Audits by the federal Department of Labor and the IRS (these two agencies signed a memorandum of understanding in 2011 to work together in misclassification audits. Since that time federal audits in this area have been on the rise) and/or state employment development departments can arise for a number of reasons. Increasingly we are seeing such audits arise when someone has been incorrectly classified as an independent contractor and/or applies for unemployment, SDI or worker’s compensation benefits. At the federal level several common triggers have been where:
- W-2’s and 1099’s overlap for the same employee in the same year,
- An independent contractor who files a Form SS-8 seeking government determination of employment status, and
- An independent contractor who claims employee status when filing for unemployment benefits.
During an audit, the auditor typically reviews the employer’s financial books and records to confirm that individuals have been properly classified as either an employee or independent contractor. The audit will usually apply to all of the employer’s independent contractors, not just the contractor who initially triggered the investigation and may cover a number of tax reporting periods.
Recommendations When Under Audit
At a recent seminar on the issue the following recommendations were put forth by attorneys who have extensive experience in this area:
- Immediately notify your employment counsel upon receipt of any notification that (1) the company has been selected for an employment tax audit, (2) that the company is being asked to provide “pre-audit” information to the agency, and (3) further information is needed regarding an independent contractor who has applied for benefits.
- Companies are also recommended to consider having their counsel designated as their representative in the audit. This can normally be done by completing the agency’s power of attorney form.
- It is a good idea to use the following general guidelines in the event of an audit.
- Do not agree to allow the agency to conduct an in-house audit (e.g. at the company’s work location),
- Be careful about communicating with the agency directly, use your attorney to communicate with the auditor,
- Be careful in communicating with independent contractors and employees about the audit as the agency is likely to contact these individuals directly for information as part of the audit,
- Be wary of the audit period, avoiding the tendency to over-produce information.
- Have a spirit of cooperation; it can be useful and helpful in persuading the auditor that any misclassification discovered was not intentional, which may cause the agency to waive potential penalties for misclassification.
Audit yourself before a government agency audits you. Conduct a self-audit using an outside, independent third-party experienced in the field who can then identify red flags and work with you to correct any areas of concern. Payroll audits can generally go back three years so employers should conduct internal audits at least this often.
Consider having your independent contractors enter into a more formal agreement with you that acknowledges the intent of the relationship and waive any rights to company-sponsored benefits. Be sure to review benefits to ensure a clear definition of a plan participant.
Create separate policies and procedures for independent contractors and contingent workers. Equally important, train your managers to effectively and consistently apply these policies
Finally, it is critical that the job responsibilities of an employee differ from those of an independent contractor. The IRS and DOL look primarily to the factor of how much right to exercise control an employer has over a purported independent contractor, and how that control is actually exercised.