The contemporary labor environment has increasingly blurred the lines between employees and independent contractors, but that doesn’t mean the IRS or Department of Labor (DOL) are treating the issue lightly. On the contrary, federal and California state agencies have ramped up enforcement against worker misclassification, recognizing that employers who improperly treat workers as “1099” contractors risk depriving the government of tax revenue and employees of legal protections. Even a single unemployment claim or wage complaint by a let-go contractor can trigger a costly IRS or DOL inquiry, potentially expanding into a clandestine IRS-CI criminal tax investigation if officials determine that misclassification was willful or part of a broader tax underpayment scheme. In short, the IRS and DOL today are laser-focused on businesses’ use of independent contractors, and a high-risk tax audit in this area can carry crippling back taxes, penalties, or exponentially worse criminal tax charges for willfully noncompliant employers.
At the Tax Law Offices of David W. Klasing, our dual-licensed California Tax Attorneys and CPAs understand the gravity of federal and California state worker classification audits. We have nearly three decades of experience helping businesses navigate complex tax and labor laws governing independent contractors in audit scenarios. Our team takes a comprehensive, proactive approach – meticulously reviewing your worker arrangements and records to attempt to ensure they can withstand government scrutiny, and vigorously defending your position before the IRS, DOL, California Employment Development Department (EDD), or any other California state tax agency. We know what auditors look for in misclassification cases and how to resolve disputes efficiently, all while minimizing disruption to your business. For a reduced-rate initial consultation, contact us online or call (888) 640-3408 today.
The IRS and DOL’s Audit Focus on Independent Contractors
Both the IRS and the DOL have dramatically increased their oversight of companies that classify workers as independent contractors rather than employees. This joint focus is no coincidence – misclassification of employees can deprive governments of tax revenue and workers of fundamental rights, making it a prime target for enforcement. The IRS monitors businesses for red flags such as large numbers of Form 1099-NEC filings or anomalies in payroll tax reporting, which may indicate a company is treating employees as contractors to avoid withholding taxes. The DOL’s Wage and Hour Division, meanwhile, actively investigates cases where workers may be denied minimum wage, overtime, and benefits due to being labeled “contractors” instead of employees. Both agencies share a common goal: ensuring workers are correctly classified so that tax laws and labor protections are fully enforced.
It’s essential to recognize that the IRS and DOL apply different legal tests to determine worker status. The IRS uses a form of the common law “control test” (often distilled into a 20-factor analysis) that examines how much behavioral and financial control the company exercises over a worker. If the employer dictates not just what result is needed but how and when the work is done, the IRS is likely to deem the worker an employee subject to payroll tax withholding. The DOL, by contrast, applies the Fair Labor Standards Act’s far broader “economic realities” standard – essentially asking whether, as a matter of economic reality, the worker is in business for themselves or is dependent on the employer. Under this expansive “suffer or permit to work” definition of employment, most workers are employees in the DOL’s view.
In practical terms, however, both tests often yield the same result: workers who look, act, and are treated like regular staff should be on the payroll, not given 1099s. Employers that ignore these standards are finding that IRS and DOL auditors are more coordinated and aggressive than ever in rooting out misclassification. Both agencies can impose substantial back taxes and civil tax penalties, and even refer cases for criminal tax prosecution in egregious, willful misclassification scenarios. In short, the risk profile has never been higher for companies that rely heavily on independent contractors without carefully adhering to the rules.
Common Triggers for Audits (IRS/DOL/EDD)
Most IRS or DOL audits over independent contractor classification don’t happen at random – specific events or red flags usually trigger them. By understanding these common triggers, businesses can take steps to avoid them or at least be prepared to justify their worker classifications.
Unemployment or Disability Claims by a Contractor
If a former “independent contractor” files for unemployment benefits (or a workers’ compensation/disability claim) and identifies your company as their source of work, it raises an immediate red flag. In California state, an unemployment claim by a contractor all but signals to the EDD that the person was actually an employee in substance. Similarly, contractors aren’t covered by workers’ comp or state disability insurance provided by an employer – if they file a claim, agencies suspect misclassification.
Mixed W-2 and 1099 Forms for the Same Worker
The IRS uses information returns to sniff out inconsistencies. If an individual receives both a W-2 and a 1099 from the same company in one calendar year, it invites scrutiny. Often this happens when a business transitions a worker from contractor to employee (or vice versa) without changing their actual duties. The IRS will rightly question why someone performing the same job was not classified as an employee all along. A related red flag is when a business issues no Form 1099 or W-2 at all for a worker who received compensation, paying under the table, which can trigger audits if discovered.
Worker Complaints to the DOL or State Labor Agency
An unhappy contractor who feels they were denied overtime, minimum wage, or benefits can file a complaint with the DOL’s Wage and Hour Division or a state labor office. Such whistleblower complaints are a common way misclassification issues come to light. The DOL can launch an investigation into the company’s pay practices upon receiving a tip, and California’s Labor Commissioner can do the same at the state level. Increasing public awareness of misclassification means workers are more likely than ever to report suspected abuses.
Worker Filing IRS Form SS-8 or 8919
In some cases, a person treated as an independent contractor becomes concerned about their tax situation. They might file Form SS-8 (Determination of Worker Status), asking the IRS to decide if they were misclassified officially. Alternatively, a worker who believes they should have been classified as an employee (and thus had Social Security/Medicare taxes withheld) can file Form 8919 with their tax return to report uncollected payroll taxes. Either action can prompt the IRS to examine the employer’s payroll practices, potentially spurring a full employment tax audit.
Business Characteristics and Filing Anomalies
The IRS uses data analytics (including the Discriminant Index Function or “DIF” scores) to identify businesses with anomalous tax filings. Several patterns can attract attention: a company that reports high payments to contractors relative to wages, especially in roles integral to the business, might get flagged for an audit. Paying people in cash with no payroll records is another red flag, particularly if any of those workers later file for benefits or fail to report the income. Additionally, inconsistencies between what a business deducts as labor expense versus what it reports in employment tax filings can lead to an inquiry. The bottom line is that using many independent contractors in roles that look like regular jobs puts a target on the company’s back.
Keep in mind that federal and state agencies also share information. A misclassification finding by the EDD in California, for example, can be referred to the IRS, resulting in a parallel federal audit (and vice versa). This means one trigger event can snowball into multiple investigations, compounding the danger. To avoid these headaches, it’s wise to address any potential classification issues before any of the above triggers occur – once an audit notice arrives, you’re already on the defensive.
Penalties for Worker Misclassification
Misclassifying employees as independent contractors can expose a business to severe financial and criminal liabilities. The potential penalties are extensive and can escalate quickly if the misclassification is found to be willful.
Civil Penalties and Back Taxes
Misclassification often leads to substantial back tax assessments. Employers may owe back payroll taxes, including the employer’s share of Social Security, Medicare (FICA), federal unemployment tax (FUTA), and state unemployment insurance (UI), plus interest on the unpaid amounts. The IRS can also impose significant civil penalties, including failure-to-deposit penalties (IRC § 6656), accuracy-related penalties (up to 20% for negligence), and steep fines for filing incorrect information returns (IRC § 6721). At the state level, California’s Employment Development Department (EDD) can assess $5,000 to $25,000 per willfully misclassified worker, along with back UI taxes and interest. Moreover, the Department of Labor (DOL) can impose double back wages as liquidated damages if it finds that a misclassification deprived workers of minimum wage or overtime protections.
Personal Liability for Trust Fund Taxes
Misclassification can also trigger personal liability. The IRS Trust Fund Recovery Penalty (TFRP) allows the government to recover 100% of unpaid trust fund taxes (withheld but not remitted payroll taxes) from business owners, officers, or anyone responsible for payroll decisions. These personal liabilities can be financially devastating, as they survive bankruptcy and can lead to aggressive asset seizures by the IRS. California imposes similar personal liability provisions for unpaid state payroll taxes, extending the financial risk to individuals.
Criminal Tax Penalties for Willful Violations
In worst-case scenarios, intentional worker misclassification can result in life-changing criminal tax prosecution. Willfully failing to collect or pay over payroll taxes (26 U.S.C. § 7202), filing false tax returns (26 U.S.C. § 7206), or attempting to evade taxes (26 U.S.C. § 7201) are all federal felonies, punishable by up to five years in prison, substantial fines, and restitution. Employers found guilty can face up to $100,000 in fines for individuals and $500,000 for corporations, plus back taxes, interest, and penalties. The DOL can also pursue criminal charges for wage theft and worker misclassification under the Fair Labor Standards Act, adding further exposure.
Given these severe financial, personal, and criminal risks, businesses must proactively address misclassification issues before they escalate into costly audits or criminal tax investigations.
Contact the Tax Law Offices of David W. Klasing if You Face Worker Classification Issues
Misclassifying employees as independent contractors can lead to catastrophic financial and criminal tax consequences, but proactive legal guidance can significantly reduce your exposure. At the Tax Law Offices of David W. Klasing, our dual-licensed Attorney-CPAs are uniquely equipped to help businesses navigate the complex landscape of employment tax audits. We provide comprehensive services, including voluntary disclosures, and strategic audit defense, to protect you from both federal and state penalties. If you suspect that your contractor arrangements might not fully comply with IRS or EDD standards, we can help you correct those issues before they trigger life changing criminal employment tax investigations.
Early intervention is critical. We can help you determine whether your workers truly qualify as independent contractors under the IRS, DOL, and California’s strict AB 5 standards. If you discover past misclassifications, our firm can guide you through voluntary disclosure programs that may significantly reduce your tax liability, cap civil tax penalties, and avert criminal tax referral. We also handle negotiations with federal and California state tax authorities, aiming to resolve disputes quickly and quietly, without escalating to criminal tax charges. Our experience extends to high-stakes Trust Fund Recovery Penalty (TFRP) cases, where we defend business owners against personal liability for unpaid payroll taxes.
Don’t wait for the IRS, EDD, or DOL to make the first move. If you have received a worker classification audit notice or suspect that your contractor arrangements could be challenged, contact the Tax Law Offices of David W. Klasing for a reduced-rate initial consultation. We will assess your risk, develop a customized compliance strategy, and aggressively defend your rights at every stage of the process. Call us today at (800) 681-1295 or reach out to us online to take the first step toward protecting your business and personal assets.
