Tax Misclassification: Lost Employment Benefits for Disabled Workers
March 6, 2025
SCOPE AND PURPOSE: NCD’s investigation identified outdated tax provisions that remain in effect and have not kept pace with the evolution of modern disability employment policy and its goals. NCD examined the definition of “employee” under the Internal Revenue Code (as distinct from the definition under Department of Labor regulation) and the legal implications of a 1965 Revenue Ruling that may be applied inappropriately to classify people with disabilities as “rehabilitation clients” rather than “employees.” These exemptions create employment barriers for people with disabilities and prevent them from attaining full employment status and as a result, ineligible to receive the full array of employment benefits and protections. NCD conducted this investigation to highlight the potential magnitude of worker misclassification and its impact on people with disabilities and their employment benefits. This form of misclassification can create a segregated payroll system that is detrimental to workers with disabilities who choose employment in sheltered workshops. This report concludes that improved federal oversight, random payroll audits, and criminal prosecutions of willful employment tax fraud is needed.
KEY FINDINGS
• Revenue Ruling 65-165 and similar exemptions may be inappropriately applied to exclude people with disabilities from sheltered workshop’s payrolls, leaving them ineligible for many key employer-sponsored benefits offered to their colleagues without disabilities.
• Sheltered workshops may be incentivized to misclassify people with disabilities to avoid paying payroll taxes, workers’ compensation insurance, and avoid providing health insurance.
• Sheltered workshops that properly classify people with disabilities for tax purposes face disadvantages in contract bidding as a result of their higher labor and administration costs compared to workshops that misclassify.
KEY RECOMMENDATIONS:
• Congress should repeal tax provisions that exempt people with disabilities in sheltered workshops from the term “employment.”
• GAO and the IRS should conduct a comprehensive national study that examines sheltered workshops’ tax records, their employees’ IRS W-2 information, and their nonemployees’ 1099 information for the past 10 years to identify putative employees who should receive employment benefits retroactively.
• Financial planning and benefits counseling for people with disabilities who rely on government safety net programs should encourage their participation in the IRS’s federal antipoverty programs.