Worker misclassification audits are becoming more common as federal and state regulators increase scrutiny of how organizations classify independent contractors. If a company incorrectly classifies workers as contractors instead of employees, it can face significant penalties, back taxes, and legal risk.
This guide outlines 15 ways organizations can reduce their risk of a worker misclassification audit and strengthen contractor compliance.
The bottom line: Businesses of all sizes and industries can be subject to an audit. As the independent workforce continues to grow, the issue of worker classification has been thrust into the spotlight and audit occurrences are now more frequent.
Our guide outlines the steps to take if your company is audited along with important parts of the process, including:
We also offer detailed information on the 15 best practices to implement to avoid a misclassification audit.
A worker misclassification audit occurs when regulators review whether a company improperly classified employees as independent contractors. Agencies such as the IRS and Department of Labor may conduct audits when they suspect businesses are avoiding payroll taxes or employment obligations.
Companies that misclassify workers can face penalties including back taxes, fines, and unpaid wages.
You receive a notice that your company is being audited for independent contractor misclassification. How did this happen? More importantly, how do you respond? And what protections need to be put in place to ensure that it doesn’t happen again?
Independent contractor misclassification happens to companies of all sizes. Audits are private and, as such, we typically only hear about high-profile cases that involve class action lawsuits. The increased usage of independent contractor talent has led to increased oversight from government agencies on the matter of misclassification.
Worker misclassification is complicated, as federal, state, and local government agencies each apply different tests to determine the proper classification of an employee.
Misclassification tests include:
Other important factors
No one factor or set of factors is conclusive. The entire relationship and all its factors must be examined to make an informed decision.
As usage of independent contractor talent has increased in recent years so has heightened security from government agencies regarding the issue of misclassification.
Attorneys, recruiters, and employment professionals are increasingly mindful of the government’s crackdown on the misclassification of employees as independent contractors. Despite the prevalence of this issue, it seems unlikely that it will ever happen to you…until it does. The truth is that any company, regardless of size or industry, can be audited for misclassification. Here are some of the primary factors that may trigger an audit.
The requirements for workers' compensation can vary from state to state, with some states considering independent contractors as employees under their workers' compensation law. For example: In 2010, the New York State Construction Industry Fair Play Act was signed into law and amended the Labor Law and the Workers’ Compensation Law to establish a presumption of employment in the construction industry. This makes it imperative to understand state laws and requirements so you can ensure that contractors are compliant as well.
When an independent contractor files for benefits, the claim is evaluated and can trigger an audit. Because independent contractors are not employees, they are ineligible for unemployment compensation. However, if the individual in question is found to have been misclassified as an independent contractor, they can be reclassified and may be entitled to unemployment compensation and retroactive benefits specific to traditional employees.
An independent contractor can notify the IRS if they believe themselves to be wrongly classified. The IRS requires that whistleblowers provide solid and specific information. If the information leads to an action such as investigation, judgment, or collection, the whistleblower (in this case the independent contractor) could qualify for an award, which may be up to 30% of the taxes and penalties the IRS collects.
An independent contractor who feels they have been improperly classified can file a Form SS-8 with the IRS for their own classification determination. Or they may also file a Form 8918, Uncollected Social Security Tax and Medicare Tax on Wages, with their personal income tax return.
A worker who receives both a W-2 and a 1099 from an employer in one year can trigger an audit. This may happen when you engage an independent contractor as a traditional employee. If the employee performed the same work, the IRS may wonder why they were not classified as an employee all along. While this raises the risk of a misclassification audit, there are certain instances where you would treat a worker as both an independent contractor and a traditional employee in a single tax year. For instance: In a 2007 case, a radio host and program director who performed side work finding and working with sponsors was found to meet the dual classification test (Ramirez v. Commissioner; May 20, 2013).
The IRS, DOL, or a state unemployment agency often selects companies in high-risk industries for audits. In fact, some industries such as construction, food and beverage, and field service technical support experience a greater frequency of audits. Operating in one of these industries could increase your exposure to audits.
No company wants to be audited, but if you are, it’s important to cooperate with the auditor to the fullest extent. You can do so by understanding what happens in an audit and how to prepare.
The audit letter will typically contain the following:
The agency will also request specific records such as:
Audit letters will generally not have much detail. However, you can ask for specificity and the auditing agency will be required to provide it. Overall, it’s important to put parameters around what will be covered.
Understanding what happens during an audit can help you be prepared and achieve the best possible outcome.
To prepare for the audit, review and work through the following steps:
Your legal representation will also do the following in advance of the audit:
Your legal counsel may review your records for prior audits and their outcomes. They will also identify if there are similarities that triggered the audit and consider any fraud or penalty issues.
The auditor may want to schedule an on-site visit, but you can suggest that meetings be held in a neutral location such as the offices of your outside legal counsel. If possible, send documents to the auditor after the request has been made—submit your most defensible cases to the auditor first. You can also schedule a meeting with the auditor to review any borderline or difficult cases. It’s critical to provide an honest assessment where misclassification is obvious or where you are unable to defend the 1099 classification.
If applicable, negotiate your settlement amount as well as any fines or penalties that may be assessed. When you submit your settlement check to the agency, be certain to reserve all rights and indicate that you are not admitting liability for misclassifications.
Next, you’ll want to make voluntary changes to your process for engaging and managing independent contractors. This could include revamping your internal documented process or partnering with third party vendors who can manage this process for you. It might also be beneficial to reclassify certain workers.
Misclassification can be disruptive and expensive.
The potential consequences include:
If you are audited, take the opportunity to refine your process for engaging independent contractors while minimizing the risks of misclassification.
Following these 15 best practices can help organizations reduce contractor compliance risk and prepare for potential worker misclassification audits.
Independent contractors can be a vital resource for your company and are increasingly becoming an integral part of doing business. You can minimize the risk of a misclassification audit by implementing and consistently enforcing a standardized process for engaging and managing independent contractors.
Conclusion
Organizations that engage independent contractors must have clear policies and processes in place to ensure proper classification. Following these 15 best practices can help companies reduce misclassification risk, strengthen compliance, and prepare for potential audits.
What happens during a worker misclassification audit?
Regulators typically request records such as contracts, tax filings, and details about how contractors perform their work.
What agencies conduct misclassification audits?
Audits may be conducted by the IRS, the Department of Labor, or state labor agencies investigating worker classification.
What are the penalties for worker misclassification?
Companies may face back taxes, wage liabilities, fines, and potential lawsuits if workers were incorrectly classified.
How can companies reduce misclassification risk?
Best practices include conducting internal audits, documenting contractor agreements, and training managers on classification rules.