition, misclassified workers also lose the benefits of workers' compensation, health and safety protections, and other fair labor standards employees regularly enjoy.

The National Employment Law Project, a labor advocacy organization, estimates employers cut their labor costs by as much as 30 percent when they engage in misclassification or underground activity. This obviously provides a significant advantage over reputable contractors because reduced labor costs allow employers to offer lower prices than contractors who comply with the law. As a result, contractors who follow the law often lose job opportunities to employers that do not abide by the law.

Ending the practice

Federal and state governments have ramped up efforts in recent years to combat the problem of worker misclassification and overall underground activity. On the federal level, the Wage and Hour Division of the Department of Labor (DOL) has taken a more aggressive approach to enforcement.

DOL has begun hiring more investigators to monitor misclassification activity. It also has begun strategic enforcement efforts to target industries where labor violations are the greatest, such as construction. Through these efforts, DOL's goal is to create changes in behavior beyond the individual businesses under investigation with the hope of creating more compliance in the broader economy. As part of this approach, DOL is identifying the entire contracting chain so those businesses or entities at the top of the chain will evaluate their compliance efforts to ensure they do not use the services of employers that participate in the underground economy. DOL also is publicizing the results of significant enforcement efforts, which it hopes will deter such activity in the future.

One such example of this approach is the DOL investigation of Paul Johnson Drywall Inc., a drywall contractor from Phoenix that contracted with a labor-only subcontractor for drywall labor. The investigation determined the labor-only subcontractor regularly misclassified workers for Paul Johnson Drywall as members/owners instead of employees. The investigation also determined the labor-only subcontractor violated FLSA because it failed to keep accurate records and pay its workers proper overtime rates.

As a result of the investigation, Paul Johnson Drywall agreed to pay $556,000 in overtime back pay and liquidated damages as well as $44,000 in civil penalties. Paul Johnson Drywall also agreed to hire an independent monitor to ensure the contractor and its subcontractors comply with FLSA.

A similar enforcement action by DOL involved a $395,000 consent judgment against a general contractor for misclassifying its laborers, electricians and other trades and failing to pay them proper overtime compensation.

DOL also has begun operating under the presumption that most workers are employees, not independent contractors. In July 2015, DOL's Wage and Hour Division administrator issued an Administrative Interpretation that clarifies the DOL's current position regarding whether a worker is considered an employee or independent contractor. There are many tests to determine independent contractor status, and most of them rely on whether the employer exerts control over the employee (see "A slippery slope," November 2014 issue).

According to the agency's July 2015 interpretation, DOL uses a test that does not place an oversized role on an employer's lack of control over a worker. Instead, DOL's new focus is whether the worker is economically dependent on the employer or whether the worker is in business for himself or herself. Under this "economic realities" test, a worker can be considered an employee even if the employer does not exercise control over the worker, provided the worker is economically dependent on the employer. The Administrative Interpretation also lists six factors DOL will weigh in any determination, including the following:

  • The extent to which the work performed is an integral part of the putative employer's business
  • The worker's opportunity for profit or loss depending on his or her managerial skills
  • The extent of the relative investments of the employer and worker
  • Whether the work performed requires special business skills and initiative
  • The permanency of the relationship between the employer and worker
  • The degree of control exercised or retained by the employer

Unscrupulous employers that routinely misclassify workers will find it much more difficult to prove their cases in subsequent investigations by DOL using this test.

DOL also has created a Misclassification Initiative, which is a partnership between federal and state agencies to coordinate enforcement efforts and promote the sharing of information regarding noncompliant companies. To date, DOL has entered into a Memoranda of Understanding (MOU) with 28 states that detail the collaborative efforts, which can involve agencies such as the Employee Benefits Security Administration, Occupational Safety and Health Administration, and the Office of Federal Contract Compliance Programs.

Similar to DOL, the IRS also is taking a more collaborative approach to combat worker misclassification. In November 2007, the IRS launched the Questionable Employment Tax Practices (QETP) program, which seeks to identify employer tax schemes and other illegal practices and exchange this information between the states and other federal agencies. Under the QETP program, the IRS and states share information critical to compliance efforts, including audit records, enforcement tools and employment tax records. States and other agencies voluntarily participate in the QETP program through the signing of the MOU. To date, 37 state workforce and revenue agencies have signed the MOU.

The IRS also created the Voluntary Classification Settlement Program (VCSP) in 2011, which allows employers to reclassify independent contractors as employees for future tax periods in exchange for partial federal tax relief. Enrollment in the program is voluntary, but an employer is not eligible for the VCSP if it currently is under an employment tax audit by the IRS, DOL or a state workforce agency. However, it is believed participation in the program is low because employers are concerned enrollment could bring attention to federal and state agencies that a company's past treatment of its employees was improper.

During 2014, the IRS increased efforts to promote its SS-8 program, which allows individuals or firms to file a Form SS-8 to initiate a review of a worker's independent contractor status for the purpose of federal employment and income tax withholding. In June 2014, the IRS also announced an increase in its corporate audits of S corporations because it determined many were misclassifying their workers as independent contractors. And the IRS has its own MOU with DOL to combat misclassification activity.

On July 31, 2014, President Obama signed the Fair Pay and Safe Workplaces Executive Order, which will require prospective federal contractors to disclose employment and labor violations from the previous three years. These disclosures would occur during the bid process and, if an award is made, would continue every six months thereafter. The Executive Order also will require contracting agencies to consider any employment or labor violations as disqualifying factors when awarding federal contracts.

In addition, employers will need to provide notices to their workers that detail a worker's classification status as an employee or independent contractor, exempt or nonexempt status under the FLSA, and other information related to compensation. Contractors also will be required to incorporate these requirements into downstream subcontracts.

The Executive Order's requirements will apply to all federal contracts and subcontracts in excess of $500,000 and will be implemented this year following the development of regulations by the Federal Acquisition Regulation Council and DOL.

State action

State workforce agencies also have played a crucial role in the fight against worker misclassification and the underground economy. Many state agencies have increased the number of random and targeted audits they perform. Some states have done so as part of the coordination of enforcement efforts with federal agencies.

For example, the New York Labor Department completed more than 12,000 misclassification audits during 2014. In these audits, the department determined 133,000 workers were misclassified, and it assessed more than $40 million in fines for unpaid unemployment contributions. In 2013, Massachusetts audited more than 18,000 businesses and recovered more than $15.6 million as a result of worker misclassifications. Similarly, Illinois conducted an audit of more than 3,500 employers in 2013 and recovered $5.1 million in unreported unemployment contributions as a result of worker misclassifications.

Some agencies have even taken the extraordinary step of debarring contractors who violate wage and labor laws. One such example is National Drywall, a contractor from Ontario, Calif., who was debarred by the state's Division of Labor Standards Enforcement from working on public projects. The division's investigation was launched after workers complained to a labor compliance monitoring agency that National Drywall was misclassifying its workers and not paying them the appropriate prevailing wages. In its decision, the division determined National Drywall had committed several labor violations and defrauded the state and its workers of more than $1 million in back pay.

States also are focusing on independent contractor misclassification activity through the unemployment and workers' compensations claims process. Many workers who were treated as independent contractors have applied for unemployment benefits. When these claims are filed, local claims examiners are determining more workers have been misclassified and are entitled to unemployment benefits even if a worker has signed an independent contractor agreement or is receiving compensation in the form of a 1099. These claims determinations are particularly useful because misclassification of a single worker may trigger a broader investigation into an employer's practices.

Legislation is being introduced in states to curtail misclassification of employees and underground activity. Most bills provide for civil and criminal penalties, debarment from public projects, presumptions in favor of employee status and even private rights of action, which would allow individual workers to bring suits against their employers for willful misclassification. Some laws also have created worker misclassification task forces.

New Jersey passed the New Jersey Construction Industry Independent Contractor Act in July 2007, which creates a presumption that a worker is an employee if he or she performs services "in the making of improvements" to real property and is paid by an employer. The employer has the burden to prove the worker is not, in fact, an employee but an independent contractor.

Severe consequences exist for employers that violate New Jersey's law. Construction industry employers, including officers, agents, superintendents, foremen or other employees, that misclassify workers can be found guilty of a criminal offense and face prison terms ranging from 10 days to 10 years. These employers also can face penalties and fines ranging from $1,000 to $75,000. New Jersey also grants misclassified workers the right to bring civil suits against their employers for lost wages. An award for wages under a civil suit may be doubled if the misclassification was intentional, and employees may receive payment of their attorneys' fees, as well.

In 2013, the governor of Tennessee signed a bill into law that imposes stiff penalties on construction companies that misclassify workers. Under the law, a construction employer can be fined if it underreports or conceals its actual worker payroll amount, true number of construction workers or any construction worker's duties. For every violation, an employer can be fined up to $1,000 or 1 1/2 times the average yearly workers' compensation premium for the employer, whichever is greater.

The District of Columbia passed the Wage Theft Prevention Amendment Act of 2014 (WTPAA), which became effective Feb. 26, 2015. Under the WTPAA, every employer in the District of Columbia is required to provide each employee with written notice of his or her employment status stating the employer's name and address, including any "doing business as" designations; information regarding the employee's rate of pay and eligibility for overtime or prevailing wages; and the employee's regular payday. The WTPAA also protects workers against retaliation by their employers if they file any complaints.

If multiple employers are responsible for an employee, the WTPAA imposes joint and several liability on employers for wage violations. For example, the WTPAA makes a subcontractor and general contractor jointly and severally liable for the subcontractor's violations of the WTPAA, as well as the District of Columbia's Living Wage Act and its Accrued Sick and Safe Leave Act. Under this scenario, the District of Columbia can assess fines and penalties against the subcontractor, general contractor or both for wage violations on the part of the subcontractor. Similarly, the WTPAA also imposes joint and several liability on employers and temporary staffing firms for violations.

The WTPAA includes penalties for a number of different violations. An employer that negligently fails to comply with the act will be found guilty of a misdemeanor and may be fined up to $2,500 for a first offense or $5,000 for a subsequent offense. If the employer's failure to comply is willful, the employer can be fined up to $5,000 on the first offense, face imprisonment for 30 days or both; for any future offense, the employer can face fines up to $10,000, face imprisonment for 90 days or both.


Multiple attempts have been made to enact legislation at the federal level, but none of these initiatives have become law. In 2008, the Employee Misclassification Prevention Act (EMPA) was introduced into both houses of Congress. It was reintroduced in 2010 and again in 2011. The bill, if passed, would have imposed substantial record keeping and notice obligations on employers and, for the first time, made misclassifying employees a federal offense.

The Payroll Fraud Prevention Act (PFPA) was introduced into Congress in 2011, 2013, 2014 and 2015. Like the EMPA, the PFPA would have made worker misclassification a federal offense. The bill also would have created a presumption of an employee designation and required employers to provide employees with written notice of their status as an employee or independent contractor. And the bill would have imposed treble damages, meaning the court could triple the amount of the actual/compensatory damages to be awarded, on employers that willfully violate minimum wage or overtime laws through misclassification practices.

What you can do

As a reputable contractor, you have several options to combat underground construction activity and worker misclassification. First, reach out to your state workforce agencies; many of them have divisions that investigate and monitor underground activity. These agencies often set up ways to anonymously report any suspected fraudulent activity. Also, work to educate project owners and general contractors about the risks of doing business with unscrupulous contractors. General contractors, in particular, should be made aware of the requirements of the Fair Pay and Safe Workplaces Executive Order and will face the risk of debarment from federal projects if their subcontractors fail to comply with the law.

Also make efforts to support and pass legislation in your state and municipality that impose stiff penalties on contractors who do not follow the law. On a federal level, push for Congress to reintroduce legislation such as the PFPA, which could encourage states to use the PFPA as a model to enact similar legislation.

Finally, educate your workers whose friends and colleagues could be participants in the underground construction economy. Workers who are concerned about their classification status should be aware they have options: They can file the SS-8 form with the IRS to determine whether they have been properly classified, and they can file wage claims with their state agencies to determine whether they have been properly classified. An unemployed worker who was misclassified or paid under the table still may file an unemployment claim. These steps will force an agency to investigate an employer's labor practices and may even trigger a broader investigation.

Improvement is coming

Underground construction activity creates significant costs for reputable companies, misclassified workers, and state and federal budgets. This issue has been a growing concern for reputable contractors who are losing business opportunities to employers that willfully avoid the law. However, many federal and state agencies are responding to the issue and have begun to implement compliance and enforcement efforts in an attempt to curtail worker misclassification and other underground activity. Reputable contractors should work with these agencies and educate their customers about the dangers of the underground economy to halt this problem.

William E. Burnett is an attorney with Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.



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