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A Start-Up Nightmare: the Department of Labor Audit and How to Avoid It

One of my most painful memories in business was the four days I survived a New York State Department of Labor audit of my employees (that would be one, me.) Talk about butt-twisting agony. With that in mind, I’ve been very conservative about how I designate Independent Contractors at Social Media Today.  This issue has never been more important, as businesses become more virtual and task-driven.

We've invited David Branch from IC SimplifyImageto join a webinar next week on this topic.  We’ll also have a panel member from the federal Department of Labor and from the National Federation of Business.  And we’ll have a very knowledgeable attorney on board, or own, who has graciously agreed not to bill for his advice.  David has provided the following overview.

Please join us next week if you have more questions, or just need another shoulder to cry on.

Most small businesses would agree that the use of independent contractors seems like the better choice to hiring full-time employees, especially in the very early stages of the business. They open access to a pool of highly specialized skills on an “as needed” basis, permitting you the operation flexibility while decreasing long-term obligations.  But the biggest draw is that they come without the costly FICA, federal and state taxes, unemployment insurance, workers comp, and a variety of benefits usually bestowed to employees. Sounds like the perfect arrangement right?

While the use of Independent Contractors may appear to be the perfect arrangement it is not without its pitfalls and risks.  Governing laws, tax codes and other ordinances are complex and rapidly becoming more challenging than ever.

Even attempting to ascertain the proper classification standards by utilizing government supplied “tests” has become increasingly convoluted as criteria increasingly conflict with one another. In addition to the IRS 20 Factors Test, nearly every state has its own laws and means for determining worker status for unemployment and workers comp. If that wasn’t enough the DOL also uses a separate test to ensure ICs aren’t being improperly excluded from FLSA, which by itself has become a hot issue.

 It is no wonder that many small businesses have thrown caution to the wind and rolled the dice hoping an audit won’t come their way. But these businesses should understand that misclassification can amount to hundreds of thousands of dollars in fines from the IRS, $25,000 from certain state agencies, and exposure to lawsuits for back wages, overtime, benefits, civil penalties and attorneys’ fees. While no one can accurately predict the likelihood of an audit, it is important to understand that it isn’t completely random.

  • An independent contractor files a claim to receive unemployment or worker comp benefits.
  • Issuance of a W-2 and 1099 for the same worker by the same company in the same year.
  • Unmatched 1099 to individual income tax reporting.
  • A government tax audit. All tax audits by the government now require a subsequent 1099 audit.
  • Formal review request initiated by the individual contractor for misclassification (IRS form SS-8).

So what is a small business to do? Well attempting a full understanding of the guidelines is beyond the scope of this article; a good place to start would be with the IRS’s 20 Factors and specifically the ones that concentrate on Behavior Control. Most IC misclassifications are due to this class of factors. What is Behavior Control? It is simply how the employer directs or controls how the worker does the work.  Examples would be does the employer tell the contractor:

  • How, when, or where to do the work
  • What tools or equipment to use
  • Where to purchase supplies and services
  • What assistants to hire to help with the work

Also it is important to note that no single factor automatically makes the worker an employee or an IC. Unfortunately the IRS 20 Factors is only a set of guidelines. It is not a definitive guide. To see how these guidelines have been interpreted one needs to look at the IRS Revenue Rulings and case law to understand their relative importance. Thankfully there is a tool that has done that for you. Be sure to check out, which has weighted the factors and can give you an idea of the risk of misclassification based on how you are managing the IC.


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