A growing number of larger companies are incorrectly calling some of their employees “independent contractors” and saving as much as 30 percent in payroll costs by doing so, according to employee advocates testifying at a House Ways and Means Committee hearing on Tuesday.

Misclassifying some of the more than 10 million independent contractors in the U.S. in this way leaves small businesses that follow the rules at a competitive disadvantage, the advocates said. It also allows companies that purposely — or mistakenly — fail to follow the rules to take advantage of low-level workers unaware of the labor-law protections that they’re entitled to.

While the issue has garnered lawmakers’ attention, some House members said they’re unsure how to penalize companies that intentionally misclassify workers without harming businesses that are simply confused about the current rules. Much of the confusion stems from the abundance of differing rules, which vary widely by state and among federal agencies.

More and more companies are apparently finding that tapping into a person’s expertise temporarily or on a contract basis is useful. The number of independent contractors in the U.S. workforce grew from 6.7 percent in 1995 to 7.4 percent of the workforce in 2005, according to the Government Accountability Office.

But an Illinois study found that some companies are not properly accounting for those workers. State unemployment audits done in 2001 revealed that 14 percent of employers had misclassified employees as independent contractors. Four years later, that number rose to nearly 20 percent, or about 64,000 employers.

By issuing a worker a 1099 tax form, rather than a W-2, a company doesn’t have to pay for that person’s unemployment insurance, workers’ compensation, health benefits, or Social Security taxes. Companies also aren’t required to withhold income taxes.

In cases of proper classification, independent workers can benefit from their entrepreneur status by having flexibility in who they work for and when they work. But workers considered independent contractors don’t have much recourse for complaints because regulations designed to protect employee rights don’t apply to them. For example, they aren’t protected under the Occupational Safety and Heath Act (OSHA).

What’s more, panelists noted, there’s no method of communication among agencies or state governments for sharing information about companies that habitually misclassify workers. Indeed, part of the problem is the range of definitions companies must wade through when determining how to classify a worker, said Sigurd Nilsen, a GAO director. The National Labor Relations Act, the Civil Rights Act, the Fair Labor Standards Act, and the Employee Retirement Income Security Act have different definitions and criteria for classifying someone as an employee or contractor.

While experienced entrepreneurs tend to realize what the status of being an independent contractor means, too often there are workers who do not understand the risks of what they are missing — such as eventual Social Security payouts and Medicare benefits, advocates say.

Witnesses at the hearing said such ignorance is prevalent in the construction industry, which encompasses 22 percent of independent workers in the United States, according to the GAO. John Kendzierski, president of the Professional Drywall Construction in Springfield, Mass., claims that some of his competitors “prey” on employees who don’t understand the risks they take by agreeing to be an independent worker.

By doing so, they could be out of a job and without health insurance if they get injured. They likely won’t be eligible for unemployment insurance. And since such workers may have avoided paying income taxes for years, they could have a harder time finding work elsewhere. “It’s really a system where these contractors pay their people in a way so they can trap and kind of control a workforce,” Kendzierski said.

Kelly Pinkham, assistant director of the Center for Full Employment and Price at the University of Missouri-Kansas City, contends that construction companies use independent contractors to save substantial amounts of money by avoiding the industry’s high workers’ comp premiums. In Missouri, the statewide rate for workers’ comp is less than $3 for every hundred dollars of payroll, but that dollar amount rises to an average premium rate of $10 for construction workers, he testified.

Under a “safe harbor” Internal Revenue Code provision, companies found to have misclassified their workers do not have to adjust their process as long as they have a reasonable basis for classifying the workers and have done so consistently. They may be subject to a $50 fine, however. Rebecca Smith, an attorney with the National Employment Law Project, recommended that Congress consider amending this provision as a priority to fix the misclassification problem. “This loophole makes no sense to me,” she said. “It prohibits the IRS from correcting problems that occurred in the past.”