Are you rEDDy for the Audit?

Incoming Financial Audit
Photo credit: chaofann

By Jeffrey Davine

We regularly assist clients with worker classification audits that are conducted by both the Internal Revenue Service (the “IRS”) and the California Employment Development Department (the “EDD”).  It appears that these types of audits may be occurring with greater frequency than in the past. Waiting until after the IRS or the EDD comes calling to review the status of these workers is not a good option.

There are two categories of workers- employees and independent contractors.  From the perspective of a business, classifying a worker as an independent contractor is usually less expensive and entails fewer administrative burdens than classifying a worker as an employee.  This is because various tax obligations (such as withholding and remitting income and employment taxes) are triggered when a worker is classified as an employee.  In addition, if a worker is an employee he or she may be eligible for certain fringe benefits such as paid vacation, health insurance, and retirement plan participation.  Moreover, labor laws impose numerous obligations on a business when it hires an employee.  These tax and administrative requirements do not need to be satisfied when engaging an independent contractor. Generally speaking, an independent contractor is simply paid a gross amount and no withholding of income or employment taxes is required.  The independent contractor is obligated to remit whatever taxes may be owed to the IRS and the EDD without any involvement from the business.  Aside from having to issue a Form 1099 to the independent contractor and to the IRS (for payments that total at least $600), the business has no further tax reporting obligations with respect to its independent contractors.

The purpose of a worker classification audit is to determine if a business is properly classifying the persons who provide services to the business.  Due to the financial, administrative, and legal burdens that are imposed upon a business when it hires an employee, businesses will sometimes opt for the less complicated route and classify a worker as an independent contractor even in a situation where the worker should be treated as an employee.  Although this may be a seemingly palatable option, it can be shortsighted and extremely risky.

If the IRS or the EDD determines that a business has misclassified its workers as independent contractors, the business could find itself in the situation where it is liable for the income and employment taxes that it should have withheld from the compensation paid to each employee.  The IRS and the EDD can impose significant penalties (plus interest) on top of the tax liability.  If these amounts are multiplied by a few dozen employees over several years, the resulting liability could be devastating.  Although there are provisions under both federal and California law that can reduce the potential liability in certain circumstances, no business wants to find itself on the wrong end of a worker classification audit.

Based upon the number of clients who have contacted us over the last several months in connection with worker classification audits, it appears that these audits may be increasing, especially audits conducted by the EDD.  As a result, we strongly suggest that each business that engages independent contractors spend some time reviewing its policies and procedures for engaging these independent contractors to ensure that its classification of these workers as independent contractors can be defended if it becomes necessary.

In determining whether a worker is properly classified as an employee or as an independent contractor, the definitive question is:  Does the recipient of the services have the ability (whether or not exercised) to control the “details” or “manner and means” utilized by the worker to complete his/her work?  If the answer to this question is “yes’, the worker is an employee.

In determining if the requisite degree of control is present to classify a worker as an employee, the IRS and the EDD will often analyze several factors.  These factors include the following:

  1. Whether the worker is engaged in a separately established occupation or business;
  2. Whether the worker can be discharged at any time without cause;
  3. The skill that is required to perform the services and accomplish the desired             result;
  4. Whether the business or the worker supplies the tools, equipment, and place of             work;
  5. Whether the work is an isolated event or continuous in nature;
  6. The method of payment, i.e. by time, a piece rate, flat fee, or commission;
  7. Whether the work is part of the principal’s regular business;
  8. The relationship (i.e. employee or independent contractor) that the parties believe they are creating;
  9. Whether the principal provides the worker with training or supervision;
  10. Whether the worker is provided with “fringe benefits”;
  11. Whether the worker is engaged in a business enterprise or is providing the services as an individual;
  12. Whether the worker can make business decisions that will enable him/her to earn a profit or incur a financial loss.

            The analysis is complex, because not every factor is applicable in each situation and some factors are more important than others are.

The lesson to be learned is that, with the apparent increase in worker classification audits, it would be prudent for each business that engages independent contractors to take a close look at these persons to ensure that they are properly classified.

We are, of course, happy to assist in the evaluation process and offer our advice on mitigating the risks in the worker classification context.

Please contact the MSK tax team for more information.

David Wheeler Newman
Allan B. Cutrow
Jeffrey D. Davine

Jeffrey K. Eisen
Robin C. Gilden
Robert J. Lowe

Daniel Cousineau
Andrew Park

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