What's Scarier Than an Agency Audit? Three Agency Audits

Misclassifying employees as “independent contractors” may put employers in triple jeopardy. (See article infra by Rosanna Sattler.) The U.S. Department of Labor (DOL) is teaming up with the Internal Revenue Service (IRS) and state agencies to crack down on “misclassification.” Thirteen state labor agencies have joined forces with the federal DOL in this initiative. This coordination will lead to a greater likelihood of companies being caught and a much higher cost for employers that have the unfortunate fate of the triple audit.

Misclassification occurs when an employer treats a worker as an independent contractor, even though the worker is actually an employee. The DOL has made this a top priority, seeking $3.8 million and 35 full-time workers to fight misclassification in its 2012 budget proposal. Misclassification costs the government tens of billions of dollars in lost tax revenue, so these agencies have a huge incentive to zealously pursue cases against employers.

Properly classifying a worker as an “employee” or “independent contractor” is a complicated task. Different agencies use different tests and no single factor controls. The tests use a multitude of factors (the IRS looks at 20 ), and the tests change over time.

If you wish to hire independent contractors, you should review the tests from different agencies at the state and federal levels and make an honest assessment of the situation. You should also consult with counsel knowledgeable about this area, particularly if you plan to hire many workers of this type. Skilled counsel can help determine the correct status of the worker and may draft an “independent contractor agreement” to help protect you if you get audited. Such an agreement should set forth facts supporting your determination. However, you cannot transform an employee into an independent contractor by agreement. If your situation remains unclear, you can request an agency opinion in advance, but remember that different agencies use different tests.

Finally, using outside counsel may help you avoid creating documents that the government can obtain from you which confirm the weakness in your determination that the worker is an independent contractor, i.e., the “smoking gun. For example, if your HR director writes your CEO a memo explaining why the classification may be wrong, and the government sees that memo, it is hard to argue you did not know the classification was questionable or, worse yet, simply wrong. However, if your attorney creates such a document, it is unlikely you will have to produce it to the government as your attorney will claim it is a privileged attorney-client communication.

While your prospective decisions are a concern, a bigger issue is what you should do if you may have already misclassified employees as independent contractors. Conduct an internal audit to reconsider old decisions, but be prepared to act on your findings. If you have already misclassified workers and are not currently being audited, consider the IRS's Voluntary Classification Settlement Program, which can reduce your liability without triggering an audit. Being proactive can help you avoid the administrative agency triple threat.

Robert G. Brody, a member of this newsletter's Board of Editors, is the founding member of Brody and Associates, LLC. Rebecca Goldberg is an associate with the firm.

Misclassifying employees as “independent contractors” may put employers in triple jeopardy. (See article infra by Rosanna Sattler.) The U.S. Department of Labor (DOL) is teaming up with the Internal Revenue Service (IRS) and state agencies to crack down on “misclassification.” Thirteen state labor agencies have joined forces with the federal DOL in this initiative. This coordination will lead to a greater likelihood of companies being caught and a much higher cost for employers that have the unfortunate fate of the triple audit.

Misclassification occurs when an employer treats a worker as an independent contractor, even though the worker is actually an employee. The DOL has made this a top priority, seeking $3.8 million and 35 full-time workers to fight misclassification in its 2012 budget proposal. Misclassification costs the government tens of billions of dollars in lost tax revenue, so these agencies have a huge incentive to zealously pursue cases against employers.

Properly classifying a worker as an “employee” or “independent contractor” is a complicated task. Different agencies use different tests and no single factor controls. The tests use a multitude of factors (the IRS looks at 20 ), and the tests change over time.

If you wish to hire independent contractors, you should review the tests from different agencies at the state and federal levels and make an honest assessment of the situation. You should also consult with counsel knowledgeable about this area, particularly if you plan to hire many workers of this type. Skilled counsel can help determine the correct status of the worker and may draft an “independent contractor agreement” to help protect you if you get audited. Such an agreement should set forth facts supporting your determination. However, you cannot transform an employee into an independent contractor by agreement. If your situation remains unclear, you can request an agency opinion in advance, but remember that different agencies use different tests.

Finally, using outside counsel may help you avoid creating documents that the government can obtain from you which confirm the weakness in your determination that the worker is an independent contractor, i.e., the “smoking gun. For example, if your HR director writes your CEO a memo explaining why the classification may be wrong, and the government sees that memo, it is hard to argue you did not know the classification was questionable or, worse yet, simply wrong. However, if your attorney creates such a document, it is unlikely you will have to produce it to the government as your attorney will claim it is a privileged attorney-client communication.

While your prospective decisions are a concern, a bigger issue is what you should do if you may have already misclassified employees as independent contractors. Conduct an internal audit to reconsider old decisions, but be prepared to act on your findings. If you have already misclassified workers and are not currently being audited, consider the IRS's Voluntary Classification Settlement Program, which can reduce your liability without triggering an audit. Being proactive can help you avoid the administrative agency triple threat.

Robert G. Brody, a member of this newsletter's Board of Editors, is the founding member of Brody and Associates, LLC. Rebecca Goldberg is an associate with the firm.