With worker misclassification issues at the forefront and landmark cases paving the way for added legislation, fines and penalties for improperly classifying workers, it’s surprising that intelligent business leaders still believe they can simply wish away federal or state audits.

And it’s alarming that many businesses are still operating without solid processes in place to ensure compliance when engaging 1099 independent contractors. Given the extreme tax liability of engaging 1099 workers, business leaders shouldn’t assume they’re safe from an audit.

Corporate counsel, human resources managers, procurement leaders, CFOs and others in a position of decision are constantly exposed to information on the risks of misclassifying workers as independent contractors. And still, there’s a propensity to believe they won’t be audited: “Yeah, it may be happening to others, but there’s no way it’ll happen to my company.”

Worker Misclassification Under Scrutiny

The IRS announced it will conduct 6,000 additional audits in 2010 starting in February. What’s the motivation? It’s estimated that the government is losing billions and billions of dollars in unpaid taxes due to the misclassification of employees as independent contractors.

As a senator, Barrack Obama co-authored legislation to remove the last loophole in the IRS tax code, Section 530 of the Internal Revenue Service Act of 1978—a clause the IRS must consider in a 1099 audit that can potentially preclude an employer from paying back taxes, penalties and fines for misclassifying workers.

Currently, there is no reason to think that our new president will move away from this effort given three primary drivers:

1. The government wants and needs the unpaid tax dollars
2. The belief that misclassified workers are not afforded the same rights under Fair Labor Standards Act, Title VII of the Civil Rights Act of 1964, Family and Medical Leave Act and more
3. Misclassifying employees and independent contractors is an unfair business practice

There has been more legislation proposed or passed in the past two years regarding worker misclassification than ever before. And conventional wisdom suggests that the effort to crack down on employers will continue to escalate. Recent legislation has significantly increased the penalties and fines associated with misclassification and in some cases, include felony charges and losing the right to operate a business.

A plethora of court rulings exist against employers who misclassify employees as ICs. While many employers are unintentionally misclassifying workers, they still face stiff punishment from failing an audit. Those found to be intentionally misclassifying workers can face even greater consequences.

Elevated Risk for All Businesses

There is far too much evidence that the misclassification issue crosses all segments of business regardless of industry, geography, size and position. It also crosses all divisions of organizations, ranging from customer service, marketing and sales to engineering, information technology and even human resources.

Companies should be taking the proper steps in 1099 risk assessment, especially in this economy. The recession has increased an employer’s risk. Why? There are several reasons:

• Independent contractors who finish a job or are no longer needed in a market where unemployment is at its highest, file claims for unemployment insurance naming the company they were providing services to as their employer
• Laid off workers are rehired as independent contractors performing the same tasks under the same control
• Independent contractors concerned about continuing to provide services file IRS Form SS-8 (or state equivalent), claiming to be an employee
• Independent contractors cannot afford health insurance and file for workers’ compensation

Creating a Proper Worker Classification Process

Many companies attempt to build a 1099 process but typically don’t have the expertise. Or they simply cannot stay current with ever-changing legislation. To complicate this further, the various state and federal agencies that audit an employer’s 1099 relationships use different tests. They can range from the IRS 3 factors/20 questions test to common law, ABC, relative nature of work, FLSA’s economic realities test and many more.

The issue of employee misclassification is clearly approaching top of mind with legislators, government agencies, courts and ethical businesses. The use of independent contractors is growing as well. The combination of the two will inevitably result in greater scrutiny, audits, penalties and fines.

Business leaders: It’s time to stop wishing and take action before action is taken on you. Create your corporate 1099 compliance plan before it’s too late.