4 Steps to Take in a Worker Classification Audit

By MBO Partners • July 29, 2024

5 MIN

Team made up of employees and independent professionals

Key points

With the right knowledge and preparation, you can successfully navigate an audit professionally and even help safeguard your company against future problems.
Even if you’ve kept immaculate records, retaining the services of a tax preparation professional or attorney will provide you with access to an experienced expert who has dealt with audits before.
If you can determine what triggered the audit, you may be able to try and limit the scope of the investigation.

Any business that engages independent talent will take precautions to minimize the risk of worker misclassification, but if you do find yourself with an IRS audit letter, what do you do? Because audits can result in large fines, negative press, back-tax payments, and even class-action lawsuits, the prospect of going through one can be scary. But with the right knowledge and preparation, you can successfully navigate an audit with professionalism and even help safeguard your company against future problems.

Being Audited for Worker Misclassification

When your company is audited, you’ll receive an audit letter. This letter typically doesn’t contain a lot of detail, but it will let you know the time period, records, and specific entity under review. Think of this letter as an initial instruction sheet that you’ll want to follow as closely as possible. Your auditor may also send a pre-audit questionnaire, which provides them with additional information to create a detailed audit plan. Once you receive an audit letter, it’s time to act.

If your company is audited for worker misclassification, consider following these four essential steps:

1. Bring in the professionals

Even if you’ve kept immaculate records, retaining the services of a tax preparation professional or attorney will provide you with access to an experienced expert who has dealt with audits before. Right off the bat, a tax attorney can assist in planning your pre-audit questionnaire responses to help you avoid potential problems down the road. In addition to document preparation and legal representation, a professional can also assess if your independent contractors were properly classified, gather extensive details about their work, and assess whether or not there is any potential for fraud or penalties.

You’ll also want to appoint an internal audit team that consists of representatives from your legal, HR, payroll, and tax departments who can help assemble and prepare documents.

2. Respond to requests promptly

Being timely will go far. While you don’t have to respond to requests immediately, you don’t want to give the impression that you are stalling. After receiving the audit letter, organize your materials as best as possible and then schedule a call with your auditor. Auditors often want to see documents from the years or months before and after the specified audit period. Work with your auditor to determine the exact information from the exact time period they need so you can best utilize your resources.

If you are able to determine what triggered the audit, you may be able to try and limit the scope of the investigation. For example, if a single claim triggered the audit, you may have the right to limit the scope to a particular individual or group. Work with your professional representative to determine the best course of action.

3. Organize files and paperwork

The requested paperwork and files will vary depending on the scope of an audit. Typically, an auditor will request all 1099s over a three-year period. However, if that is a massive amount of data, the audit might instead focus on a random number of 1099s from each year. Other types of requested records can include copies of checks, cash payments, brokerage statements, credit card statements, bank records, income tax returns, tax reports, financial statements, and work-related travel logs.

Focusing preparation around the 1099s is a good place to start. If you see any situations where an independent contractor received both a W-2 and 1099 in the same or consecutive tax years, flag these instances. Remember, the IRS has likely already researched and knows about your red flags. If you’ve undergone an audit before, or have dealt with employee lawsuits, be prepared to answer questions about these situations.

4. Cooperate and plan ahead

Audits are an extensive process that takes a long time, so stay calm and remain cooperative. Remember, it’s up to the auditor to decide whether a worker is an employee or independent contractor. Due to the number of different legal tests and factors, this determination can be highly subjective. The IRS will likely want to speak with some of your workers to see if they confirm the information you’ve provided. Preparing for this task ahead of time by finding a few workers to be witnesses and including them in your file can save you stress down the road.

Independent contractors are likely an important resource for your business. If you know what triggered your audit, use this knowledge to prevent future problems. Ensure you have a standardized program for compliantly engaging and managing independent contractors to help minimize the risk of another audit. Partnering with a company like MBO specializing in independent contractor engagement and compliance can also help minimize your risk.

The information provided in the MBO Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs. Before acting on any information in the MBO Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.