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    How will I get caught if I misuse Independent Contractors?

If workers are are not classified correctly the employer will get caught.  Employers get caught though various channels.  These main ways that they get caught cover everything from employees reporting the abuse to IRS audits.

Worker Files a Workers Compensation Claim

If a worker gets hurt on the job and they are an independent contractor they are not covered under workers comp insurance.  If an independent contractor is hurt on the job and they do not have their own workers comp policy they will often file a claim against the employer. If it is found that the independent contractor should have been classified as an employee than the employer will be required to pay the medical expenses out of pocket for the injured worker.

Employee Reports Misclassification

Classifying an employee incorrectly as an independent contractor has several consequences that affect governments and workers. Employers who do not classify employees correctly are failing to provide unemployment insurance (UI) and workers’ compensation (WC) as well as failing to pay employer withholding taxes leaving workers with large tax bills.

Employees who believe they have been misclassified as independent contractors have several avenues for resolution. These suggestions are not intended to substitute for legal advice, nor are they intended to be an exhaustive list of available options or remedies.

First, workers can contact their state departments of revenue and labor to report suspected misclassification, including UI, WC, and tax fraud. Many states give workers the option of anonymously reporting employers who are erroneously misclassifying employees as independent contractors.

Second, if the employer has classified the employee incorrectly as an independent contractor and paid less than minimum wage or failed to pay overtime, then the worker may can contact the U.S. Department of Labor Wage and Hour Division to report minimum wage and overtime pay violations.

Third, workers can anonymously report suspected tax fraud (employer failure to withhold taxes) to the Internal Revenue Service (IRS) by using Form 3949-A.  Workers can also file Form SS-8 with the IRS for a determination of worker status.  Form SS-8 CANNOT be filed anonymously.


Worker Files an Unemployment Claim

An audit is often triggered by a former worker applying for unemployment insurance, which is taken as an assertion that the person was an employee of your company and entitled to unemployment payments.

When an individual files an unemployment claim, the taxing agency looks for the wages reported by the employer. When there are no wages reported, this could trigger an audit. It begs the question “Why does this worker not have any taxes paid into the unemployment fund by their employer?”

The business is flagged by the state for using independent contractors and the state starts an audit to investigate the potential abuse.

Businesses that either use independent contractors to supplement their workforces or that operate on the basis of independent contractor business models have also been targeted increasingly by plaintiffs’ class action lawyers. Independent contractor misclassification lawsuits have mushroomed against both large and small businesses. Almost no industry is free from these types of lawsuits,

The Audit Process

An audit begins with a formal notification of audit through postal mail. The auditor will send a list of requested documentation and a pre-audit questionnaire.

A minimum documentation request includes:

  • Verification of business ownership
  • Check registers and stubs
  • Bank statements and canceled checks
  • General ledger and journal
  • Annual financial statements
  • Vouchers and pay-out slips
  • Forms 1099

The pre-audit questionnaire is designed to elicit admissions and give the auditor enough information to develop an audit plan. You must carefully plan your responses to avoid problems later. If you have not yet consulted a skilled tax attorney, this would be a good time to do so. A tax attorney can help you minimize admissions that could cause problems down the road.

An audit typically covers a three-year period unless circumstances arise that cause the auditor to go back further.

When it comes to employment classification, the auditor has the discretion to define and apply a list of factors to determine whether a worker is an employee or an independent contractor, which brings us around to the relationship between employment classification and payroll tax audits.

The EDD auditors always assess the factors, used to determine employment classification (which are highly subjective) in their favor; therefore, it is more difficult to convince them that a contractor is not an employee.

Potential Audit Results and Penalties

An audit can result in one of four outcomes:

  • No change, meaning no differences were found
  • Overpayment, in which a refund or credit is issued
  • Underpayment, meaning the difference will be assessed and charged to you
  • Both underpayment and overpayment

Demand for payment of penalties, interest, and back taxes within 30 days is usually made. If you cannot pay this in full within the time allotted, a 10% penalty will be added. Penalties often drive EDD audits because the penalties can exceed the taxes owed in certain conditions.

As you can see, an adverse audit decision can cause substantial payroll tax liabilities for your business. To add to the issue, the IRS generally adopts the conclusion of the EDD auditor and assesses federal payroll taxes, interest, and penalties. Filing for bankruptcy will not resolve the problem with the EDD.

If you are classifying your employees as independent contractors you will get caught eventually through one of many channels listed above.  It is better to change your employee classification then to wait and get caught.  Please contact me if you need assistance.  You can reach me by phone or email me brett@paragonpayrollhr.com.


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