Closing the Contribution Gap: Misclassification, Pass-Throughs, and Social Security

Much of the debate over how to close Social Security’s funding gap has focused on lifting the cap on the payroll tax, so higher earners contribute more. Less attention has been paid to another potential source of revenue: labor income that falls outside Social Security’s contribution base when workers are misclassified or when business owners take pay for their work as profit rather than wages.

Since Congress last restored solvency to Social Security’s trust fund reserve in 1983, the labor market has changed substantially. Contractor work, digital labor platforms, and pass-through businesses have become a larger part of the economy. As they have grown, the rules that distinguish wages, self-employment earnings, and business profit have become more important to Social Security’s finances.

This paper argues that worker misclassification at the bottom of the labor market and business structuring at the top are two expressions of the same underlying problem. Firms treat workers as independent contractors while retaining many employer functions, and active business owners reduce their own Social Security contributions by characterizing their labor income as profit rather than wages. The rules differ, but both practices have the same effect: Social Security collects less because of how work and income are labeled, not because the underlying economic activity has changed.

Capturing this revenue could make a major difference. For instance, Social Security’s actuaries estimate that taxing the pass-through business income of high-income business owners could close a quarter of the program’s long-term funding shortfall.

Fissured Work and Lost Contributions from Below

Changes in the organization of work have weakened Social Security’s contribution base. Since the 1980s, companies have increasingly outsourced work once performed in-house to subcontractors, staffing agencies, and, more recently, digital labor platforms. Although firms often continue to control how work is priced, scheduled, and evaluated, they classify workers as “independent” contractors rather than employees, allowing them to avoid responsibilities they would otherwise bear as employers. What at first glance may appear to be solely a labor rights issue also has implications for Social Security. First, misclassified workers tend to earn less than comparable employees, reducing the earnings on which contributions are based. In addition, their contributions depend on individual reporting rather than automatic payroll withholding.

Former US Wage and Hour Administrator David Weil calls this the “fissuring” of the workplace. It shifts costs and risk onto workers, incentivizes misclassification,¹ and strips away minimum wage, overtime, and collective bargaining protections. Weil, Heather Boushey, and others trace much of the growth in earnings inequality over the past several decades back to this transformation.  In 2020, the National Employment Law Project estimated that between 10 and 30 percent of employers misclassified at least some workers.

The effects on earnings, and with them on Social Security contributions, are substantial. A 2022 Center for New York City Affairs study found that misclassified full-time independent contractors in low-wage New York industries earned about 31 percent less than payroll employees in those industries. Lower pay results in fewer earnings that are taxed for Social Security. A 2026 Economic Policy Institute study of 11 commonly misclassified occupations found that social insurance contributions fall by as much as 30 percent for each misclassified worker.

Moreover, misclassification changes how contributions are collected. Employees contribute automatically through payroll withholding, whereas independent contractors must track their net earnings, calculate self-employment tax, and file quarterly payments through a far more complicated system. The National Academy of Social Insurance finds that self-reporting lowers compliance and is particularly burdensome for workers with irregular earnings to navigate.

A 2023 survey of freelancers and gig workers by American University’s Kogod Tax Policy Center shows the implications for workers: 37 percent of respondents said they felt anxious or confused about how to file their taxes, 25 percent did not know how to file at all, and about 33 percent did not know whether they owed quarterly estimated taxes. The IRS’s most recent compliance estimates, based on tax years 2014 to 2016, found that income with little or no third-party reporting (the category most contractor income falls into) is misreported about 55 percent of the time. For wages subject to full withholding, that rate is just 1 percent. The IRS has not updated this behavioral estimate since, though its most recent tax gap projections, for tax year 2022, put unpaid self-employment tax from underreporting and non-filing at $80 billion annually.

Congress tried to facilitate reporting in 2021, when the American Rescue Plan Act lowered the threshold at which gig platform companies like Uber and DoorDash had to report workers’ earnings from fares and delivery fees to the IRS, from $20,000 a year to $600. The change mattered because many gig workers earn well under $20,000, and even those who earn more in total may remain below the threshold on each individual platform they use. As a result, platforms did not directly report much of their workers’ income to the IRS. The 2025 One Big Beautiful Bill Act reversed the reform and restored the $20,000 threshold retroactive to 2022. The Joint Committee on Taxation estimates that this will reduce federal revenue by $8.9 billion over 10 years. The law also raised the reporting threshold for bonuses and incentives paid separately from fares, from $600 to $2,000, beginning in 2026. Both changes mean that platforms report less income directly to the IRS.

And reporting has gotten harder for another reason. A $1.1 billion cut to the IRS’s 2026 budget left the agency with fewer staff and less taxpayer assistance capacity. The agency also lowered its call-answering target from 85 percent to 70 percent and ended its free Direct File program. The Center on Budget and Policy Priorities has documented how cuts to IRS funding, staffing, and taxpayer assistance, along with the cut of Direct File, have made tax compliance harder, especially for low- and middle-income filers.

Together, lower earnings and incomplete reporting reduce not only the contributions Social Security receives but also the benefits and protections available to workers and their families. The American Academy of Actuaries finds that a worker who has only half their career earnings reported can see their future benefits cut by a third. A 2026 analysis by Craig White and Matias Sokolowski similarly shows how underreporting gig earnings can compound over a career and substantially reduce retirement benefits. In some cases, workers may not qualify for benefits at all because they lack sufficient reported earnings over enough years. According to the Social Security Administration, a worker who becomes insured at age 20 has a one-in-four chance of developing a disability and a one-in-eight chance of dying before reaching retirement age. Misclassification can leave workers with disabilities, or surviving family members, without benefits they might otherwise have received.

The costs of fissuring are also highly uneven. Misclassification disproportionately affects lower-income workers, immigrants, and workers of color, who are least able to absorb unstable income and the loss of labor protections. They bear the brunt when firms reduce their labor costs and shift responsibility for Social Security onto workers.

Business Structuring and Lost Contributions from the Top

Business owners can also erode the contribution base from above, not by reclassifying workers but by reclassifying labor income itself. As business ownership has evolved, economically similar labor income is increasingly treated differently depending on the legal form and tax classification under which it is earned, allowing some of the highest-income earners to contribute less to Social Security than employees with comparable earnings.

This issue has become more important with the rapid expansion of pass-through businesses, including partnerships, S corporations, and limited liability companies (LLCs), whose profits are reported directly on their owners’ individual tax returns rather than taxed at the corporate level. Today, pass-through businesses employ most of the private-sector workforce and generate roughly half of all US business income. Matthew Smith et al. estimate that the shift toward pass-through businesses accounts for one-third of the measured decline in the corporate-sector labor share, which fell from 62.9 percent in 1978 to 57.9 percent in 2017.

For Social Security, the significance lies in how different forms of income are taxed. Social Security taxes wages and self-employment earnings, but not business profits distributed to S corporation shareholders and certain limited partners. That creates an advantage for some owners, especially S corporation shareholders and certain partners, who can receive part of the income generated by their own work as wages and part as profit.² By reporting more of their labor income as profit, they can reduce their Social Security taxes without reducing their total income.

High-income earners benefit disproportionately from this structure. The Urban-Brookings Tax Policy Center estimates that the top 1 percent of tax filers report more than three-quarters of all partnership and S corporation income. A substantial share of that income reflects payment for the owners’ work. Smith et al. estimate that about three-quarters of the pass-through income reported by high-income owners is actually labor income, not returns to capital.

Tax law attempts to limit this practice. S corporation owners who perform services for the business must pay themselves “reasonable compensation,” subject to Social Security tax, before taking the remainder as profit distributions. What is considered reasonable, however, is inherently subjective, creating substantial opportunities to understate wages while maximizing distributions.

Applying Social Security taxes consistently to active S corporation shareholders and limited partners who materially participate in the business they own would close 48 percent of the program’s projected 75-year financing shortfall.

Enforcement could close this gap. In 2021, the Treasury Inspector General for Tax Administration examined S corporation returns filed from 2016 to 2018 with a single shareholder, more than $100,000 in profits, and zero reported officer compensation, the most easily detected violation of the rule. Those owners took $69 billion in distributions while reporting no wages, and the inspector general estimated they failed to report nearly $25 billion in compensation, resulting in about $3.3 billion in unpaid Social Security and Medicare taxes. From 2017 to 2019, the IRS audited fewer than 1 percent of S corporations, and even when it conducted an audit, nearly half of examinations did not review whether owners paid themselves reasonable compensation.³

Recent changes have only widened this gap. The 2017 Tax Cuts and Jobs Act allowed eligible business owners to subtract up to 20 percent of qualifying pass-through income when calculating their taxable income, giving them another reason to report income as profit rather than pay. The Center on Budget and Policy Priorities found that the provision did little to spur new investment and instead largely encouraged owners to relabel existing labor income as profit. More than half of its benefits went to millionaire households, and Treasury estimates that roughly 90 percent went to white households. Congress made the deduction permanent in 2025.

The implications for Social Security are considerable. The Social Security Administration’s Office of the Chief Actuary estimated that applying Social Security taxes consistently to active S corporation shareholders and limited partners who materially participate in the business they own would close 25 percent of the program’s projected 75-year financing shortfall.⁴ Combined with removing the payroll tax cap, this change could close most of the long-term financing shortfall.

Rebuilding the Contribution Base

Social Security’s financing rules should reflect today’s economy. That means closing the loopholes that allow firms and high-income business owners to lower their contributions by changing how workers and labor income are classified. Three complementary reforms would go a long way toward that end.

1. (Re)establish employer responsibility for contract and platform work. Businesses that routinely rely on contractors, including digital labor platforms, should contribute to Social Security just as employers do for payroll workers. Congress should require them to pay a “Contractor Tax,” an employer-equivalent Social Security contribution made on the worker’s behalf and credited against the worker’s self-employment tax to avoid double taxation. Requiring businesses to contribute regardless of how workers are classified would reduce the incentive to misclassify workers in the first place. The payment should supplement, not substitute for, existing labor protections such as minimum wage and overtime laws.
2. Require Social Security contributions consistently for active pass-through owners. People who actively work in businesses they own should contribute to Social Security on the income they earn from that work, regardless of how their business is organized. Congress should apply Social Security taxes to labor income earned through S corporations, partnerships, and LLCs, even when it is reported as business profit.⁵ The principle could also extend to carried interest in private equity and hedge funds, where compensation for managing other people’s money is often treated as investment income rather than earnings from work.
3. Improve reporting, withholding, and enforcement. As Social Security increasingly relies on workers who report and remit their own contributions, Congress should expand withholding for contractor income, restore Direct File, and rebuild IRS enforcement. It should dedicate funding specifically to enforce worker classification and pass-through tax rules and require the IRS to report publicly on how the funds are spent and what revenue it recovers. Enforcement should prioritize firms that exploit classification rules and make compliance easier for low-income workers with volatile earnings.⁶

These reforms work together rather than in isolation. A Contractor Tax would restore business contributions for outsourced work, while stronger reporting support would make contributions easier to collect. Consistent treatment of pass-through owners would close gaps that the subjective “reasonable compensation” standard leaves open. Together, the reforms would make it much harder to avoid Social Security contributions simply by relabeling wages as contractor earnings or labor income as business profit.

Conclusion

Social Security’s retirement program faces a long-term financing shortfall that threatens the adequacy of benefits for millions of people, particularly those who rely on it most. But that shortfall is not the product of demographic change. It reflects an economy that has outgrown the financing rules that were last comprehensively reformed in 1983.

Since then, earnings and wealth have become increasingly concentrated at the top, while a growing share of labor income has moved outside Social Security’s contribution base. Firms have shifted work to contractors while retaining many employer functions, and high-income business owners have increasingly characterized compensation for their own labor as business profit rather than wages. In each case, the label attached, not the work or income itself, determines how much reaches Social Security.

These reforms would substantially contribute to closing the funding gap. Social Security’s actuaries estimate that even a limited reform focused on the active business income of high-income owners could close about a quarter of the projected long-term shortfall. Restoring Social Security’s finances therefore requires rebuilding the contribution base so that economically similar labor income is subject to comparable contributions, regardless of the contract or legal entity through which it is earned. That does not require reinventing Social Security. It requires updating its financing rules to reflect how labor is organized today rather than how it was organized four decades ago.