15 Ways to Avoid a Worker Misclassification Audit (Guide)

What it Means to Be Served with an Audit

You receive a notice. Your company is being audited for independent contractor misclassification. How did this happen? More importantly, how do you respond and put protections in place to ensure that it does not 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 become class action lawsuits. As use of independent contractor talent has increased in recent years so has heightened security from government agencies regarding the issue of misclassification.

Misclassification can be tricky as federal, state, and local government agencies each apply different tests to determine the proper classification of an employee.

Misclassification tests include:

• The Department of Labor (DOL) uses an economic realities test to determine the meaning of “employment relationship” in applying the Fair Labor Standards Act (FLSA). This test focuses on economics rather than technical concepts and looks at whether or not the individual is economically dependent on the business it serves.
• The IRS examines three broad categories—financial control, behavioral control, and type of relationship—with a focus on determining tax liability.
• State laws assess whether an individual is an independent contractor or employee according to state workplace laws. Lack of uniformity among these tests means that an individual may be properly classified under one test and improperly under others. While there is no uniform definition of what constitutes an employee versus an independent contractor, one of the most important and common factors is the right to control. In short, does the employer have the right to control how, when, and where the job is performed?

Other important factors

• The worker’s business: Does the worker in question consider themselves to be a business and offer their services to the market?
• The relationship of parties: How do the worker and the employer perceive their relationship and how does it appear to the public?
• Economic factors: How is the worker paid, how are expenses handled, and does the worker receive any benefits?

No one factor or set of factors is conclusive; the entire relationship and all factors must be examined in order to make an informed decision.

As use of independent contractor talent has increased in recent years so has heightened security from government agencies regarding the issue of misclassification.

5 Potential Triggers for an Audit

Attorneys, recruiters, and employment professionals have talked about 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 the main red flags that can trigger an audit.

1. AN INDEPENDENT CONTRACTOR FILES A WORKERS’ COMPENSATION OR DISABILITY CLAIM

Workers’ compensation requirements can vary by state, and state requirements may treat an independent contractor as an employee under 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 in order to ensure that contractors are compliant as well.

2. AN INDEPENDENT CONTRACTOR FILES FOR UNEMPLOYMENT COMPENSATION BENEFITS

When an independent contractor files for benefits, the claim is evaluated and this evaluation can trigger an audit. Because independent contractors are not employees, they are not eligible 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 not only to unemployment compensation, but also to retroactive benefits specific to traditional employees.

3. A WHISTLEBLOWER REPORTS MISCLASSIFICATION

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 also 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.

4. DUAL CLASSIFICATION IN THE SAME TAX YEAR

A worker who receives 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 certainly instances for legitimately treating a worker as both an independent contractor and a traditional employee in a single tax year. 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).

5. HIGH RISK INDUSTRY

The IRS, DOL, or a state unemployment agency selects companies in high risk industries for audits. In truth, some industries such as construction, food and beverage, nail salons, and field service technical support have a high rate of audits. If your company is in one of these industries you may have greater exposure to audits.

Details of an Audit

No company wants to be audited, but in the event that you are it is important to cooperate to the fullest extent with the auditor. You can do that by understanding what happens in an audit and how to prepare.

The audit letter will typically contain the following:
▪ Period covered by audit
▪ Scope of records to be reviewed
▪ Specific entity being audited

The agency will also request specific records such as:
▪ 1099s
▪ Checks, cash payment records, and bank statements
▪ Tax reports and income tax returns
▪ Payroll records
▪ Financial statements
▪ List of the corporation’s officers and related corporate entities

Audit letters will generally not have much detail. However, you can ask for specificity and the auditing agency is required to provide it. It is smart to put parameters around what will be covered.

It is essential to understand what happens in an audit in order to be prepared.

Preparing for the Audit

To prepare for the audit, review and work through the following steps:

1. Appoint an internal audit team with representatives from legal, HR, payroll, tax, and outside counsel.
2. Schedule a conference call with the auditor. You may also want to schedule subsequent conference calls in an attempt to narrow the scope of the investigation. The auditor will typically ask for all 1099s for a three-year period. If this is a large amount of data, then it may focus on a random number of 1099s from each year or a spot check. The audit can also include the review of all 1099s.
3. Determine the audit period so that you can focus your information gathering and resources accordingly.
4. Limit the scope of the audit. If the audit was triggered by a claim, it may be broad, but you have the right to limit the scope. You can focus response to that particular individual, group, or segment.
5. Find out what triggered the audit. This not only helps in preparing for the audit, but in preventing future problems.
6. Separate Employee Identification Numbers (EINs) from Social Security numbers (SSNs).
7. Focus your audit preparation around 1099s.
8. Flag situations where a contractor received both a W2 and 1099 in the same or consecutive tax years.
9. Consider setting aside reserves and issuing a litigation hold.

Your legal representation will also do the following in advance of the audit:

• Obtain background information by interviewing department heads and managers
• Determine the contractor’s role and responsibilities or a description of the services they rendered
• Assess if the independent contractor was properly classified, which may include:
  • Reviewing contracts, invoices, and any other documents that support independent contractor status
  • Reviewing the contractor’s website and advertisements
  • Reviewing the contractor’s list of clients

Gather as much detail as possible about the working relationship between your organization and the contractor

• Group all the individuals involved in the audit by categories, if possible
• Determine if the contractor’s services are or were also performed by traditional W2 employees and, if so, focus on the differences

Your legal representation will also do the Your legal counsel may also review your records for prior audits and outcome. They will identify if there are similarities that triggered the audit. Your counsel may also consider whether there are any fraud or penalty issues.

Conducting the Audit

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 schedule a meeting with the auditor to review any borderline or difficult cases. It is critical to provide an honest assessment where misclassification is obvious or it is clear that you will not be able to defend the 1099 classification.

Resolving the Audit

If applicable, negotiate your settlement amount. You can also negotiate penalties and fines. 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, make voluntary changes to your process for engaging and managing independent contractors. This may include working with third party vendors, or reworking your internal documented process. It may be in your best interest to agree to reclassify some workers.

Consequences of the Audit

Misclassification can be disruptive and expensive.

The potential consequences include:

• Responsibility for back pay and liquidated damages
• Having to pay back taxes, interest, and penalties
• Paying Social Security and FICA
• Disqualification of company benefit plans
• Liability for overtime, meal periods, PTO, leaves, and rest brakes
• Contractors may claim 401(k), severance, health or welfare coverage, or employee stock purchase plans
• Criminal and civil penalties and sanctions
• Additional contributions to unemployment compensation and workers’ compensation funds

15 Steps to Avoid an Audit

If you are audited, use the experience to improve your process for engaging independent contractors while minimizing the risks of misclassification.

Follow these 15 steps to put a better process in place for engaging and managing independent contractors.

1. Develop guidelines for hiring and managing independent contractors. Work with your HR team and hiring managers to get input on the process. You will want to develop policies that are consistently enforced.
2. Consider written policy changes as applicable. You want to have policies that ensure compliance, but do not hinder the process of doing business. Be willing to review and update your guidelines as needed.
3. Update your hiring and contractor engagement procedures so that going forward, contractors are properly classified.
4. Conduct your own internal audit and investigate current classification practices.
5. Have a detailed description of the services performed by contractors for your records.
6. Ensure that the contractors you engage qualify as independent:
   a. Research contractors on your own to make sure they have other clients and are advertising their services to the public.
   b. Require all contractors to obtain a federal tax ID number.
7. Have a written contract when engaging independent contractors. Make sure that all of your hiring managers understand this as well. It is important to ensure that your standard contract include provisions that specify that contractors are free from control, that they have insurance, and that they can hire their own employees.
8. Have a check and balance with Accounts Payable to ensure that a contract is in place before paying a contractor invoice.
9. Avoid having contractors use your office or company equipment.
10. Refrain from engaging independent contractors to perform the same type of service as an employee or former employee of the company. That does not mean you cannot engage independent contractors for overflow or to support staff on special projects.
11. Do not have contractors submit time cards. Independent contractors should submit an invoice for payment based on the terms of your agreement.
12. Don’t re-engage a former employee as an independent contractor to perform the same services.
13. Be mindful of co-employment. Co-employment, or joint-employment, occurs when two companies both have rights and obligations as an employer. This commonly happens when staffing agencies hire independent contractors for their clients. Co-employment can increase the risk of litigation when a contractor thinks they have been misclassified, or if your company is audited and found to have treated contractors as employees, or vice versa.
14. Form an internal team to deal with these issues before they arise. A cross-functional team that includes legal, compliance, human resources, and procurement can help you to address red flags before they become bigger issues.
15. Partner with a company that specializes in independent contractor engagement and compliance.

Additional Thoughts

Independent contractors can be a vital resource to your business and are increasingly becoming an integral part of doing business. You can minimize the risk of a misclassification audit by having a standardized process in place for engaging and managing independent contractors that is consistently enforced.