ASK THE IRS AUDITOR: 10 THINGS TO KNOW ABOUT WORKER MISCLASSIFICATION
Based on a Q&A session with Kathy Breedlove, Director of Compliance Services for Secure Talent, and David Sity, CPA, former IRS auditor and member of the Secure Talent Compliance Team.
1. The question we are asked most frequently by clients, prospects, readers of our blog, audience members, etc… is “how real is the risk”? How many companies are audited on 1099 issues each year?
The IRS has announced plans to audit 2,000 companies per year for the next three years. 100 additional auditors were hired recently by the IRS to focus on collection of employment taxes. Previously, probably less than 1,000 companies per year were audited on 1099 issues. However, with the additional auditors on staff, the IRS will significantly increase the number of audits conducted over the next three years.
2. Are there specific industries that are being targeted, or specific fact patterns that will attract IRS attention?
With regard to specific industries, historically the construction industry has been a big target. However, given that the IRS intends to double their audit rate, they can only do this by pursuing other industries which commonly rely on 1099 workers, such as the technology sector. It is also likely that medium and small size companies will become audit targets.
There are a number of fact patterns that may trigger IRS attention. For example, the IRS will compare payroll and 1099’s year over year – if a company shows a significant decrease in payroll and a corresponding increase in 1099’s this will be flagged. The IRS will also look at the sales to payroll ratio in relation to industry standards. Low payroll to sales ratios may cause the IRS to look for 1099’s issued.
3. I know about the 20 factor test – but what would you say are the three biggest factors?
The control factor. The IRS will look at whether the worker is performing most of the work on-site, whether they are working independently or as part of a team with W-2 employees, whether they have the same supervisory relationship as W-2 employees (weekly 1:1’s, team meetings, etc.). A true independent contractor is held accountable only for the results obtained, and not directed as to how to achieve those results.
Ability to make a profit/loss. A worker who is paid hourly looks like an employee. A worker who is paid by the project has the ability to make a profit or loss based on the amount of hours it takes to complete the project. A short-term, fixed fee project with payment only upon deliverables is a strong case for 1099 status.
Existence of other clients.. A worker who can show that they work for multiple clients (and do not receive the majority of their income from one company) looks like a 1099 worker. It is also helpful if they have advertising, such as a website, business cards, listing in association directories, etc.
4. On the flip side, what are the three biggest “red flags” that scream Misclassification?
Probably the most common “red flag” scenario consists of (a) a former employee who comes back to work as a 1099, (b) performing substantially the same work. If this is a long-term, indefinite engagement where the individual is (c) working essentially full-time for the company, paid on an hourly basis, it looks like a classic case of misclassification.
5. Does working with only individuals who have a corporate entity (LLC or Inc) mean that I’m safe from an audit? Am I even required to issue a 1099 to these types of corporations?
Yes and No. The first thing that the IRS will look at is 1099’s reported under an individual social security number (SSN) and not a federal employer identification number (FEIN). You are not required to issue a 1099 to corporate entities. However, an audit risk still exists, since audits may be triggered by 1099’s that were issued to similarly situated workers. The audit can then expand to the corporate entity that was also engaged by the client company. The fact that the worker has incorporated will not preclude the IRS from applying the 20-factor test. In particular, the IRS will look at whether the company advertises, has more than one employee, and has multiple clients. If the workers’ company fails the test, the worker will be reclassified as a W-2 employee. Because certain protections, such as the Safe Harbor provision (Sec. 530) and the Voluntary Classification Settlement Program for misclassified workers (VCSP) are available only to employers who issued 1099 for the workers, many companies choose to issue 1099’s even to corporate entities.
6. What about having a contract with the worker that clearly states that they are an independent contractor and are responsible for their own payroll taxes?
While a contract is certainly good to have (it suggests a business-to-business relationship), boilerplate provisions in a contract dealing with issues such as supervision and control, provision of equipment, right of termination, etc., will not be persuasive when they are contradicted by the realities of the situation and the statements of workers and/or supervisors.
7. If my company is audited, how far back does the audit go?
Three years is typical. State audits may attempt to reach back further.
8. What is my potential liability if I’m audited and I don’t have a solid case?
The company may be held liable for payroll tax withholdings including payroll taxes, social security, Medicare, and federal unemployment. What many employers don’t realize is that these assessments can include both the employer and employee share of these withholding taxes*. Interest and penalties are also assessed. As a general rule, you could estimate federal and state agency liability of approximately 40% - 45% of the amount paid to the misclassified worker. And this liability could go back 3 years for each individual. Of course, this doesn’t include potential liability for unpaid benefits (e.g. medical benefits, stock options, 401(k), sick pay, holiday pay, etc.), overtime, and other liabilities which may also arise as a result of misclassification.
9. What can I do if my company is selected for an audit?
Generally speaking, the best advice is to be cooperative, but not talkative. Don’t volunteer too much in an attempt to establish that you have “nothing to hide”. You may inadvertently give the auditor information that they wouldn’t have asked for, but that can now lead them to seek out other information that is not helpful to you. Immediately find a knowledgeable representative to serve as the point person and primary point of contact. They can field information requests, gather information, and present it in the most favorable light. The perceived strength of your case will be an important factor in negotiating settlement.
10. What records should I be keeping in the event of an audit?
A defensible audit file includes a contract/Statement of Work that clearly defines the scope of work, project duration, where the work is to performed and under what level of supervision, payment schedule (i.e., hourly or fixed fee, maximum budget amount), and termination provisions. The file should also include documentation of the basis for classifying the particular worker as an independent contractor, based on a screening process and standards that are applied uniformly throughout the company. For example, evidence of business formalities such as corporate documents or fictitious business name statement, business license, proof of insurance, etc., along with sample marketing materials and evidence of other clients, should be included.
*The IRS does not “give the employer a break” by checking to see if the worker paid their taxes. The employer may request that the worker sign an attestation stating that the relevant taxes were paid. However, even if the worker can be located, they are often not cooperative and may fear that signing a statement will invite an audit of their own taxes.
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