Even if you’ve done everything you can to minimize the risk of a misclassification audit, you may find yourself with an IRS audit letter. So, now what? Because audits can result in large fines, bad press, back tax payments, and even class-action lawsuits, the prospect of going through one can be scary. But with the right knowledge and preparation you can successfully navigate an audit with professionalism, and even help safeguard your company against future problems.
When your company is audited, you’ll receive an audit letter. This letter typically doesn’t contain a lot of detail, but it will let you know the time period, records, and specific entity under review. Think of this letter as an initial instruction sheet that you’ll want to follow as closely as possible. Your auditor may also send a pre-audit questionnaire, which serves to provide them with additional information to create a detailed audit plan. Once you receive an audit letter, it’s time to take action. Here are four essential steps to take.
Even if you’ve kept immaculate records, retaining the services of a tax preparation professional or attorney will provide you with access to an experienced expert who has dealt with audits before. Right off the bat, a tax attorney can assist in planning your pre-audit questionnaire responses to help you avoid potential problems down the road. In addition to document preparation and legal representation, a professional can also assess if your independent contractors were properly classified, gather extensive details about their work, and assess whether or not there is any potential for fraud or penalties.
You’ll also want to appoint an internal audit team that consists of representatives from your legal, HR, payroll, and tax departments who can help assemble and prepare documents.
Being timely will go far. While you don’t have to respond to requests immediately, you don’t want to give the impression that you are stalling. After receiving the audit letter, organize your materials as best as possible and then schedule a call with your auditor. Often, auditors will want to see documents from the years or months before and after the specified audit period. Work with your auditor to determine the exact information from the exact time period they need so you can best utilize your resources.
If you are able to determine what triggered the audit, you may be able to try and limit the scope of investigation. For example, if the audit was triggered by a single claim, you may have the right to limit the scope to a particular individual or group. Work with your professional representative to determine the best course of action.
The requested paperwork and files will vary depending on the scope of an audit. Typically, an auditor will request all 1099s over a three-year period. On the other hand, if that is a massive amount of data, the audit might instead focus on a random number of 1099s from each year. Other types of requested records can include: copies of checks, cash payments, brokerage statements, credit card statements, bank records, income tax returns, tax reports, financial statements, and work-related travel logs.
Focusing preparation around 1099s is a good place to start. If you see any situations where an independent contractor received both a W2 and 1099 in the same or consecutive tax years, flag these instances. Remember, the IRS has likely already done research and knows about your red flags. If you’ve undergone an audit before, or have dealt with employee lawsuits, be prepared to answer questions about these situations.
Audits are an extensive process and can take a long time, so stay calm and remain cooperative. Remember, it’s up to the auditor’s discretion to decide if a worker is an employee or independent contractor. Due to the number of different legal tests and factors, this determination can be highly subjective. The IRS will likely want to speak with some of your workers to see if they confirm the information you’ve provided. Preparing for this task ahead of time by finding a few workers to be witnesses and including them in your file can save you stress down the road.
Independent contractors are likely an important resource to your business. If you know what triggered your audit, use this knowledge to prevent future problems. Help minimize the risk of another audit by making sure you have a standardized process in place for compliantly hiring and managing independent contractors. Partnering with a company like MBO Partners that specializes in independent contractor engagement and compliance can also help minimize your risk.
To learn more about how MBO can help your business stay compliant, contact us today.
This content from MBO Partners does not constitute legal or financial advice.