What is a classification audit?

A classification audit is an examination by tax authorities reviewing whether workers have been properly classified as employees or independent contractors, potentially resulting in reclassification, back taxes, and penalties. For professional service firms using contractors, classification audits carry significant financial risk.

Key characteristics

• Reviews worker classification

• Can be federal or state

• Examines control factors

• Reclassification triggers back taxes

• Penalties apply to misclassification

• Can cover multiple years

Why it matters for professional service firms

Classification audits carry significant financial risk. Reclassifying contractors as employees triggers back employment taxes, penalties, and interest, potentially covering multiple years. Professional service firms should properly classify workers at the outset and maintain documentation.

Real-world example

6 contractors audited Michelle's firm. Auditor examined: who set the schedule, who provided the equipment, the right to direct work, and integration into operations. Result: 4 reclassified as employees. Assessment: 3 years back, FICA and FUTA plus penalties totaling $42,000. Firm revised classification practices and reduced contractor use going forward.