In this article, we are going to dive through the nuts and bolts of how to really prepare for the audit when it comes to the subject of independent contractors and potential misclassification issues.
First, if you have independent contractors, you are going to want to start gathering evidence that they are their own independent business.
- Do they have business cards?
- Do they have a business license, are they willing to otherwise document that they're an independent business?
- Do they have a website?
- Do they have advertising?
There are a lot of ways to go about this and obviously the best strategy is specific to the type of work that they do.
Gathering the 1099 independent contractor information
The independent contractor portion of preparing for the audit is by far the most labor-intensive and time-consuming portion of the project, so we have devoted special attention and reveal our inside process for preparing for an independent contractor audit.
The starting point for this is fact-specific depending on what type of business you are dealing with, but essentially you want to build a core business model and examine the relationship between how the company relies on its employees and how it utilizes contact labor.
You may be dealing with 50,100, or even thousands of contract workers, but the thing about businesses is that they are going to fit into categories based on the roles that they perform in each business.
The idea is that you want to break down these independent contractors into “buckets” and you want to start preliminary assigning what your buckets are going to be.
You've got the salespeople, you've got the admin people, you've got professional services people, for example. You assign people to buckets based on their individual roles and not whether they are W2 or 1099 independent contractors.
Then within the buckets, you want to take a look at who is there and start distinguishing between the W2 and 1099 workers you have in those buckets.
Are their roles different? You may, for example, have an internal bookkeeper but an outside accountant. With the 1099 contractors, you also want to distinguish them from the revenue generation function of the business. Workers who are inherently tied to the revenue-generation function of the business are going to tend to be scrutinized and reclassified as employees.
From a practical perspective, you will start putting people into buckets then go through the bucket as a whole.
As you start going through the bucket as a whole, you'll assess who's there. For example, you might say:
Okay, I've got bucket one and I have three people in here. Are there any issues associated with these three people? Do I know something about these three people that would distinguish them from one another? If I have three independent contractors in the bucket, which one am I going to want the auditor to speak with if they were to interview them.
I would want the auditor to talk to Todd. He owns his own construction business. He's got a website and we have a copy of his business license on file. Okay, Todd's a good person that we could present to the auditor. Okay, who's next?
Then we have got Dan. Dan works construction too, but he does not really own his own business. He’s 40 hours a week for us and, because of that, he does not really do anything else for anyone else. However, we file a 1099 for Dan because we always have paid him on a 1099…..Ok, we definitely DO NOT want the auditor to talk to Dan.
You see? This where the magic happens. As you start having these conversations, a presentation strategy emerges where you push your Todds in the direction of the auditor and tend to under-emphasize your Dans. If you have a “Chuck” that falls in the middle, you need to make a strategic decision of how to present him to the auditor. Is he more like Todd or more like Dan?
Then, you assemble records. Every Todd should have a file with as much information in it as possible to build your case. Seriously, hit the tax auditor over the head with as much as you can in support of making Todd look more like a Todd. With Chucks, depending on how much support you can gather, you will find out pretty quickly if they are a Todd or a Dan.
This is the hardest part because a lot of this information may not be readily available or at your fingertips. And because a significant portion of your time spent preparing for the audit may center around independent contractor classification issues, you should build in as much time as you can to build your case as possible.