A tax audit letter from a government agency can sink even the hardiest of business owner’s stomach. Yet, a tax audit letter from the Department of Economic Security (DES) may not create the same sense of dread. These audits typically involve low dollar amounts, which may lure business owners into a false sense of security. However, a DES audit should put business owners on high alert. Although the dollar amounts may be low, a determination by DES that a business’ independent contractors are actually employees creates precedent that can lead to additional scrutiny at the state and federal level. Such a determination may be used against the business by Arizona’s Department of Revenue, the Department of Labor, the Internal Revenue Service, and even a disgruntled worker claiming unpaid overtime. In short, ignore that audit letter at your peril.

The crux of the audit will likely be whether DES concludes that a business’ independent contractors are actually employees. That test involves looking at the substance of the parties’ relationship and the hiring party’s degree of direction, rule or control. The regulations on the matter provide twelve indicia of direction, rule or control, which are:

  1. Whether the hiring party has any authority over a contractors’ assistants;
  2. The extent of the contractors compliance with the hiring party’s instruction;
  3. Whether the hiring party requires any oral or written reports;
  4. Whether the hiring party requires the work to be performed at a specific location;
  5. Whether the hiring party requires that a specific individual perform the service;
  6. Whether the hiring party establishes the work sequence / order that the work is performed;
  7. Whether the hiring party has the right to discharge the contractor;
  8. Whether the hiring party sets the hours of work;
  9. Whether the hiring party provides any training;
  10. The amount of time the contractor spends working with the hiring party;
  11. Whether the hiring party provides the contractor with tools and materials; and
  12. Whether the hiring party reimburses the contractors’ expenses.

The regulations also provide six additional factors that tend to show independent contractor status. These factors are:

  1. Whether the contractor makes him or herself available to the public;
  2. Whether the compensation is tied on a per project basis;
  3. Whether the contractor can realize a profit or a loss;
  4. Whether the contractor is contractually obligated to perform a project; and
  5. Whether the contractor has simultaneous contracts with other hiring parties.

In analyzing these factors, DES will review documents, interview contractors, and interview the hiring party’s principals and employees. DES may even visit the hiring party’s place of business. It is critical that DES receives accurate information during this process. Loyal employees may provide incorrect information because they are “only trying to help,” and the independent contractors may be less than honest because they have a vested interest in being reclassified as employees. Audits, and even appeals, have been adjudicated based on an incomplete or incorrect statement from a principal, contractor, or employee.

When contacted by DES, Arizona business owners should seek the advice of competent legal counsel to prevent a small problem from multiplying into a business-threatening concern.