Just got audited for worker misclassification - warning to others

Posting this as a warning to others. My startup just got hit with an IRS audit for worker misclassification. We had 6 "contractors" who the IRS says should have been W-2 employees. Now we're looking at back taxes, penalties, and interest going back 3 years.

The total damage is looking like $180K+. We're a small company - this could sink us.

What triggers these audits? How do other companies structure this correctly? I thought as long as we used 1099s and they signed contractor agreements, we were fine.

Sorry to hear this. Unfortunately, signing a contractor agreement doesn't determine classification - the IRS looks at the actual working relationship. The three main factors they examine:

• Behavioral Control: Do you control how/when/where they work? Set their hours? Require them to be in office?
• Financial Control: Do they have significant investment in their own equipment? Can they profit or lose money? Work for other clients?
• Relationship Type: Are they integral to your business? Do they get benefits? Is the relationship ongoing with no defined end?

If most answers favor "employee," a contract saying "contractor" won't save you.

Common audit triggers I've seen:

• A contractor files for unemployment after you end the relationship
• Contractor files SS-8 form asking IRS to determine their status
• State agency (EDD in California, etc.) flags you during routine audit
• 1099 amounts look suspiciously like salary (same amount every 2 weeks, year after year)
• Whistleblower complaint from current/former worker

@StartupSteve - was there a specific trigger you know about?

Yeah, one of the contractors we let go filed for unemployment. California EDD denied it initially, but then they opened an investigation into our company. That's what triggered the whole thing.

The EDD audit led to an IRS referral. Now we're dealing with both state and federal issues.

California is brutal for this, especially after AB5 passed. The ABC test there is much stricter than the federal standard.

Under AB5, a worker is an employee UNLESS:

• A: Free from control and direction in performing work
• B: Performs work outside the usual course of your business
• C: Engaged in an independently established trade/business of that nature

That "B" prong kills most tech companies. If you're a software company and you hire a "contractor" to write software... they're doing work in your usual course of business. That alone makes them an employee under California law.

Let me break down the potential penalties since I don't think people realize how serious this is:

IRS Penalties for Misclassification:

• 100% of employee's share of FICA that should have been withheld
• Employer's share of FICA (7.65%)
• Federal income tax withholding (can use safe harbor of 1.5% of wages)
• Interest on all back amounts
• Potential 20% negligence penalty or 75% fraud penalty

State Penalties (California as example):

• Back unemployment insurance taxes + penalties
• State disability insurance
• Workers' comp violations (big deal if someone got injured)
• Labor code violations - unpaid overtime, missed meal breaks, etc.

Plus the workers themselves can sue for benefits they should have received. This is why $180K is unfortunately realistic for 6 workers over 3 years.

We went through something similar 2 years ago. Here's what we did differently after:

1. Any long-term work (3+ months) = employee, period
2. Contractors must have their own LLC or Corp, own equipment, own liability insurance
3. Contractors work on defined projects with deliverables, not ongoing "help out with whatever"
4. Never require specific hours or on-site work
5. They MUST have other clients (we ask for proof)

It's more expensive to hire employees but way cheaper than an audit.

Question - what about using staffing agencies? My company uses contractors through agencies. Does that transfer the risk to the agency?

@NewbiePM - Using a staffing agency does help because they're the employer of record. The agency handles W-2s, payroll taxes, workers comp, etc.

BUT there are still risks:

• Joint employer liability if you exercise too much control
• If the agency goes bankrupt or doesn't pay taxes, you could be on the hook
• Some agencies misclassify their OWN workers and you could get caught up in their audit

Due diligence on the agency matters. Make sure they're legit, established, and properly insured.

Update for anyone following: Our tax attorney is exploring the Section 530 safe harbor defense. Apparently if you have a "reasonable basis" for treating workers as contractors (like industry practice or prior IRS audit that didn't reclassify), you might reduce penalties.

Also looking into the Voluntary Classification Settlement Program (VCSP) - you can come forward and reclassify workers going forward in exchange for reduced penalties on past years. Wish we'd known about this before the audit started.

Good move on VCSP - that's exactly what it's designed for. For others reading this thread:

Voluntary Classification Settlement Program (VCSP):

• Must not currently be under audit
• Must have consistently treated workers as contractors
• Must have filed all required 1099s for the past 3 years

If you qualify, you pay about 10% of the employment tax liability for one year, no interest/penalties, and no audit for prior years. It's a great deal if you realize you've been misclassifying.

Unfortunately once an audit starts, you can't use VCSP. That's why proactive compliance review is worth the cost.

I'm on the other side of this - I'm a legit contractor (own LLC, multiple clients, my own equipment) but I'm always worried clients will try to treat me like an employee.

Red flags I watch for:

• Client wants me to use their email domain
• Required to attend all-hands meetings
• Being told when to work, not just deadlines
• Being restricted from working with other clients

If I see these, I push back. Not only for the client's protection but for mine - if they get audited and I get reclassified, it messes up MY taxes too.