Why Misclassification of Independent Contractors May Lead to Tax Audits

If you have received a TWC Tax Audit letter from the Texas Workforce Commission (TWC) Regulatory Integrity Division you should read this article.  If you are a Texas employer, you should be aware of the Agency’s enforcement division that is charged with collecting delinquent taxes and enforcing other aspects of the unemployment tax laws.

The Texas Workforce Commission (Commission) has effective processes and controls in place to verify that employers who are subject to unemployment insurance tax are paying what they owe.  The TWC looks for Texas employers who have misclassified workers as independent contractors when those workers are in fact employees; in such a situation, the TWC seeks to collect tax payments and penalties for the State of Texas.


To give you some perspective, the Commission collected $2.1 billion in unemployment insurance taxes from 450,966 employers in 2010.  The Commission has enhanced its unemployment tax collection  efforts against delinquent or unregistered employers.

Why Does the Commission Audit Texas Employers and Businesses?

The Commission is required by federal guidelines and the Commission’s own polices under Texas employment law to conduct Unemployment Insurance Tax Audits.  The U.S. Department of Labor established performance measures for tax audits. In calendar year 2009, states were required to audit 2 percent of their active employers. The U.S. Department of Labor also requires that 1 percent of all tax audits cover “large” employers or employers with 100 or more employees.  In 2009, the U.S. Department of Labor reported that the Commission met or exceeded that performance measure by conducting 9,067 tax audits, or tax audits of 2.0 percent of the 444,935 liable active employers.  Of these 9,067 tax audits, 163 (1.8 percent) were of large employers.

In addition, the Commission completed 21,446 tax audits from September 1, 2008, to January 31, 2011. These tax audits resulted in an additional $563,625 in taxes due to the Commission and the identification of 15,289 misclassified workers. Not only are the tax audits required by state and federal guidelines, they also generate taxes and penalties for the state and federal government. The tax audit helps bring Texas employers in compliance with the state laws on employee classifications.

TWC Enforcement Division is organized into regions

TWC Enforcement Division is organized into regions for Tax Audit Purposes

How are employers identified for Tax Audit?

The Texas Workforce Commission (Commission) identifies unregistered employers using data from the U.S. Internal Revenue Service, the Texas Office of the Secretary of State, and the Texas Office of the Comptroller of Public Accounts.  The Commission reviews the annual filings of Texas employers with the records filed with the IRS.  If the Commission discovers that a business filed return with the IRS but failed to establish a TWC account, an audit will be triggered.  If the Commission discovers that a business has more employees reported to the IRS than what is reported to the Commission, an audit will be initiated. Sample audit notice letters are found here.Sample Tax Audit Letter Sample Tax Audit Letter (2)  The Commission also has audit procedures that are triggered by TWC unemployment filings by employees that claim they were misclassified as independent contractors.  Even though independent contractors understand their status, they often file for unemployment after termination and let the Commission determine if they are employees and eligible for unemployment benefits.  One of the most common reasons why IRS or Commission audits are triggered is the simple employment disputes.  An independent contractor may be unhappy with work condition or wages may turn in in the company to the Texas Workforce Commission or the IRS or the Social Security Disability Administration. The most important issue in those instances is whether or not the independent contractor was a missclassified employee.  It is important that when an employer is appealing a claim for unemployment benefits filed by a former independent contractor, they get counseling from a Texas employment lawyer.  The attorneys at the Tran Law Firm counsel small and medium business owners on the proper way to classify employees and to set up wage and hour practices that are in compliance with State and Federal employment laws.  When a company has missclassified a worker as an independent contractor, there may be wage and  hour violations that lead to an investigation by the Department of Labor. The Department of Labor often audits employers that have large labor forces with frequent missclassification trends; some example would be the construction and marketing industries.

As a taxing authority, the Texas Workforce Commission must carry out several responsibilities with regard to the state unemployment tax imposed on employers of Texas employees.  Among the more important of those responsibilities are keeping track of all wages paid, reports submitted, chargebacks from benefits paid to former employees, and taxes paid by each employer.  The access to tax and wage information allows the Commission to help TWC’s Regulatory Integrity Division in collecting delinquent taxes and enforcing other aspects of the unemployment tax laws.  As a result tax audits are triggered in several ways.

  1. TWC may perform a random audit of the employer as part of its goal of auditing about 1% of all businesses every year.
  2. A former worker may file an unemployment claim.  If no wages were reported for that claimant by the employer, the claim may be disallowed, in which case the claimant will probably appeal.  This appeal red flags the account to the TWC that there may be a misclassification of a worker as an independent contractor instead of an employee; or worse, the worker is being paid under the table.  The Tax Department will investigate, and such an audit has the highest priority; it must be completed within 30 days.
  3. A business competitor, worker or any individual (usually worker’s family member) that is aware of the misclassification of employees as independent contractor may report a company.  The Tax Department will audit the company’s entire workforce and keep the source of its information confidential;
  4. IRS audits triggers TWC audits or vice versa;
  5. Department of Labor (DOL) audits for wage and hour violation triggers TWC or IRS audits;
  6. Social Security Administration red flags a suspicious reporting of an employee or groups of employees.

Compliance Tools Available to TWC

With a successful audit, the TWC’s Regulatory Integrity Division has several enforcement tools to bring what they think are delinquent employers into compliance.  The Commission can assess interest and penalties on unreported wages and unpaid taxes; notice of assessment; liens; bank freeze and levy; warrant hold; posting of a bond to continue employing workers in Texas; injunction; and even receivership.  Employers found to have misclassified employees as independent contracts faced all of these penalties by the State of Texas and possible Federal Tax audit and penalties assessed by the Internal Revenue Services (IRS) or the recoveries of unpaid wages and penalties by the Department of Labor (DOL).

What to Do When You Get a Tax Audit Letter

Hire a Texas employment lawyer that is familiar with Texas and Federal employment laws on employee vs. independent contractor status.  An employee should not be judged solely by the TWC’s 20 factors.  Both state and federal case law can be used to determine employee status.  A key point to remember is that statements made during the TWC appeals process and TWC Tax Audit can be used against the company in a subsequent IRS audit.  Violation of U.S. Tax laws can lead to additional fines, penalties and criminal prosecution.

An employer receiving a notice that a tax audit will occur should try not to panic. The main purposes of an audit are to review an employer’s payroll records and to try to discover misclassified wages that should have been reported and taxed.  Many audits result in no finding of anything wrong and are finished within a few hours, depending upon how well the employer has been keeping records of workers and payments to workers. The process may take longer if large numbers of workers are involved, or if the employer’s records are incomplete or inconsistent.  A Texas employment attorney can handle most of your communication with the TWC, and can help you evaluate and present your case on whether employees have been misclassified as independent contractors.

Certain records must be kept under TWC statutes and regulations.  Business records which may be needed for a TWC Tax Audit includes:

  1. name and address of each employing unit
  2. address of the main (central or HQ) office of the business
  3. addresses of the employing unit’s branches and divisions in Texas
  4. names and addresses of owners, partners, officers, and/or directors
  5. address where business records are located
  6. payroll records and pay records for independent contractors
  7. in the case of a group account, the address of the group representative.

Records that must be kept on individuals performing services include:

  1. name, address, and Social Security number
  2. dates of employment and state or states where service is performed
  3. wages paid in each pay period
  4. dates on which wages are paid
  5. remuneration in forms other than cash (this is also important in Texas Payday Law cases)
  6. pay periods during which the individual works less than full-time
  7. job descriptions specifying duties of each worker
  8. records on workers other than “employees” (statutory non-employees, independent contractors)

TWC Tax auditors sometimes ask for several different kinds of documentation, depending upon the nature and purpose of the audit. More documentation might be required if one of the questions to be settled is the nature of the employing unit itself, since there are some differences in taxes between corporations and sole proprietorships and partnerships. There is no real alternative to supplying the documentation. If documentation needed for a decision is not available, then the tax examiner has the authority to base the decision on the best evidence that exists, which may or may not result in a decision you like.

Texas employers who are responding to a TWC Tax Audit or designing a document retention protocol should assemble and maintain the following types of records:

  • All cancelled checks
  • Time cards
  • Cash vouchers
  • Cash disbursement journal
  • Petty cash
  • Individual earnings records
  • Check register
  • Records of bonus or incentive pay
  • Payroll records
  • TWC tax reports
  • IRS Forms 940, W-3, and W-2
  • General ledger
  • IRS Forms 1099, 1096 and
  • Master vendor files
  • Chart of accounts
  • Profit and loss statement
  • Company ownership and change of ownership records
  • Corporate minutes
  • Corporate charter
  • Federal tax return (1040, 1120, 1120S, etc…)
  • Any other records which may reflect services rendered by the individuals in question

It is important that business owners not handle Tax audits without the guidance or assistance of an experience attorney or tax consultant.  One of the reasons for this is the inadvertent release of information or statement to a government investigator that leads to a wider investigation or worst a finding of missclassification.   An example would be the release of company records that exceed the scope of the investigation when a more narrow more responsive disclosure would suffice.  It is better to classify employees correctly in the first place but it is never to late to start all over and get in compliance once the inadvertent mistake has been discovered.

The attorneys at the Tran Law Firm LLP provide employment law services to individuals and companies in Texas. Call us at (713) 223-8855

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