By Michael J. Svoboda and Stephanie C. Pfister
Amid federal and state budget shortfalls and rising unemployment claims, the IRS and state agencies have stepped up enforcement of worker classification laws. This combined federal and state effort may result in increasingly aggressive audits and the reclassification of independent contractors as employees. Consequently, companies that utilize independent contractors should be prepared for a worker classification audit.
In our experience, three primary events trigger worker classification audits:
- Industry-wide audit wherein the IRS and/or a state agency targets numerous employers in a particular industry.
- Obstructed claim for unemployment benefits (i.e. an independent contractor files for unemployment benefits typically available to employees only).
- A disgruntled worker (or former worker) reports the company to the IRS or a state agency.
Audit Notice Response
Upon receipt of a worker classification audit notice, companies should not ignore it. The audit will not go away. In fact, ignoring an audit notice may result in additional penalties and/or sanctions. Companies should respond timely and provide the information requested, or, if necessary, call the auditor and request additional time to prepare.
In addition, the company should consider asking the auditor why the audit is being conducted. This information will help identify erroneous or preconceived notions the auditor may have regarding the classification of workers in the company and help focus the audit inquiries.
The audit notice will contain a list of documents the auditor would like to review. The primary documents requested will likely be forms 1099-MISC. The auditor will likely request forms 1099 for all years open under statute (generally the last three calendar years for IRS audits, and three or four years for state audits).
When gathering the 1099 forms, categorize them by the type of service performed (e.g. janitorial services, clerical, sales, technology support, etc). After services are categorized, create a file for each worker, including any documents that support that worker's status as a bona fide independent contractor, including copies of invoices, business cards, Web pages, client listings, etc.
Ideally, companies should compile all such documentation before an audit notification is received. Proper maintenance of documentation will also help companies take a proactive approach identifying any workers that may be misclassified.
Typically, the auditor will not make a status determination on each worker, but rather a determination on the entire service category. As a result, if an auditor determines that an entire service category constitutes employment, an assessment will be issued on all workers who performed services in that category. Companies may request that the auditor select a random sample of workers within a category, both agreeing that the status determination for those workers will be applicable to all workers in that category.
Once the audit has commenced, the auditor will generally use the last completed calendar year as a "test year" to examine worker status. If no significant worker reclassifications issues are found within the test year, the auditor will usually not examine the remaining years open under statute. However, if the auditor finds significant issues within the test year, the remaining years open under statute will typically be opened to examination.
At the close of an IRS worker classification audit, if improper classification has been found, auditors are required to offer participation in the Classification Settlement Program (CSP), which provides an opportunity for companies to reduce the amount of tax assessed under the audit. In order to participate in the CSP, the company must have issued and filed all applicable forms 1099-MISC in a timely manner.
Under the CSP, the company agrees to prospectively re-classify workers that have been misclassified as independent contractors in exchange for:
- An assessment of one year of the tax liability determined, or
- If the company has a "colorable argument" for the misclassification, a reduced assessment equal to 25 percent of the one-year liability. The CSP is offered on a service category basis, thus, a company participating in the CSP may agree to re-classify workers in one or more service categories, but not in others.
Auditors are also required to ascertain the applicability of Section 530 of the Revenue Act of 1978 to the reclassified workers. Section 530 allows for relief from tax and penalties if the following three requirements are met:
- All applicable forms 1099 were issued and filed in a timely manner.
- The company had a reasonable basis for misclassifying the employees as independent contractors.
- The company consistently treated all workers in a given service category as independent contractors rather than employees, and as such issued those workers 1099 forms rather than W-2s.
Section 530 absolves the company of tax and penalty assessments and does not require reclassification of workers as employees on a prospective basis. Thus, the company may continue to treat the workers as independent contractors.
Note, however, that the reasonable basis requirements of Section 530 are more stringent than those of the CSP, and legislation has been introduced in previous sessions of Congress to curtail the use of Section 530 for future audits.
In summary, when the IRS or a state agency comes knocking, companies should gather their records, respond timely, respond accordingly, and know their rights to assessment relief. The best offense is always a good defense.
Michael J. Svoboda and Stephanie C. Pfister are with KPMG LLP. This article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP, an audit, tax and advisory firm (www.us.kpmg.com).