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Worker Classification Still Hot Federal-State Audit Issue

May 11, 2022, 3:08 AM

Whether a worker is an employee or an independent contractor is intensely interesting to federal and state regulators, according to two tax consultants speaking at the APA’s 40th Payroll Congress, May 10.

Both the IRS and the Labor Department audit employers to uproot worker misclassification, said Mindy Mayo, a managing director with KPMG LLP. And both agencies believe there is money to be found, with the IRS collecting lost tax revenue and the Labor Department collecting fines related to wage and hour violations for workers who have been treated as independent businesses but who are actually employees.

States follow suit, said Jason Russell, managing director with Deloitte Tax LLP. Outside of New York, which is more interested in cross-border issues, worker classification is top of the list when it comes to employer audits.

“I believe we’ll see more audits coming,” Mayo said, because employers are more likely to turn to independent contractors to save money during economic downturns such as we are now experiencing.

Employers are wise to get ahead of the auditors and understand their vulnerabilities. Looking at a company’s reporting forms is low-hanging fruit, Mayo said. Red flags should fly for any employee who receives both a Form 1099-NEC, used to report payments to a contractor, and a Form W-2, used to report wages paid to employees. Similarly, any Form 1099 showing a worker’s Social Security number instead of another taxpayer ID should be troubling, because it raises a question as to whether the worker is running an independent business.

“An audit will look back three years,” Mayo said. You have no idea where your independent contractor might be in three years, she added, so employers should collect any evidence that will help them in an eventual audit. “Does the worker have a business card? Get it,” she said. “Do they have a website? Get a screenshot.” A website may serve as proof that the contractor is advertising services to the public, which may be key to an investigation, Russell said.

Tax audits for misclassification, both federal and state, often hinge on the IRS’s 20-factor test, originally published in Rev. Rul. 87-41. In the years since the revenue rule was published, the IRS has focused more on three factors relating to behavior control, financial control, and the relationship of the parties. However, those three factors are a distillation of the original 20-factor test, according to Mayo and Russell.

Russell recommended that any employer discovering problems with worker classification enter the IRS’s Volunteer Classification Settlement Program, which might allow an employer to settle the outstanding tax debt for 10% of the liability and a promise to correctly classify workers in the future.

For payroll professionals working for employers that are reluctant to settle up, Russell recommends reviewing the amounts at risk in an audit, which can be considerable.

Two misclassified workers might not pose a substantial financial risk, Russell said. However, if the business model relies on misclassifying workers, that much-more-considerable risk should be reflected in the company’s financial records. At a minimum, the company’s books should show that the company is ready to write a check for whatever fine is likely to be levied.

“This can affect the company’s financial position,” Russell said. No company should take risks without proper planning. It the sort of thing that causes CEOs to lose their jobs, he said. “They cannot ignore it.”

To contact the reporter on this story: William Dunn in Las Vegas at