Independent Contractor Compliance Blog

Last week I introduced the infamous Layered Defense Strategy Argument.  Over the next few articles, I’m going to break down each part of the argument into separate treatments, so we can see the flaws.

The First Layer:

Only between 2 to 5% of employers are audited in a given year, so the odds of being selected for an audit are very low and in our favor. If I could consistently get 95% to 98% odds of winning in Las Vegas, I’d quit my day job.

The statement sounds pretty good, and taken as a pure, isolated academic fact, it is true.  However, don’t be misled by statistics. The 5% is of the total, raw employer population (i.e. the entire universe of all employers), which is over 1 million businesses in California. This means over 50,000 businesses are audited by the government in California each year for employment tax or labor issues. However, who is selected for an audit is not a straight statistical calculation of the total population. In reality, the population considered for an audit is much smaller, which makes the 50,000 proportionally much larger.

What can flag your account and increase the probably for (or almost guarantee) an audit:

• A claim for unemployment (UI) or disability (DI) benefits by anyone who worked for you and was not reported as an employee,
• A consultant who is injured on the job,
• Co-employment, civil law suites,
• Complaints by competitors or former workers
• You file an appreciable number of 1099s (I’ll explain later)

Actually, this list is not complete. In my seminars I provide a list of over ten major events that will get your company selected for either a state or federal employment tax audit.

When a business experiences one of these events the probability for being audited shoots up to the top of the list. The raw, 50,000 number cited above, actually comes from a more exclusive population that has been curried and vetted from the general population. Businesses that have none of the “Flags” are excluded from the potential audit population, because tax agencies publically acknowledge that an estimated 80% of businesses are substantially reporting correctly.  Therefore, they almost never select a company for an audit at random. There is not an audit lottery. That cuts out about 80% of all businesses from being considered for an audit.

So now let’s re-do the math. We’re now selecting the 50,000 businesses that are audited each year from a total population in California of approximately 200,000 (20% of one million). If your company is flagged as part of that group your odds for being audited just shot up to 25%.

50,000/200,000=.25

From that new , the government refines the list further by applying the following Risk Factors:

• Number of potential misclassifications:
  • For example, your company has had several claims recently for UI or DI benefits by individuals not considered your employees. 
  • Another sure fire way to be noticed is by filling a large number of 1099 MISC each year. The IRS estimates 48% of all 1099′s represent misclassified workers.  Based on that estimate, if you issue fifty 1099′s in a year, statistically you have a potential of misclassifying 24 workers. That number will insure you make the final cut. A lower number may also get you in-keep reading.
• Medium-to-large dollar amounts of the potential misclassified wages How much is that?  It depends, but in general over $15,000 for the state and over $100,000 for the federal will put you into the finals (the amount is flexible depending on other issues-keep reading).
• Some industries are higher priority than others because historically they are more prone to misclassify their workers. The list varies from time-to-time and by region.  \You probably know if you are in an industry that falls into this category.

If you have any one of the above Risk Factors, you made “The Playoffs” to be selected for an audit.

The weighting for final selection varies by geographical region.

Two businesses with substantially the same risk factors, but in different geographical regions, may be at different risk levels for an audit. It isn’t fair, but it’s a fact. A business, with the same factors as another business that’s selected for an audit, may be ignored in a different region. This is because each local tax audit office generally selects business to be audited in their area. 

Each office gets a zip code divided list of businesses that appear to have audit potential in their jurisdiction. This list provides a variety of information about the companies, but what we’re interested in is that it indicates the dollar amount paid and number of “possible misclassified workers” for each business. From that point the person responsible to set up audits in that office selects those with the most potential first, and then goes down the list until all the personal resources available in the tax office are utilized. So the odds can change dramatically depending on:

• Where you are located
• Who are your neighbor-competitor businesses
• How many auditors are available to work the list

If you are looking for a simple answer…

I’d estimate the odds of being selected for an audit are close to 90% if your company has one or more of the Risk Factors listed above.

What’s next?

Even if you are selected, your attorney is confident you will beat it-either at the audit level or in appeal. Right!