How Do I Prepare for a 1099 Independent Contractor Audit

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How to Prepare for a 1099 Independent Contractor Audit

We have previous discussed the idea of putting your different workers into different buckets. In this chapter, 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. So, 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? Alot of ways to go about this and obviously 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.

So, 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, you have etc….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 that 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 will 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.

“Well, 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?"

"Well, 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. 

 

Google and Social Media Screening in 1099 Independent Contractor Audit Preparation 

The EDD tax auditors use google and social media just like you do to run searches on people and to gather information. Social media and google have become a big part of how the tax auditors are conducting background research these days (guess what, the auditor has probably already googled your business and figured out who you are). So, it is important to run social media and google checks of all the people that the auditor is likely going to run into during the course of the audit.

You are looking to see if there are any initial red flags right off the bat, mainly anybody who is listing themselves as an employee of the business and is not, or who has not identified themselves as being in business for themselves. Catching these people and asking them politely to change their LinkedIn profile to reflect the true nature of their occupation will really help. Again, if there's something that is materially untrue, we don't want your tax auditor to see that.

If you have got an independent contractor who is openly representing that they are an employee of the business, you need to make sure that the information being represented is accurately reflected. Because, as you can imagine, the EDD is going to use that social media and that profile against your client during the audit. So, make sure that information is clear ahead of time, and then you should be in pretty good shape.

 

Other Key Documents in Preparing Supporting Documentation for the 1099 Independent Contractor Audit

Let us talk about some other things that play a key role in the audit starting with independent contractor agreements. A lot of times what we see people do when they are audited by the EDD is to go and create independent contractor agreements during the course of the audit. A word of advice, if you do not have an independent contractor agreement in your place with your independent contractor, do not go and create one in the middle of your audit and submit it to the auditor. It sounds stupid and probably counterintuitive, but it just is solidifying the evidence that the person is not really an independent contractor by submitting a currently dated independent contractor agreement. So, let’s not do that, but if you have an older independent contractor agreement please submit it.

Professional license is really important for workers who classify for that. So, doctors, dentists, attorneys obviously, any sort of health professional, cosmetology. Any sort of professional licenses that those people will submit to you otherwise are great. Then any other document that they may have to produce to promote independence. If they've got advertising, if they've got one sheet or a flyer, or anything like that, producing that to the auditor is very strong evidence that they are independent and not within the control of the employer. So, it's definitely a good thing to have with respect to that.

In addition to professional licenses, any proof of liability insurance, commercial insurance, or professional liability insurance, particularly if it establishes that your independent contractor was insured independently insured is a really good thing.