Independent Contractors: How to Protect Yourself–Before You’re Called in for an Audit

The problem can surface without warning. A former independent contractor applies for unemployment benefits, but the state can’t find any record that the person was on your payroll or that you paid unemployment taxes. Before you know it, you’re being audited and facing huge penalties for all the workers you may have misclassified as independent contractors. And then you find out that California law is even stricter than federal law and there are no special exceptions you can look to for protection.

The HR Management & Compliance Report: How To Comply with California Wage & Hour Law, explains everything you need to know to stay in compliance with the state’s complex and ever-changing rules, laws, and regulations in this area. Coverage on bonuses, meal and rest breaks, overtime, alternative workweeks, final paychecks, and more.

As more employers utilize independent contractors as a way to cut expenses and retain flexibility, the high cost of misclassifying workers is becoming a greater concern. But there are still some little-known ways to protect yourself.

Who Is an Independent Contractor?

To determine whether a worker qualifies as an independent contractor, the IRS generally uses a 20-factor test. (See CEA January 1992.) Among other things, the IRS looks at the amount of control you have over how the work is performed and whether the person is available to work for other companies or clients. Ideally, the contractor should operate as a genuine independent business.

Even if you can’t satisfy all the criteria in the 20-point test, recent changes in IRS policy offer some relief. The government has somewhat relaxed the guidelines used by its investigators, suggesting that under some circumstances strict adherence to the 20 factors may not be required.

Also, under the so-called federal safe harbor rule, employers who misclassify workers as independent contractors are protected if they had a reasonable basis for not treating the workers as employees-such as a long-standing industry practice. (See CEA August 1996.) To qualify for this safe harbor, there are several requirements, including showing you filed 1099 and 1096 forms and consistently treated similarly situated workers as independent contractors.

State Criteria Less Flexible

California, however, has no comparable provisions. If the worker doesn’t meet the state’s test for independent contractor status-which is similar to the IRS’s 20 factors-you could have to pay back unemployment taxes, employment training taxes, state disability insurance and personal income taxes.

Four Ways to Protect Yourself

One of the main points California focuses on in deciding the legitimacy of an independent contractor classification is whether the person really runs a bona fide separate business. With this in mind, some employers are beginning to require contractors to act more like businesses and less like employees. Here are some approaches to consider:

  1. Insist on business formalities. Robert L. Sommers, a San Francisco tax attorney, says you should make sure independent contractors use company or business names. They should also have a business license. Plus, it’s a good idea to require contractors to obtain an IRS employer identification number instead of using their personal social security number-even if they have no employees. These steps will help bolster your position that the contractor is actually an independent business rather than an employee.
  2. Require stationery and business cards. Independent contractors should have printed stationery and business cards showing their business name. Their answering machine or voicemail message should also use the business name.
  3. Request invoices. Invoices should be on the contractor’s business stationery. And although not mandatory, it usually looks better if the contractor is paid by the job rather than by the hour.
  4. Review contracts. Finally, make sure your written independent contractor agreements include a provision requiring the contractor to cooperate with you in the event you are audited. In particular, they should agree to produce their relevant tax returns and documents.